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March 22, 2021 | In this issue of The Institutional Risk Analyst, we feature a discussion with political analyst and historian Joe Costello about the state of the American political economy in the age of the internet and social media. He's had long experience working in and following American politics. Along the way he's also worked for political campaigns in Nigeria and Tanzania. Joe has written two books: Of By For and The Politics of Technology . "Mugabi" The IRA: Thank you for taking the time to speak to us Joe. How are you holding up in the age of COVID? We’ve been renovating a house over the past month and literally planned the whole job online. And for the record, the wholesale price of a clear pine 2x4 is now $10 in Westchester County New York, whether you buy lumber online or in person. Costello: One of the trends we’ve seen with this crisis, for better but also sometimes for worse, is that the push to go to the screen is massive. It is problematic for society in many ways. The IRA: As one of our favorite mortgage CEOs said to us the other day, you can maintain relationships on Zoom but you cannot build new relationships online. I am not sure that we agree. What is your take on democracy in the age of anti-social media? Costello: I agree with the observation about building relationships online. But the other, more important point is that the screen – television, computer, or smartphone – has never been democratically controlled. And it still isn’t. That is the real problem of pushing people online to conduct many personal and public tasks. When the internet first emerged three decades ago, I thought it had some potential to improve society, particularly politics, but it has not lived up to that promise. The IRA: We learned many years ago that the only free press or media is the one you own. If you don’t have your own soapbox like a Jeff Bezos or Rupert Murdoch, then you are a subordinate. Going back to the earliest days of the republic, Americans of power and wealth have always owned their own propaganda organs. But as we’ve seen with Jack Ma and Alibaba Group in China, Xi Jinping and the Chinese Communist Party will not tolerate competition when it comes to control over the media. How do we give Americans more freedom online without ending up with an oppressive authoritarian model a la communist China? Is the old common carrier concept for regulating the legacy media even a useful point of departure in the wake of Donald Trump and the 2020 election? Costello: Right. In the US, for centuries really, if you were going to start anything political, the first thing you did was start a newspaper. In a Connecticut Yankee, Mark Twain has his character start a newspaper as his first political action. The real question is how you deal with concentrated power, historically that's been politically problematic, industrialization created new ways to centralize. Common carrier started with the notion you'd allow massive centralized power to control a given medium. The IRA: Rush Limbaugh started on cable TV in 1992. He led the vanguard of conservative broadcast media that outflanked the old consensus media channels all Americans depended upon after WWII. American media was government controlled during the great war, which was won by big companies and big banks singing a government approved song. You changed that equation radically in the 1990s. Costello: Tried anyway. In 1992, when I ran communications for Jerry Brown’s presidential campaign, we went around all of the established media. We used cable news, which was a new medium, and also an old but underestimated media called talk radio. We went around the lock that both political parties had on the established broadcast media and they hated it. That’s when I got introduced to the internet. I started speaking to some of the early adopters of the internet and started to look at how it was structured. To answer your question about structure, we need to look at a whole new way of understand and managing distributed networks. We need to better understand how distributed networks function, both technically and politically. When the internet first arrived, everyone thought that the new internet technology would break up existing monopolies in the media, but instead new big players came in and today we have Facebook (NYSE:FB) and the Google unit of Alphabet (NYSE:GOOG) . The IRA: Over a century ago, a Republican progressive named Theodore Roosevelt was able to engage publicly on the question of monopoly power and the big trusts, which of course were controlled by big banks. We rarely hear the use of antitrust laws discussed today. In those days, it was J.P. Morgan’s control of industrial, transformative industries and the railroads that mattered. Today we have broad information monopolies that turn Americans into prey, effectively economic serfs in their own land. How do we take the data away from the data monopolies and return control of data back to the individual? Costello: Looking back at my discussions with some of the early pioneers on the web, they did know that there was a lack of understanding regarding the impact of electronic media on the world, but they all had a terrible lack of political understanding. Thirty years on, we still don’t have a good understanding of this political aspect of technology and particularly how private media and public discourse come together. We get on Twitter or whatever and think that we have a voice. But Twitter is disappearing people and censoring people all the time, yet nobody seems to care. I can’t understand how people are not completely enraged by Twitter CEO Jack Dorsey’s decisions. People think that they have their own platform on the social media channels, but if you are on somebody else’s platform, you don’t have anything. They can disappear you or censor you instantly. The IRA: Dorsey is essentially playing the role of censor just as the CCP in Xi Jinping’s Chinese prison does for over a billion people. In China, all live beneath the state and the party. So, what is the solution? Do we go back to the common carrier model and net neutrality? Costello: No, the common carrier model is a legacy term that lacks a way to address the larger political issues raised by technology. We should have a better understanding of this, but so far, the model has been developed to suit the economic interests of large, publicly owned and financed media conglomerates. We could, for example, do a truly open distributed network for all Americans to use free of the whim and caprice of the owners of private networks. But we did not follow that path. What would that look like? How would that work? The IRA: It is ironic that the original conception of the internet going all the way back to DARPA was a pure pee-to-peer structure. The original goal of the internet was creating a peer-to-peer communications network that could survive a nuclear war. Costello: How the internet was developed and structured has never been well understood, but today we have a private network that is controlled by some very large and very powerful forces. I am not sure, given the economic power of the private networks, how we even get that conversation started. In the end these are all political questions, but our politics at this point are completely broken. The IRA: In the 1950s, there was a national web of smaller publications and radio stations, local papers and broadcasters whose economic power was also local. They belonged to national news networks. The consumer credit bureaus were also local. Fast forward to present day and the tech that rolled up small newspapers and radio stations and credit bureaus simply rolled up into national media and data conglomerates. Humans tend to aggregate. We always seek to maximize profits by eliminating competition. The new technology enables and accelerates corporate concentration of economic power. Are we wrong to expect freedom of expression on private networks? Costello: These are some of the basic political issues that they had at the founding of the American republic, like the questions of free speech and copyrights. The freedom of information is fundamental to any kind of democratic structure. In any free society, you must have freedom of information. For example, Thomas Jefferson was hostile to the idea of copyrights and patents. Jefferson was the most small “d” democrat of the founders. Remember, power is like gravity; it attracts. More and more power gravitates to the large media and data owners. Democracy is decentralized. You cannot have democracy if there is central control, as in the case of China or Twitter. Democracy is decentralized, always was and always will be. The IRA: People vote, so democracy starts with the individual. So to summarize, democracy requires a truly distributed network while concentrated and centralized networks are authoritarian. Seems simply enough. Why don’t people recognize this simple truth? Costello: We are so busy making money in the new internet age that we never take time to think about what we are doing and why. Take an example that most people remember: Napster . Napster was a way to download music, but it had the potential to be so much more because of the distributed nature of the software. Napster was that platform and you could build all sorts of functionality. Napster was killed in the name of protecting artists, but it was about keeping control over the medium. The IRA: What about bitcoin? Isn’t crypto supposed to be decentralized money? Costello: No, bitcoin is an attempt to create money by people who don’t understand money. Money is a political construct. You cannot remove the politics from money as bitcoin pretends because money is inherently political, since the Sumerians. We could certainly see a more distributed payment system in the future, but I don’t think bitcoin fills that role. It’s foolish to think that we can take politics out of money. We need to focus on the political problems posed by the concentration of economic power instead of thinking that we can run away from the problem via bitcoin. The IRA: But back to Jefferson. He said famously that we need a little revolution now and then. Jefferson also said that “commerce between master and slave is barbarism.” Do we have to elevate anti-trust back to the top of the political discussion? How do we restore and protect democracy given that money and politics are inseparable? Costello: That is the least we can do, but anti-trust in a historical sense is not the answer. The anti-trust laws of the early 20th Century are limited by the fact that the lawyers and the economists redefined it based upon whether consumers are harmed. Going back to the old progressive Republican position, the analysis was different and said that democracy cannot tolerate concentrations of economic power. That was the measure, not harm to consumers. We have to create laws, new political structures, and a broader national discussion that says we cannot allow power to be so concentrated. This should be the most important part of our political discussion today. Yet there is no discussion about the concentration of economic power in America today. How do we prevent the Facebooks and Googles from dominating our political life? That is the question we must answer. The IRA: Thanks Joe.

March 15, 2021 | In this issue of The Institutional Risk Analyst , we reflect on some reader comments about the growing number of financial frauds littering the global landscape, particularly in Europe. And we can’t help but notice the number that have ties back to those savvy investors at Softbank . Alan B on the Left Coast reflects that this near-bank called Greensill bears a striking resemblance to Penn Square Bank , an Oklahoma-based lender with offices in a shopping mall that failed in July 1982. “That crappy bank was funded by brokered deposits, ended up taking down some bigger banks and causing a bit of embarrassment among regulators,” notes Alan, who always tends toward understatement. In fact, when the Federal Deposit Insurance Corporation repudiated the loan participations sold by Penn Square, it caused five other banks to fail because of – wait for it – participations in leveraged loans. We wrote in American Banker in May 2016: “The investor exodus away from leveraged loans with exposure to the petroleum sector brings back memories of the 1970s oil bust, an economic shock that led to the failure of Penn Square Bank in 1982, the subsequent failure of Seafirst Bank later in that year, followed by Continental Illinois Bank in 1984. Before its failure, Penn Square technically continued to "own" — and service — loan interests held by other banks with participations. As receiver for the failed bank, the Federal Deposit Insurance Corp. deemed those investors to be nothing more than general creditors of the failed bank's estate. Those participating banks lost their entire investment.” Aside from the lack of stable funding, Greensill was doomed to fail for the same reason that most nonbank finance companies fail, namely that the originate-to-sell model for private loans is inherently unstable and often unprofitable. Only by adding more risky assets to the mix of “supply chain” finance was Greensill able to construct the appearance of profitability and then only temporarily. “Time to turn on the lights and find the rest of the cockroaches,” notes Alan B, reflecting the judgement, which we share, than more revelations will be forthcoming in this latest Softbank project. There is never just one cockroach in a financial mess this large. As more counterparties of Greensill acknowledge their error, the financial loss is likely to grow. The fact that the folks at Softbank reportedly injected $2 billion into Greensill should come as no surprise. Another famous fraud that exploded all over EU regulators last year, Wirecard AG , also featured a large investment by Softbank. Indeed, the Japanese investment fund seemingly facilitated the earlier fraud. The $1 billion invested by Softbank in 2020 allowed Wirecard to raise almost $4 billion in debt leading up to its eventual declaration of insolvency last year . Revelations that the individual principals of Wirecard stood to benefit financially from the Wirecard deception has caused EU officials to start an investigation. But given that the government of Angela Merkel has allowed multiple frauds to flourish during her tenure, led of course by the ongoing fiasco at Deutsche Bank AG (NYSE:DB) , we’d be surprised to sere any actual penalties imposed on Softbank and its shadowy leader, Masayoshi Son . Aside from regulatory incompetence, the reason that frauds such as Greensill and Wirecard are able to flourish is that central banks, by lowering interest rates to unnatural levels, enable dishonest people to lure gullible investors into a trap. Both in terms of market prices and credit quality, volatility is the operative term. “In a ZIRP/NIRP world, every asset feels like a [principal only] PO, and there are scant [interest only] IO assets,” notes our old pal Nom de Plumber , a senior risk manager with a penchant for suing federal agencies. “So, assets generally behave in a digital manner, ping-ponging between 0:00 (extension and default) and 100:00 (prepayment), as you illustrate via accounting treatment. And market volatility and illiquidity go in tandem. Thank you.” By driving interest rates down, central banks not only increase volatility, but provide fertile ground for fraud as investors desperately search for yield in a market denuded of duration. Even the ridiculously thin loan margins offered by Greensill were attractive to investors for a time, but as soon as one investor backed away from buying loans from the nonbank it collapsed into bankruptcy. The common piece in the puzzle in the case of both Wirecard and Greensill is the tendency of EU regulators to outsource basic supervisory tasks. The German regulator BAFIN, for example, is located in Bonn, away from the financial center of Frankfurt. The German regulators actually outsource a lot of the supervision work to external auditors, which was also the key issue in the case of the Wirecard fraud. "The key issue with Wirecard was that the corporate auditing supervision was outsourced by BAFIN to an underfunded mutual entity of the auditor industry which had only 1 staff working on the dossier for 18 months," one insider in Berlin tells The IRA . In Germany, it seems, there are more than enough lawyers to ensure that everyone is following the letter of the law, but few regulators to actually oversee the substance. Meanwhile, below the surface, Europe has become a Wild West of financial chicanery and money laundering. Recall that global audit firm Ernst & Young dropped the ball with respect to the Wirecard fraud, leaving investors defenseless. We note with some astonishment that the bankers at DB just voted themselves higher bonuses even as shareholder dividends remain frozen. But a backlash is forming against the bank’s bonus pool of €1.9bn, which is 16x Deutsche’s net profit in 2020, according to its annual report. About half of that amount is allocated to investment bankers, reports the Financial Times . When outside monitors put in place by US regulators suggested to DB’s US unit that it needed to curtail activities in Vladimir Putin’s money laundering empire, the German Bank rejected the guidance and instead announced that it intended to expand operations in Russia. So much for prudential regulation on either side of the Atlantic. Readers of The Institutional Risk Analyst will recall that DB used “mirror trades” to disguise illegal transactions that helped major criminal organizations, terrorist groups, and drug cartels launder and transfer billions in dirty money. We wrote in our review the important book by David Enrich , “ Dark Towers: Deutsche Bank, Donald Trump, and an Epic Trail of Destruction , ” officials at the Fed and other agencies have never been called to account for DB. Likewise, at Credit Suisse (NYSE:CS) , bankers have just reported losing $10 billion in client money in the Greensill fraud, but will still apparently receive enhanced bonuses for their fine work in 2020. “Deutsche’s payouts would have been even higher without intervention from the European Central Bank,” notes the FT’s Lex column . “Banking’s social contract is constantly rewritten. Paymasters should proceed warily.” But, in fact, the bankers operate with impunity as governments from Washington to Berlin lose the will to enforce the rules. But if we are to hold investment professionals to a higher standard, then what about central bankers? Should we ask the Federal Reserve to provide a cost benefit analysis of monetary policy and financial deception? And maybe, just maybe, somebody in Congress ought to ask Fed Chairman Jerome Powell why DB is still allowed to operate in the US? How much fraud and financial market instability should voters in the US and EU tolerate as a result of low interest rate policies? Perhaps it is time to ask Federal Reserve Chairman Jerome Powell how much fraud and financial abuse the US should tolerate as it travels the road to full employment. As Ed Caeser wrote in The New Yorker last year of the DB bankers who were sanctioned for the Russia activities : “Those who worked above him at the bank continue to thrive, however, and their incompetent, unethical, or simply illegal behavior has gone unpunished. Meanwhile, dirty money continues to pump around the financial system like a pathogen. The FinCEN files, while revelatory, are also dispiriting. It’s hard to escape the conclusion: crime pays.”

Review & Analysis March 12, 2021 | In this issue of The IRA Bank Book , we take a look at the health of the US banking sector as we approach Q1 2021 earnings. The good news is that banks are liquid and well-capitalized, but the bad news is that total credit provided to the US economy is falling. The chart below illustrates the failure of current policy by the Federal Open Market Committee, with deposits soaring and lending declining, led by lower commercial and industrial (C&I) loans. Source: FDIC If we take a closer look at total deposits, the growth in total deposits contrasts with the marked decline in time deposits placed with US banks. As more fiscal stimulus moves into the US economy, Treasury cash held by the Federal Reserve will decline and bank deposits will grow, but there is little indication that further expansion of bank deposits will lead to increased lending and economic growth. Source: FDIC/WGA LLC Bank deposit growth rates slowed overall in Q4 as Treasury cash balances grew but federal outlays were constrained prior to the November election. That said, bank deposits still grew at almost a 5% annual rate in Q4 2020 even as loans fell slightly. The key point is that there appears to be no added leverage in the US economy due to the added bank liquidity from QE. If we broaden the analysis and add the assets sold and securitized by US banks, the data again reveals a decrease in credit creation and business volumes moving through banks. Note that sales of C&I loans have ceased entirely and most other loan categories are down significantly. Bank sales of 1-4 family residential loans are now below $400 billion per quarter and are likely to continue to fall even as the industry has another strong year in terms of mortgage originations. Source: FDIC Even as bank lending and asset sales continue to fall, the cost of funds to the industry is also declining rapidly. This has the effect of boosting short-term earnings, but does little to boost assets returns or bank income over the medium term. For example, in the secondary market for residential mortgages, secured bank warehouse facilities are earning just 1.75% over LIBOR and larger nonbank borrowers are demanding even lower rates. Of note, even as yields on Treasury securities and mortgage-backed securities have risen in the past month, the yield on new loan pools trading in the to-be-announced (TBA) market moved very little. As the secondary market spread available to lenders shrinks due to competition for a dwindling supply of new loans, large nonbank lenders are seeking to defend their profits by lowering the cost of funds from the major banks. Meanwhile, commercial banks as an industry continue to withdraw from both residential mortgage lending and servicing. If you want one picture to describe why the Federal Housing Finance Agency (FHFA) , Federal Housing Administration (FHA) and the Financial Stability Oversight Counsel (FSOC) are worried about nonbanks, here it is below. Source: FFIEC Looking at the chart above, the increase in mortgage servicing by nonbanks is dramatic and again illustrates the retreat of commercial banks from both owning and servicing 1-4 family mortgages. Progressive elements in the American political equation, many of whom have influential roles in the Biden Administration, have effectively made US consumers toxic from a risk perspective. Prudential regulators reinforce this trend of risk avoidance and the depositories have reacted accordingly. Also, we should recall that the risk-adjusted returns on residential loans are negative, even before accounting for reputational risk. Thus, again, the depositories have made the rational decision and are avoiding high-LTV, low-FICO borrowers. Bank of America (NYSE:BAC) , for example, a decade ago turned its back on wholesale and correspondent lending after acquiring Countrywide to the considerable detriment of shareholders. Turning from the balance sheet to the income statement, the US banking industry saw a strong rebound in income in Q4 as credit provisions continued to fall and there were even some releases of reserves back into income. We discussed the outlook for Q1 2021 bank earnings in our recent comment (“ Q1 2021 Update: QE Forever Will Kill US Banks ”). The basic calculus of bank earnings this year fundamentally turns on credit costs, particularly in commercial loans. Whereas a year ago we and most other analysts were bracing for a big uptick in consumer defaults, that result did not materialize. The CARES Act and other federal and state debt moratoria have pushed eventual consumer credit costs out another three to six months. The chart below shows loan loss reserves vs charge-offs through Q4 2021. Suffice to say that we expect to see further reserve releases into income in Q1 2021 . Source: FDIC As one senior regulator told us this week, eventually the forbearance will end and then will come the reckoning. And when the banking industry is forced to again build reserves, income will be negatively impacted. But for now, realized losses (aka “charge offs”) of bad loans are running at very low levels, even with the uptick in commercial loan loss severities, suggesting several quarters of reserve releases lie ahead. The rate of reserve release will depend upon prudential regulators and auditors, who must endorse future bank loan loss projections. Bank Credit Charts Below are the credit charts for the $10 trillion loan portfolio of the US banking industry. We use two perspectives: First, the rate of delinquency and charge-offs is shown. Second, we look at loss given default (LGD), which is the net loss after recoveries. We use the simple form of LGD going back to Basle I because it provides a clean look at how banks are managing credit. In those series tied to residential housing, the shortage of existing homes, and the low interest rate environment and quantitative easing (QE), have badly skewed the LGDs into negative territory. This means that in those rare instances of a default actually going through to foreclosure, the bank pays off the full amount of the loan and takes the surplus back into loan loss reserves. Total Loans & Leases Notice in the chart below that delinquency is rising, but charge-offs are falling, a graphic illustration of the impact of loan forbearance c/o the CARES Act and state loan payment moratoria. Source: FDIC Source: FDIC/WGA LLC Total Real Estate Loans The chart for total real estate loans displays the impact of the FOMC's interest rates policies as well as loan payment moratoria, Source: FDIC As with all bank loan types in the real estate sector, LGD for all real estate loans has been near zero or negative for several years due to QE, but more recently realized losses post-default have begun to trend higher. Source: FDIC/WGA LLC Construction & Development Loans Source: FDIC Source: FDIC/WGA LLC Residential Construction Loans Source: FDIC The data series for residential construction loans is relatively new reporting item for FDIC-insured banks. Notice the huge skew downward caused by a large recovery in this relatively small portfolio. Source: FDIC/WGA LLC 1-4 Family Loans As with the other real estate series, the $2.5 trillion portfolio of 1-4 family loans shows rising delinquency but falling losses, again illustrating the impact of loan payment moratoria. Source: FDIC As discussed above, the LGD for bank-owned 1-4 family mortgages is negative, illustrating the powerful credit effect of low interest rates and the relative shortage of supply for residential housing. Simply stated, in the current economic environment, credit in bank-owned 1-4s has little or no cost for US banks. Source: FDIC/WGA LLC Home Equity Loans As with 1-4 family first lien mortgages, home equity loans also display the powerful impact of rising home prices and falling interest rates, which combined have forced net default rates on HELOCs down to zero. Source: FDIC Source: FDIC/WGA LLC Rebooked GNMA Loans – EBOs Rebooked Ginnie Mae loans are delinquent loans repurchased out of pools of MBS by issuers, who then modify or restructure the "early buyout" or EBO. There was a surge of such buyout activity in Q2 and Q3 2020, in the case of banks led by Wells Fargo (NYSE:WFC) . Nonbanks such as PennyMac (NYSE:PFSI) have been leading purchasers of EBOs as well. Source: FDIC Multifamily Loans Source: FDIC Source: FDIC/WGA LLC Commercial & Industrial Loans Unlike the loan types related to residential real estate, the series for C&I loans displays a relatively normal profile for the pricing of risk. Net charge-off rates are currently being suppressed due to loan payment moratoria. As and when loan forbearance ends, the loss rates are likely to rise sharply. Source: FDIC Source: FDIC/WGA LLC Credit Card Loans Source: FDIC Source: FDIC/WGA LLC Auto Loans As with other consumer-related loan types, auto loans have shown a sharp decrease in net charge-off rates since the passage of the CARES Act. As and when these politically-mandated forbearance programs end, loss rates are likely to rise sharply. Source: FDIC Since the passage of The CARES Act, LGD on auto loans has been cut in half, reflecting both the legal suspension of loan collection efforts and also the increased demand for used vehicles. As and when the legal forbearance ends, we expect to see post-default loss rates return to the 60% long-term average. Source: FDIC/WGA LLC Residential Loan Delinquency Looking at the complex of residential mortgages, overall rates of delinquency are relatively low, but the FHA loan market is an area of concern. Delinquency rates are already above 2008 levels and in some states are over 20%, suggesting that there could be significant credit expenses for lenders and the FHA in the future as loan forbearance ends. Source: MBA/FHA/FHFA/FDIC Industry Outlook We anticipate significant loan loss reserve releases back into income in Q1 2021 and thereafter as banks adjust their loan loss provisions to reflect actual and expected loss rates. The enormous pile of loan loss reserves put aside in Q2 2020 is an order of magnitude too large given current and prospective loss rates. Even as bank earnings are helped by reserve releases in the near term, we expect to see asset returns for US banks continue to fall under the oppressive weight of QE and the FOMC's low interest rate policies. Returns on earning assets for US banks are likely to fall another 5-10bp in the next four quarters. We expect to see credit loss rates at US banks normalize as CARES Act and state-law debt payment moratoria end, but the rates of loss are likely to be well-below 2009 levels. The cure rate for forbearance loans in the US residential mortgage market is ~ 50%, for example. This suggests that bank loan loss reserve levels are far too high and that asset returns, and not credit, are the key areas of concern for bank investors in 2021. The IRA Bank Book (ISBN 978-0-692-09756-4) is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Book. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Book are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Book represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Book is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Book is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Book. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

March 4, 2021 | Over the past several weeks, the US treasury market has shown increasing discomfort with the direction of the Biden Administration and the Congress on fiscal matters. Somehow absurd fiscal policy in Washington was not a problem for global capital markets during four years of President Donald Trump , but that benevolent situation appears to have reversed in the first three months of President Joe Biden’s tenure. The Treasury’s fiscal posture is verging on the ridiculous thanks to both parties in Congress. Even as the economy rebounds and banks show little credit impact from COVID -- so far -- the Democrats in Congress want their trillions in spend to match the profligacy of President Trump. The judgement of the markets on Biden and Treasury Secretary Janet Yellen , however, was illustrated in the nearly failed auction of 7-year Treasury notes at the end of February. “A big move came in the early afternoon when an auction for $62 billion of 7-year notes by the U.S. Treasury showed poor demand, with a bid-to-cover ratio of 2.04, the lowest on record according to a note from DRW Trading market strategist Lou Brien who called the result "terrible," reports Reuters . Even before the auction, Reuters reports, yields on five-year and seven-year notes, the "belly" or middle of the curve, had risen significantly, following weak demand for a 5-year auction. As investors shunned the recent Treasury auctions, primary dealers were left holding more than half of the paper. And it was at this juncture that the idea of Operation Twist magically reappeared on the scene, but so far only as rumor. We hear that Operation Twist 3.0 was discussed by the FOMC, but our colleague Ralph Delguidice says nothing has been decided as yet. With the yield spread between 2-year Treasury notes and the 10 year as wide as seen in seven years, the markets have unceremoniously puked all over the idea of further deficit spending to address the quickly receding COVID crisis. Thus, the FOMC it seems must now ride to the rescue of the Treasury. Most news reporters and economists will tell you that the FOMC’s purchases of Treasury debt and mortgage-backed securities (MBS), which is labeled "quantitative easing," are some sort of economic policy action. In fact, the Fed’s purchases of Treasury debt represent a subsidy to the US government at the expense of private investors. And as the Treasury’s fiscal situation grows ever more precarious, the FOMC is forced to essentially maintain a market in Treasury debt when the primary dealers are overwhelmed. Like right now. In one sense, we should all treat the selloff in bonds over the past couple of weeks as a gift, a rare buying opportunity borne of volatility the occurs amidst the general drought of duration engineered by the Federal Reserve Board. Think of the Federal Reserve Bank of New York as a giant financial sump pump, sucking the available duration from the Treasury debt and agency MBS market in vampiric fashion. The Fed then remits the income from these assets to the Treasury, depriving private investors of a return. A remarkable form of stimulus indeed. But more important than the transfer of interest income to Treasury is the emerging fact of the FOMC standing ready to unconditionally support new US debt issuance in the bond markets. This is a disturbing development for all investors in dollar denominated assets. Like a great black hole in space-time, the FOMC is sucking the resources out of the private economy in order to feed public sector deficits in Washington. President Biden and Italian Premier Mario Draghi have more in common than they know. Now we can all join (gloved) hands, sing kumbaya and pretend that QE is about forcing down interest rates to help reach full employment and income equality. But increasingly it appears that the FOMC is hurting the US economy by facilitating public debt issuance, something that is ultimately a political problem. In so doing, the Fed is coming dangerously close to violating one of the key tenants of the Federal Reserve Act, namely having the central bank buy debt directly from the US government. The fact that the FOMC purchases the Treasury debt via the primary dealers is technically correct, but no more. When the primary dealers are already awash in Uncle Sam's IOUs, then the Fed becomes the proverbial buyer of last resort. The Treasury and the Fed are alter egos, after all, whose separation is a political fiction. One treats a dollar as an asset and the other as a liability, but both are captive to the collective obligations of the United States. Effective if not actual default by the United States, when the Fed is forced to buy an entire Treasury auction, seems to be merely a matter of timing and the vagaries of the global markets. Even with QE and the possibility of Operation Twist 3.0, the markets may simply walk away one of these days. But until then, we'll all just keep on dancing. As our friend Joe Costello likes to remind us, Americans are not very good at dealing with the obvious.

In this issue of The Institutional Risk Analyst , we present five key relationships that describe the progress of US depository institutions since March of last year. The good news is that the dip in earnings and asset quality is far less than the 2008 crisis, suggesting that the economic pain affecting millions of Americans due to COVID is not hitting US banks. The bad news is that the Cares Act and state debt payment moratoria are concealing the true credit cost of COVID – for now. And ugly is the state of bank asset returns as we approach year one of QE 5. Source: FDIC The chart above shows asset and equity returns for all US banks through December 31st of 2020. Note in particular that while equity returns in the form of earnings have rebounded in the short-term due to sharply lower credit provisions, asset returns have not. Indeed, although the yield curve has steepened in the past month, this due to the glaring lack of credibility with the bond market of the Biden Administration, the investment returns available to US banks remain muted and are declining. Banking industry income rose in Q4 2020 due to declining credit costs, which dropped to just $3.5 billion for the entire industry in Q4 compared with $14.4 billion in Q3 and $61 billion in Q2 2020. Likewise funding costs for US banks fell to 2015 levels of just $11 billion for almost $21 trillion in bank assets. As the chart below illustrates, bank income has recovered but the Fed has not yet allowed dividends from insured banks to their parent holding companies to resume pre-crisis levels of payout. Source: FDIC The pivotal role of provisions in the bank earnings outlook is even more important than usual because of the lack of visibility on future bank credit losses. The loan payment moratoria imposed by Congress via the Cares Act and also by the states via various types of consumer and business moratoria make it difficult to assess forward loan loss exposures. At the moment, regulators are allowing banks to reduce provisions and even return some reserves into income, as shown in the chart below. Down the road, this positive credit trend may well be reversed. Source: FDIC The distortions in loan credit performance caused by the Cares Act and state loan moratoria are shown in the chart of the $11 trillion in total bank loans below. Loan delinquency is rising, but loan losses in the form of charge-offs are falling. Since state and federal regulators are essentially giving banks a pass on recognizing loan losses, loan loss provisions are also falling as shown in the previous chart. How long with this divergence between loan delinquency and actual realized loan losses persist? Until Congress and federal regulators decide to reinstate GAAP accounting. Source: FDIC Aside from the now political question of the timing of recognizing actual credit losses, the larger issue facing US banks is the relentless compression of yields on loans and securities. Via QE 5, the Fed is slowly killing the ability of banks and other investors to generate returns on fixed income assets. From a recent high of 85bp in 2019, the return on earning assets for all US banks has fallen to just 70bp at the end of 2020. While the FOMC may think that tapering purchases of securities is a monetary policy question, the fate of US banks depends upon this calculous as well. Source: WGA LLC

In this issue of The Institutional Risk Analyst, we speak with Ed Kane, an old friend and fellow alumnus of St. Johns College High School in Washington, D.C., about the state of US economy and economic data used to track it. Professor Edward J. Kane teaches at Boston College and has published extensively in the economics and bank regulatory literature. Professor Kane was a founding member of the Shadow Financial Regulatory Committee. He served on this committee from 1985 to 1995 and again from 2005 to 2015. He also served for twelve years as a Trustee and member of the Finance Committee of Teachers Insurance and for about five years as a Senior Fellow in the FDIC's Center for Financial Research. Currently, he consults from time to time for the World Bank. The IRA: Ed, thank you for making time to speak with us. Your comments to us earlier about inflation and the state of prices in the economy since the outbreak of COVID are quite provocative. The dual mandate of full employment and price stability assumes we can accurately measure inflation. Talk about the changes you observe in behavior since the start of the pandemic. Kane: Once people and organizations learn that they don’t have to work physically every day in an employer-owned building, enormous changes in lifestyle become feasible. Many people have found out that they could work effectively from a home office if they can make one. This will allow them to reduce the frequency of costly and inconvenient home-to-business commuting Also with tony restaurants, stores, and theaters shut down, going back and forth to the central city every day does not make a lot of sense. Among other things, this will reduce air pollution in our major cities. The IRA: Always good to look on the bright side. We were located in Midtown Manhattan all of last year, but made the decision to move to Westchester in February. Midtown is basically empty. The office buildings are vacant and many of the retail businesses are just barely hanging on, even after doubling or trebling prices for food and necessities. The cost of operating a grocery or pharmacy or a restaurant in Manhattan is prohibitive when volumes are so greatly reduced. COVID forced people to change their behavior. Because of technology, we and millions of others were able to make that change. Kane: Inertia leads us to go along doing things in the ways in which we have always done them until we experience a major disruption, Then we have to rethink whether and how we might do basic tasks differently. In 1989, for example, I was invited to visit Arizona State University. At the time, I was finishing up a book on the S&L mess. I realized that I could keep my secretary in Ohio busy by making extensive back-and-forth use of a fax machine. That was an early example of working remotely. The IRA: Your comments about inflation caught our eye. We have long believed that inflation in the US is greatly understated and that this has led to the terrible economic and political problem of income inequality. But you have suggested something even more, namely that the response to COVID has scrambled all of the equations and relationships used to measure aggregate prices. How do the Fed and other agencies even begin to calculate aggregate inflation? Kane: This is a really bad time to be focused on macroeconomic data. The example of the forest and the trees is instructive. We can see the forest via macro data, but we miss the individual trees and, in particular, the amount of mortality and replacement of trees that is occurring. Macro data hide the individual changes in different segments of the population. Some of these distributional changes can be quite important. The forest can seem healthy when all of the trees are doing well, but the same conclusion is possible when many species are dying out and being replaced by the expansion of new or more robust species. The blossoming species are better adapted to the environmental changes that are occurring or will occur, but merely counting trees (i.e., looking only at macro data) would fail to surface the extent of this transition. The IRA: We wrote about the land rush caused by COVID and the low-interest rate environment in many markets (" The Great Correction of 2025 "). Rents and home prices in Manhattan are falling, but prices in Brooklyn are rising. How does the FOMC parse this divergent price performance? Kane: In the face of the massive disruption of COVID, we need to ask a basic question: why is inflation apparently so low? The answer is that it is clear that individual prices are far from steady. Prices are stable in some cases but unstable in others. For example, rents in central cities and suburban areas are moving in different directions. The average change in real estate prices across the larger area might be small. But anyone can see that housing prices across metropolitan areas are not stable. Rents in central cities are falling, but they are rising in the suburbs. Hence, employment in construction is booming to repurpose both spaces. The IRA: Residential home prices nationally rose more than 10% in 2020. In some particularly hot markets, home prices have gone up twice that rate. When Treasury Secretary Janet Yellen was Fed Chair years ago, she expressed surprise that more young people were not buying a home. Of interest, that Yellen comment is the single most remarked upon post we’ve ever shared on Twitter. Kane: When the Fed says that inflation is stable, they are missing the point of what stabilization should mean in practical, human terms. Innovative forces have unleashed a lot of growth, but they have also unleashed in the Schumpeterian sense a lot of creative destruction. Things will not go back to the “same old, same old” after this pandemic subsides. The IRA: What do investors and the FOMC do about the basic instability in economic data? Is it possible to get economists to stop focusing on the erroneous macro data and start looking at the trees instead of assuming a homogenous forest? Kane: It is really a question of refocusing the questions we ask. Macroeconomics has for many years been painted as the central story economists have to tell. This seems so because, for a long time, we did not see substantial and sudden variation in prices for goods and services that can each perform more or less the same function. Now we are starting to understand that the news about the behavior of prices should be reported differently. The media have to report the good news and the bad news. Not just the average news. The average economic news does not tell you much today and is certainly not the whole story. The IRA: It’s funny you say that Ed. As you know very well, in the world of financial analysis, the first question you ask about a subject is where it stands vs the peers. You segment the population into quartiles and deciles. When we built our earliest bank model in the 2000s at Institutional Risk Analytics, my colleague Dennis Santiago immediately sliced and diced the FDIC data and generated standard deviations and other measures for bank metrics. We conducted a census of banks. But somehow the macro community just “assumes” the average is meaningful. Kane: Average inflation rates, index measures of the rising stock market and suburban building activity, and the GDP growth rate during this business-cycle recovery phase are not the main story. They are part of the story, but the rest of the narrative is about what is going on inside that inflation rate or inside the stock market. What is the standard deviation of prices within the CPI or GDP deflator? This is seldom in the news. Price weights in standard indexes are not reflecting the changes in what and how the Covid plague is re-optimizing the composition of what macroeconomic principles courses call C+I+G. This re-optimization entails reallocating household, corporate, and government revenues and spending plans. More-detailed indexes report prices and equity returns in individual industries. Consider falling prices in airlines, hotels, casinos, restaurants, retail stores and malls. Quantities sold in or by these venues are down even though retail sales were booming last month. Economists have to go inside macroeconomic numbers and ask questions about the weights that deserve to be assigned to individual prices of products and services that are becoming more and less relevant. I believe that the real story is about the lasting shift to more remote working and shopping and the large commercial and office spaces that these phenomena will require society to repurpose. The IRA: Well, we just ordered $10k worth of bathroom hardware and fixtures and never walked into the store. But we had to make an appointment to assemble the order by phone because the vendors are overwhelmed with demand for home improvement. Remember when we talked about everyone moving into the cities and “walkability”? Now they are in the suburbs fighting for the last Kohler toilet in stock at the Home Depot. Kane: Exactly, change is the story. To not stress what is happening to the job mix, work patterns and consumer demand, no matter how good or bad the averages seem, is a major mistake. A lot of people have not accepted the bad news in terms of the asset and human capital revaluation entailed by massive changes in work patterns and workplaces used by the urban workforce. Many seem to be hoping that things will go back to the way things were, back to “normal.” But I am always reminded of the concept of “hysteresis” which basically says we may travel up one path in response to outside forces, but when these outside pressures subside, we should not expect that we will return to the same ways of doing things. We have to recognize that hysteresis is a general phenomenon. Investors, in particular, must ask what kind of paths will unfold if and when we establish herd immunity, and accept that the good old days cannot completely return. The IRA: So how do we get policy makers to stop relying upon macro data and start to consider the particular of micro economics in their deliberations? Kane: I have been working on a book on this which, because of the disruption we are talking about, I may not have time to bring to a finish. The distribution effects of the contra-cyclical policies the Fed has followed over its lifetime have been great for the banking industry and the rich in general, but not so good for ordinary folks. And Fed leaders have just begun to give lip service to softening its adverse impact on the lower and middle classes. The very wealthiest Americans have been positioned politically to influence Fed policies in their favor. This helped business leaders to experience great leaps in their well-being since WWII. However, since about 1970, while members of the upper 10 percent of the income distribution have prospered mightily, ordinary households have not done nearly so well. Fed spokespersons love to claim that “a rising [macroeconomic] tide lifts all boats,” but many families feel themselves firmly stuck in the mud both when the tide comes in and when it goes out. The desire to get a better deal for lower-income households is fueling protest movements and waves of social disruption the likes of which the US has not seen since the 1930s. The IRA: You recall the political compromise that led to Humphrey-Hawkins in 1978. Democrats wanted a guaranteed job for every American, but instead Congress created the dual mandate of full employment and price stability. The FOMC targeted federal funds as the default policy tool and pushed interest rates ever lower, but all the while the purchasing power of the dollar eroded. Is this the source of income inequality today? Kane: During the post World War II era, households that were able to save some of their income and thoughtfully put some of their savings into the stock market have done very well. For example, in reading your newsletter about 10 months ago, I learned about a firm Square (NYSE:SQ) that had positioned itself to take over a lot of the banking industry’s traditional funds clearing and settlement business. After gathering more detailed information about the firm, I bought 500 shares at $28 and it traded at 10x that price this morning. The IRA: The equity bull market over the past half century was essentially fueled by low interest rates, was it not? Essentially, the Fed followed the greatest ever generation through the life cycle and is now enabling them to liquidate their equity holdings. Kane: Interest rates are an important half of the story. Traditionally, we price corporations in equity markets by discounting projected future earnings. What interest rate you pick for that calculation is a critical part of this valuation problem. But as with macroeconomic data, particular firms perform very differently from market-wide averages and indices. The GameStop fiasco with Reddit and Robin Hood is a case in point. But such examples aside, the disruptions brought on by COVID have radically affected valuations, up and down, in many industries. Here, too, we have been forced to experiment and to overcome inertia in order to deal with changes forced on us by COVID. The IRA: In the 1930s, the problem was deflation. The government had no debt, but levered up its balance sheet and bought assets and time. For example, Fannie Mae was created in 1938 to liquefy the secondary mortgage market. Today, we have mountains of debt and scores of assets like commercial real estate that seem moribund. Yet prices for residential housing are soaring. Is the problem inflation or deflation or both? Kane: The problem is disruption. Disruption forces adaptations for managers of everything, and economists and policy makers must recognize this. More than any other time in my professional career, the data upon which decision makers must rely is displaying enormous instability and dispersion. Economic forecasts are diminished by this instability. We know there are important changes underway, but we don’t have much of a handle on the nature of the change. Landlords in Manhattan, for example, must accept that the old habitation patterns are unlikely to ever return. Disruption is the over-riding challenge: to admit what we don’t know and can’t know, but also to accept the fact of change. A friend of mine had a picture of a river strategically located in his bathroom. The caption underneath the picture quoted a Greek philosopher who said “We never pass the same stream twice.” We do know that many industries associated with the travel, leisure, hospitality, the performing arts and retail sectors will never be the same in our collective lifetimes. Families, business, and governments have to face facts. That is the key to investing today in my view. Recalling the concept of hysteresis, we simply cannot expect to go back the way we came. The IRA: Thanks Ed. Be well.

“ We have the tools' to deal with inflation risk ” Janet Yellen Treasury Secretary In this issue of The Institutional Risk Analyst , we focus on the global tendency toward inflation even as economists insist that price increases remain too low. Everything from bank stocks to bitcoin has been lifted in nominal value by the manic actions of central banks, which make assets scarce even as these banksters with PhDs subsidize exploding public debt issuance. Thus long term bond yields are rising in response. Do you think Tesla (NASDAQ: TSLA) or bitcoin are the only assets rising fast in this Fed-induced inflation? No. Can you have inflation and debt deflation at the same time? Yes, this QE-fueled price surge is just a pause in the general tendency toward debt deflation. The confluence of these two facts may mean growing demand for dollars and dollar assets in the near term, not less as some analysts suppose. But little of this helps American consumers in terms of jobs or real income. The flow of new IPOs in the equity markets propelled by special purpose acquisition companies or SPACs illustrates the problem. The special purpose vehicle, of course, is generating returns for the sponsors. Creating investor value is another matter. It is interesting to note that in 2020, more than $12 billion in SPACs were financed via PIPEs, or private investments in public equity. PIPEs “are mechanisms for companies to raise capital from a select group of investors outside the market,” CNBC reports . “But as PIPEs are increasingly being deployed in conjunction with a surge in SPAC mergers, a larger group of fund managers are seeking access to this security, with limits on who and how many can invest. The heightened prevalence of this product is raising concerns about the potential lack of understanding among the broader cohort of SPAC investors about how these investments work.” Even as Washington goes off the rails in terms of fiscal policy and many other aspects of national governance, around the globe demand for dollars and near-derivatives is growing. And even as the purchasing power of the dollar declines, the greenback's popularity grows inversely to value. Liquidity, not quality, is the key criteria it seems. When we hear people talk about the impending collapse of the dollar, we naturally think collapse into what precisely? When we sell dollars, we take what on the other side of the trade? Bitcoin? Gold? Euros? Nope, too small. None of the available substitutes even begins to have sufficient mass to act as an alternative to the dollar. Ponder the dilemma of the Middle Kingdom under dictator Xi Jinping . Even as China attempts to use a “dual circulation” strategy to rebalance the economy away from dependence upon the US and other nations, and toward greater focus on supposed internal demand, it faces few good financial alternatives to export led growth. The yuan is inconvertible and cannot support significant investment activity. Only the dollar is big enough for China’s economy. The tortured liquidation of HNA suggests China remains financially unstable, in part because of the clumsy policies of the Chinese Communist Party. As Barron’s notes , we are still at the beginning of this financial unwind. “It wasn’t cheap credit that led to excesses of HNA or for that matter Anbang , Ant , or Wanda Dalian , but a shift in government policy,” Yukon Huang , senior fellow at the Carnegie Endowment for International Peace and former World Bank country director for China, told Barron’s . The combination of financial incompetence and rigid policies emphasizing state-led growth, seems hardly a prescription for success. Again, the very messy unwind of HNA is the result of deliberate government policy in Beijing. Just as the majority of US economists think inflation is not a problem, a majority of foreign analysts of China believe that the country’s growing dependence upon state run enterprises and party direction is somehow bullish for economic growth. The HNA example suggests otherwise. Meanwhile in the US, chaos reigns supreme. The Congress is in a state of disarray after completing the second, unsuccessful trial of President Donald Trump . The city built upon a swamp is focused upon negotiations for economic rescue legislation, but is a rescue required? Outside Washington, an economic surge led by housing is building due to the latest round of monetary manipulation by the Federal Open Market Committee. The US is in the midst of a bull market in residential real estate that easily rivals the mid-2000s. Not only are home prices currently rising at rates higher than in 2005, but the rate of increase is accelerating due to scarcity of existing homes in many markets. Suburban residential and commercial assets are in great demand, as evidenced by the migration of people and business out of urban centers such as New York City. In upscale destination markets around the country, more than a decade worth of inventory of pricey and thoroughly overbuilt vacation homes has been consumed in the past year. A wave of buyers fled urban areas such as San Francisco, Los Angeles and Chicago for the less crowded climes of Idaho, Colorado, Utah and Montana. None of these folks are waiting for $1,400 checks from Washington. A torrent of smart and entitled money crashed upon these small markets and their residents, causing swings in property values that leave many real estate professionals agape. But aside from the benevolence of coastal cash liquefying often glacial mountain real estate markets, there is not a great deal of benefit here for the US economy. Just another ridiculous and entirely American style misallocation of resources and on a transcontinental scale. When the great correction from the equally great monetary easing comes in 2025 or 2026, prices for homes, stocks and yes even TSLA and bitcoin are likely to suffer. The generic wave of demand for assets will subside and prices will begin to reflect some notion of fundamental value. Just remember that 2020 is likely to be the floor of the next market reset five years out. The price increases between now and then are, well, pure inflation. And after the great correction, the dollar will still be the global means of exchange, but Americans will have lost a huge amount of purchasing power in the process. Inequality will be even worse and legions of Americans will be homeless and without work, trapped in costly urban ghettos where living expenses are astronomical. And all the while, the economists at the Federal Reserve Board and Treasury Secretary Yellen will tell us that inflation is too low.

In this issue of The Institutional Risk Analyst , we compare two major players in the residential mortgage servicing space, New Residential (NYSE:NRZ) and legacy servicer Ocwen Financial (NYSE:OCN) . Although valuations in the mortgage sector have soared since April of 2020, these two firms have not fully benefitted from the low interest rate environment to the same degree. The first difference to note is that NRZ is an externally managed REIT and OCN is a legacy distressed servicer and former thrift holding company. NRZ is managed by Fortress Investment , which is a unit of Japanese hedge fund Softbank (OTC: SFTBY) run by the notorious speculator Masayoshi Son . As we noted in the past, NRZ appears to be controlled by manager Fortress. Both firms are lenders, investors in loans and servicing, and issuers of mortgage-backed securities backed by residential mortgages. And both firms are uniquely tied together by a series of asset sales over the past several years. WGA LLC served as and advisor to OCN from 2017 through 2019. Over the past 12 months, OCN’s equity underperformed to the upside (+24%). NRZ badly lagged the mortgage group to the downside (-43%) after a near-death experience last April. Thanks to the low interest rate environment over the past year and also some considerable operational effort, both OCN and NRZ have seen significant increases in lending volumes. OCN reported $30 billion in total originations in Q4 2020, up three-fold from the $6.9 billion in Q1 2020. NRZ saw originations rise to a lesser extent to $23 billion in Q4 vs $11.4 billion in Q1 2020. The graph below comes from the OCN Q4 2020 earnings presentation. For both lenders, lending margins continue to normalize after the record secondary market spreads seen during 2020. Average margins for OCN were expected to be at 77bp in Q4 vs 149 bp in Q2 2020. Total margins reported by NRZ were 185bp in 2020 vs 156bp in 2019 and 287bp in Q2 2020. Significantly, OCN recently has just announced a deal with Oaktree Capital Management to acquire MSR that OCN will then subservice and provide loan-recapture services. There are two pieces to the deal: a $250 million subordinated debt capital investment in OCN and a ~ $200 million contribution to a MSR Asset Vehicle (MAV) to acquire MSRs. The Oaktree-controlled MAV will lever to ~ $460m in total capital to support $60 billion in UPB. As we noted in a recent comment (“ Update: Commercial & Residential Real Estate, MSRs ”), lending profits are likely to decline during 2021 as competition for a dwindling pipeline of purchase and refinance loans will push secondary market spreads lower. Most issuers we have contacted in the past several weeks report shrinking mortgage backlogs. That said, there remain a number of sources of new purchase and refinance opportunities, in particular as loans currently under forbearance become current and can be sold into the secondary market. Neither NRZ nor OCN are known as particularly strong lenders, thus the extraordinary performance seen in 2020 must be treated as a welcome anomaly. The next trade, reading the Q4 2020 earnings reports from both issuers, is clearly focused on MSRs as prepayments slow and interest rates perhaps rise from the lows of last year. Yet while OCN has recently raised significant outside capital, for NRZ the situation is more difficult since the REIT as a pass-through vehicle cannot retain significant capital. Although NRZ was a significant issuers of non-QM loans in 2019, in 2020 that market essentially evaporated. As a result, the bulk of the new issuance by NRZ in 2020 was in conventional and government MBS. Indeed, one of the biggest deployments of capital by NRZ in Q4 2020 was the purchase of $3.9 billion in agency MBS, hardly a trade that is likely to enhance earnings given the negative returns in that asset class due to high prepayment rates on MBS. The chart below is from the NRZ Q4 2020 earnings presentation. The biggest expense facing both NRZ and OCN at present is the runoff of MSRs due to prepayments on MBS and loans held in portfolio. The high rate of prepayments on the NRZ portfolio drove servicing revenue negative $213 million in Q4 2020. The pressure on NRZ to maintain and grow its common dividend has compelled the REIT to grow leverage on its book to 3.6x at the end of 2020 compared with 2.8x as of September 2020. Meanwhile, OCN (and other issuers, of note) is deliberately taking down leverage below 1x as management calls in legacy term debt. One of the big questions facing both NRZ and OCN is whether they can add to their servicing business in the face of record levels of prepayments on MBS. So far, both firms have managed to originate and/or buy MSRs sufficient to keep their portfolios stable or even slightly growing. But if you look at the calculation of book value for NRZ, for example, income from loan origination and servicing, and investment results at $1.25 per share, just barely exceeded the $1.08 per share in cash flow losses on the MSR. OCN under CEO Glenn Messina has largely stabilized its business model and seems set for modest growth now that the relationship with Oaktree is in place. The biggest assets of OCN, in our view, is the servicing capacity this issuer has available, especially in distressed assets, and the veteran operating team. If OCN can grow its servicing book and position itself as an alternative to price leaders such as industry giant Cenlar FSB , then the added value of high touch distressed servicing capacity will emerge. Unlike OCN, which has integrated itself with the PHH business it acquired in 2018, NRZ continues to struggle with its business configuration. As a REIT, NRZ cannot have taxable operating businesses above a certain size limit without running afoul of IRS rules. Yet the purchase of Shellpoint in 2018 solved some considerable business issues, particularly being able to acquire Ginnie Mae MSRs. Now, however, NRZ has publicly stated the intention to spin off Shellpoint, a decidedly second-tier issuer and servicer of residential mortgages. “With rates plummeting to historic lows last year, our 2018 acquisition of NewRez, formerly known as Shellpoint Partners, put us in a position to consolidate our servicing and grow our origination business,” NRZ CEO Michael Nierenberg told investors. “This has helped to offset some of the amortization we have seen in our MSR portfolio and help to grow earnings for our company.” The acquisition of Shellpoint in 2018 solved an operational problem for NRZ, but also created a problem because the lender is constrained as the taxable appendage of an externally managed REIT. NRZ now proposes to solve this dilemma by spinning off the lender into an IPO. But the market for mortgage IPOs is cooling rapidly. On the subject of an IPO for Shellpoint, Nierenberg commented: “We continue to evaluate what a total separation would mean to the company, meaning NRZ or -- and New Res. So if we think that it will create more value for shareholders by separating the company and bringing it into the public markets it's something that's absolutely on the table. As you've seen from some of the recent either attempts or IPOs that have come out with some of our friends and peers on the mortgage company side, some of them have gone okay, others have not gone as well.” Both OCN and NRZ spend a lot of time talking about the potential benefit of rising interest rates for the value of MSRs. We agree with that view, but wonder how and when we will see a significant increase in interest rates given global trends in the opposite direction. Also, there is the stated policy of the FOMC to continue purchases of MBS. We worry that lending volumes may slow in 2021 and with shrinking secondary market margins, but MSR valuations may remain under pressure even as investor interest in the asset class grows apace. “There is not a lot of yields in the market,” Nierenberg told investors this week with respect to modest, < 3% gross yields available in non-QM lending. “We don't want to chase everything that's out there. We're going to continue to maintain higher levels of cash and think about ways that we could be deploy capital in an accretive way. I did point out that we think MSRs here are very, very cheap.” We agree with Nierenberg that MSRs are relatively cheap given the interest rate environment, but we also note the huge amount of capital and operational resources that are focused on the opportunity in 1-4 family residential mortgages. Every player in the mortgage sector is talking about increased market share in lending and servicing. And every player is adding staff and operations resources to make it all happen before the opportunity passes. Yet when volumes start to fall, whether due to rising interest rates or simply burn-out in terms of available lending customers, the capacity building process will also be reversed and cost-cutting will become the new mantra. Veteran mortgage industry consultant Joe Garret wrote to his clients recently: “We don’t want to scare anyone, but this is a good reminder of just how much volume can drop. Remember 2018 when you were wondering if you should find a new career? The majority of our clients don’t have a contraction plan for when rates someday go back up and loan volume goes down. If you do have such a plan, how about addressing the possibility that rates drop? What if rates drop to 1% in 2022? If you hold too much servicing relative to your expected volume, you could be in trouble.” The fact that NRZ uses the overly-pessimistic production projections from the Mortgage Bankers Association to justify its view of short-term upside in MSR valuations is suspect in our view. We expect volumes to be significantly higher than the MBA estimates, but on lower margins. This means that firms such as OCN and NRZ will be making less on lending, but MSR valuations may not rise as much as expected by either NRZ or OCN – until lenders start to focus again on asset management instead of manufacturing new assets. Bottom line is that both NRZ and OCN have benefited from the low interest rate environment and have strengthened their balance sheets and income statements since April’s market meltdown. Consider the fact that OCN is up 24% over the past 12 months, this after doing a reverse split in 2019. NRZ is down 43% over the past twelve months and bellwether Penny Mac Financial Services (NASDAQ:PFSI) is up 63% over the same period. As usual, the market is right in relative terms, but for reasons that most professional equity managers neither know nor understand. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

Sleepy Hollow | In this issue of The Institutional Risk Analyst , we take stock of the state of things now several weeks since the political transition in Washington. Despite some dire predictions, the world has not ended and, indeed, the Federal Reserve Board is continuing to buy over a hundred billion in securities – that is, duration – out of the market every month. The fact of quantitative easing (QE) forever has not only inflated stocks such as Tesla (NASDAQ:TSLA) but has caused its colorful CEO, Elon Musk , to “invest” $1.5 billion of his shareholders’ money, the treasury funds of the company, in bitcoin. Not only has the fact of QE forever lifted stocks, but it has also changed the behavior of investors. Passive and crypto are in, fundamentals and short-selling are out, when the central bank is overtly depriving private investors of returns to the financial benefit of the US Treasury. There was a fascinating conversation on CNBC yesterday with Carson Block of Muddy Waters Research , a shop that offers diligence based investing. The guest made the case that the fact of passive investing has caused a decrease is short selling, a logical conclusion in our book. But more than this, by targeting the Fed funds rate as a policy tool, the FOMC has forced investors to give up on short-selling strategies in all but the most extreme cases like GameStop (NYSE:GME) . CNBC anchor Becky Quick asked Block whether the rise of passive investing was not the result of the democratization of investing, a lovely sentiment. But no, there is nothing democratic about the members of the FOMC manipulating asset prices to support the political goal of full employment. Thou shall be long forever, is the message from the FOMC, meaning that we shall take long-term value from investors to boost short-term employment for those who do not invest. This was the Faustian bargain struck 50 years ago in Washington via the Humphrey Hawkins law, full employment instead of guaranteed employment. The imperative of full employment has led to the economic endpoint of zero or negative interest rates. Those investment managers and lenders who ignore this imperative to full employment do so at their peril. Of course, nothing lasts forever, especially when the equity market’s emotional center is still governed by the bond market. No less a person than Mohamed El-Erian warns that the bubble shall continue unless and until the FOMC “loses control over long-term bond yields.” But has the Fed ever really been in control of long-term yields? Or is that merely a convenient illusion? Our view, informed by long chats with Ralph , is that the offshore bid is the key factor in the analysis. Equity managers don’t generally understand the world of fixed income or currencies, but they do understand that rising Treasury bond yields are bad for client returns and commissions. The bond market seemed content to tolerate massive US deficits when a Republican was in the White House and that party controlled a majority in the Senate. With the Democrats apparently in control, that calculus may not hold true in the face of tens of trillions in new debt during the four years of the Biden Administration. To us, the imponderable question looking us all in the face is the fact that the FOMC may not be able to further expand QE from current levels. Or put another way, with reference to the chart from FRED above, volatility may continue to grow and long-bond yields could continue to creep higher, especially if Democrats in Congress begin to act unilaterally. Once the FOMC does visibly lose control of the long end of the curve, then the proverbial game may be up. Treasury Secretary Janet Yellen told CNN on Sunday that: “There's absolutely no reason why we should suffer through a long, slow recovery." Such is the hubris of Washington in February 2021, but that may not be the case in the future. Doubling down on more "stimulus" spending after four years of runaway fiscal deficits under President Donald Trump may finally provoke the bond market. “ Inflation is not dead. It is not gone. It has not been tamed,” writes Brian Wesbury, Chief Economist at FT Advisors . “We can see the impact of this affecting markets. The 10-year Treasury yield has risen from roughly 0.6% in May 2020 to 1.2% today. The gap between the yield on the normal 10-year Treasury Note and the inflation-adjusted 10-year Treasury Note suggests investors expect an annual average increase of 2.2% in the consumer price index (CPI) in the next ten years, and those expectations are rising.” One of the key factors that the FOMC considers in its monetary policy deliberations is expectations, particularly about future prices. Based upon our work in the world of housing finance, it is pretty clear that the Fed has succeeded in convincing people that home prices are going to rise for the next several years. In the nuclear winter created by the FOMC, home price affordability is a bad joke – at least so long as the FOMC is buying $60 billion per month in mortgage securities. Remember when Fed Chair Yellen expressed surprise that more young people were not buying homes? The joke's even funnier now, Madam Secretary, as home prices gallop along at double digit annual rates thanks to QE. Yet as we noted in our comment on MSRs last week (“ Update: Commercial & Residential Real Estate, MSRs ”), once the Fed buying of Treasury bills and agency MBS stops, the prices of assets with both positive and negative duration will quickly normalize.

New York | In this issue of The Institutional Risk Analyst , we assign a positive risk rating to Bank OZK (NYSE:OZK) , f/k/a Bank of the Ozarks . We interviewed OZK founder George Gleason back in 2017 . OZK is rightly seen as a bellwether for national commercial real estate (CRE) and also one of the best performing banks in the country. Significantly, Gleason predicts net runoff in CRE loan volumes in the US during 2021. The $23 billion total asset regional lender is one of the more aggressive and better managed CRE players. They eat their own cooking in terms of retaining loans in portfolio. OZK dissolved its bank holding company in 2017 and is now a unitary state-chartered, non-member bank based in Little Rock, AK. This means the bank's sole federal regulator is the Federal Deposit Insurance Corp. Thus OZK does not appear in Peer Group 1, where it could easily figure in the top 10% of large banks about $10 billion in assets. As the chart below illustrates, the bank has seen its price/book value multiple swing wildly in the past year, like much of the rest of the industry. The bank now trades at about 1.1x book vs around 1.8x for commercial lending exemplars such as JPMorgan (NYSE:JPM) and U.S. Bancorp (NYSE:USB) . Back in January of 2019, we wrote: “Long one of the performance darlings in the US banking industry, OZK was known for being a well-run regional bank from Little Rock that had a big footprint in CRE lending nationwide. The common is off 50% over the past year, a reflection of some credit write downs that were not well handled with investors and an expensive name change and corporate name change and restructuring effort that leaves many puzzled.” Financials Group: ALLY, AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, PYPL, SCHW, SQ, TD, TFC, USB, WFC Over the past two years, the bank’s stock has certainly taken a beating with equity investors, resulting in an average market volatility or “beta” of 2 vs the broad market average of 1. But Gleason and his team remained entirely focused on lending and managing credit, and to good effect. Indeed, while many banks in the US have seen net interest margin (NIM) fall steadily due to QE, OZK has actually grown its gross loan spread and its NIM, placing them in a tiny minority of best performing banks led by American Express (NYSE:AXP) . Part of the reason for OZK’s strong performance in terms of NIM was the result of credit loss recoveries from charge-offs taken in earlier periods. But even excluding these one-time returns of capital in Q4 2020, OZK still managed to expand its gross loan spread even as the bank also managed credit losses well below industry averages. And it has basically done this for the past 20 years with great consistency. “Our net interest income for the fourth quarter of 2020 increased for the third consecutive quarter and was a quarterly record $237.6 million, an increase of 10.5% from net interest income of $215.0 million for the fourth quarter of 2019,” the bank noted in its Q4 supplement. “Improvements during the quarter in our core spread and net interest margin, which increased from the previous quarter by 30 and 19 basis points (“bps”), respectively, were important factors in achieving this record net interest income.” In Q4 2020, OZK’s gross loan spread on non-purchased CRE loans was 4.75% vs a cost of funds of 70bp. By comparison, JPM had a gross spread on all loans of 4.49% and the average for Peer Group 1 was 4.35%, as shown below. Source: FFIEC More important, however, is the insight that Gleason provided to investors regarding the outlook for bank lending in 2021 during his investor conference call. He noted during the OZK investor call: “Well of course 2016 and 2017 were really large origination years which you know created a lot of pay-off headwinds in 2019 sort of you know two to three years after a lot of those big time originations and then we had you know got it last year that we expect that a lot of payouts in 2020, the slowing of completion of construction projects because of shelter-in-place orders and the slowing of the transition sort of financing, the bridge financing, permanent financing that takes us out clearly reduced payoffs and in the second quarters and third quarters of last year and pushed those out, we began to see quite a bit of that come back to the table in Q4 and will very likely have a record level of payoffs in 2021 in part because a bunch of payoffs pushed from 2020 to 2021.” Reading between the lines, not only is OZK's Gleason expecting net runoff on its own commercial loan book in 2021, but we would also expect to see mid-single digit declines in all US bank commercial lending more generally this year. Given the current aggressive posture of the Federal Open Market Committee, we suspect that this will come as an unpleasant surprise to many people in Washington and especially at the Federal Reserve Board. Although many banks saw the all-important operating efficiency erode in Q4, OZK instead improved efficiency and reported an efficiency ratio of just 38% at year end, more than 20% lower than JPM and the industry average of 61%. “Our efficiency ratio was 38.6%, and for the full year of 2020, it was 41.4%,” notes OZK. “Our efficiency ratio remains among the best in the industry, having now been among the top decile of the industry for 19 consecutive years.” As with operating efficiency, OZK’s credit performance is also excellent and the bank has managed to outperform its own moderate scenario modeled forecasts for defaults and recoveries. OZK has also outperformed the Peer Group 1 and industry average by a wide margin, as shown in the chart below from the OZK Q4 2020 supplement. By comparison, the net charge-offs for JPM in Q4 2020 were 55bp vs 28bp for Peer Group 1, thus OZK is running well-below these levels of net loss. The bank’s strong credit and recovery function have turned in consistently excellent performance year after year, a fact that ought to impress more investors and risk managers. It certainly impresses the savvy group that hold the bank's debt and equity securities. The chart below from the OZK supplement shows credit performance going back to 2009. OZK notes that “in the Real Estate Specialties Group’s (RESG) 17+ year history, we have incurred losses on only a small number of credits, resulting in a weighted average annual net charge-off ratio (including OREO write-downs) for the RESG portfolio of 11 bps.” Consistency means a lot. OZK has the capital, liquidity and earnings to continue to outperform larger banks. Our only question is whether OZK and all banks with a loan concentration in CRE are going to be able to manage the next 18-24 months, particularly in the market for underutilized urban commercial real estate. It's not about OZK or other banks mind you; it's rather about the excessive price volatility -- aka "inflation" -- injected into real estate markets by the FOMC and QE. Assessment We assign a positive risk rating to OZK because of the bank’s strong operating and credit performance over the past two decades. There was a time when OZK traded at a premium to the larger banks such as JPM and USB. True the stock is up 20% YTD, but that just means that JPM is trading close to 2x book vs OZK's 1.3x book as of today. But then again, nonbank mortgage issuer PennyMac Financial Services (NASDAQ:PFSI) is trading at 1.5x book today. We always thought the name change to "Bank OZK" was a profoundly bad idea. But stylistic points aside, even though OZK did stumble in 2018 and thereby did damage to investor confidence, the bank continued to perform well despite the volatility in the stock. At some point, investors in US banks are going to take notice of this exemplary business and credit performance and reward Gleason and his team accordingly. Be well George. 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.

New York | In this issue of The Institutional Risk Analyst, we speak with Chris Abate , CEO of Redwood Trust (NYSE:RWT) . Mortgage finance professionals know RWT as one of the pioneers of non-agency, non “QM” or qualified residential mortgage production, an important market that exists outside of the heavily regulated world of Fannie Mae, Freddie Mac and Ginnie Mae. The non-QM mortgage market is also adjacent to the $2.9 trillion market for bank-owned 1-4 family mortgages and HELOCs held in portfolio, making RWT an important macro market bellwether for investors and regulators alike. The IRA: You have seen an interesting 12 months at RWT. We started 2020 going gangbusters, then the money markets essentially melted down in mid-March. The Federal Open Market Committee responded with “shock and awe” and bought trillions of dollars in Treasury debt and agency MBS. Walk us through the past three quarters for you, both as an investor and as an issuer of private label MBS. Abate: Interesting is one way to describe it! When the markets started to seize in March, we were in a very similar position to most in the industry. But soon the Fed stepped in and started buying Agency MBS en masse . You saw the bid for conforming loans skyrocket. Jumbos and other non-agency products were left unsupported. Ironically, the jumbo loans were higher quality and ultimately have fared better in terms of credit, but no one seemed to care at the time. The IRA: Yes, we’ve often wondered why the Fed does not get the connection between prime non-QM loans and the bank portfolio market for residential jumbos. Kind of seems like an obvious area for Fed support in times of liquidity stress, but the economists don't seem to get it. The chart below shows the market for 1-4s and HELOCs as of Q3 2020. Abate: We talked about it at the time. But no matter, we pounded our way out of the crisis without any government stimulus and did so without needing any outside dilutive capital. Industry volumes today have been hovering at record levels, something hard to imagine at the depths of the crisis. The IRA: Send a thank you note to Fed Chairman Jerome Powell . But how was April of last year different from say April 2019 and the end of December 2018? Or even 2008? Abate: When people ask what made this crisis in 2020 different than the Great Financial Crisis, we believe it was the ideological misfires by the Fannie/Freddie regulator. The major Wall Street banks, unlike the last crisis, never really wavered and supported mortgage market liquidity. But the GSE regulator appeared to approach the crisis opportunistically, as a way to prioritize GSE profitability over their role in stabilizing the housing sector, presumably in pursuit of their exiting conservatorship. The IRA: Agreed. There is definitely a conflict of visions at work at the Federal Housing Finance Agency (FHFA). When you look at the totality of the rules and decisions taken by FHFA Director Mark Calabria , they really make no sense. We are going to take the GSEs out of conservatorship, on the one hand; but no, we are going to constrain profits and liquidity, on the other. How did you view Calabria’s moves in the middle of last year? Abate: The decisions made in favor of the GSEs and in opposition to supporting market liquidity blindsided most of the industry. We expected the GSEs to be a countercyclical and calming presence rather than inciting panic. The FHFA response was especially bewildering when every other facet of government was working in close coordination to stave off the crisis. For our friends in banking, imagine if the Fed started margin calling the big banks in response to the market selloff rather than supporting the system! That’s how it felt to industry participants, and the trickle-down effects to the non-bank servicers and non-agency sector were unforced errors in my view. The IRA: Well, the GSEs own the $6 trillion in conventional loans and the servicing, so you'd think that they would support their market. But let's talk a bit about the calculus used by the Fed between pushing down funding costs and the inevitable compression of yields. Where do you see yields and the Treasury yield curve over the next 12-18 months? Abate: The Fed faced twin dilemmas when the panic over COVID-19 first erupted early last year. The first was that financial markets froze and stopped functioning. The Fed used the monetary bazooka to release an unprecedented amount of liquidity into the financial markets to stabilize things. With record low benchmarks, investors realized they needed to go further out the risk curve to earn a real return on their capital. Fear of missing out, or “FOMO,” soon became the dominant market psychology and drove financial asset prices to new highs. At this point, it seems like every class of investor has moved down the credit curve in some fashion. The IRA: That is the idea. Twist the risk curve till it bleeds. But do continue with the Fed point. Abate: The second dilemma was that the Main Street economy experienced a sudden and dramatic contraction and the Fed wanted some of the newly-injected liquidity to make its way to the real economy instead. So, they dusted off their Great Financial Crisis playbook and started buying agency MBS. This provided aid directly to homeowners by driving down interest rates and creating a refi boom. We could argue about the effects QE has had on the repo markets and credit, but the Agency purchases have a populist appeal that other Fed actions simply can’t replicate. The IRA: So where do you think the Treasury yield curve goes given the policy mix and QE purchase schedule the FOMC has articulated? Abate: We believe the curve has more room to steepen due to supply of issuance that is required to fund the increased fiscal deficits. That seems like the consensus view and those expectations are priced into the market and traders are likely positioned for that. However, widespread consensus always gives us pause. The long end is likely to be more volatile as 10-year Treasuries trade within a range of perhaps 1.50% to 0.50%. With delays in vaccination rollouts, and real economic devastation to small businesses and certain sectors of the economy (including travel, leisure, and retail), we see some real headwinds to the recovery. Right now, the market is optimistic that large scale fiscal stimulus will have a positive and lasting effect on the economy. A change in expectations could cause the curve to flatten with longer rates rallying back to the middle or lower end of the range I just mentioned. The IRA: Well, seeing 1.5% yields on Treasury 10-year notes will likely get Treasury Secretary Janet Yellen in a tantrum. In a related point, talk about your legacy private label MBS and how that body of assets has fared in terms of credit and prepayments? Abate: Unlike the Great Financial Crisis, where housing led to an economic collapse, housing fundamentals and credit were on solid footing before the COVID-19 crisis. Delinquencies and/or forbearance on our traditional prime jumbo loans increased in the spring and peaked at 3% in early summer. Since then, we have seen a significant decline in delinquencies, and as of the end of 2020, the rate of new delinquencies is currently similar to what it was pre-COVID. The IRA: Your results are good for private label. Net defaults on bank owned 1-4s are still hovering around zero net charge-offs on portfolio loans because home prices and thus post-default recoveries are so strong. Source: FDIC Abate: We’re proud of how our loans have performed relative to the rest of the prime jumbo market. Total delinquencies on our private label MBS program have generally been lower than the market. We think this speaks well to our loan acquisition process, surveillance, and loss mitigation. The IRA: Your experience fits with the narrative coming from the banks, namely that consumer credit is not that bad despite COVID, but volumes of new credit creation did weaken a bit in Q4. How do you think forward delinquencies will look as loans roll off forbearance? Abate: Given the economic uncertainty, we expect industry-wide delinquencies will remain above their pre-COVID levels for quite some time as there are some borrowers who are facing significant financial hardships. Fortunately, home prices have re-accelerated due to the factors we mentioned. This means that while some hard-hit borrowers will struggle to make their monthly payments, home equity is increasing and ultimately should lead to a lower level of losses than just looking at the delinquencies in isolation. The IRA: The big question in the world of mortgage finance is prepayments. As and when refinance volumes fall, we expect to see prepays also slow and asset values for servicing assets to rise accordingly. What is your view on servicing and prepays more generally? Abate: Prepayments have increased for the entire market, and it’s difficult to draw conclusions on our program when you consider that nearly every jumbo borrower has a large incentive to refi. The performance and investor-friendly features of our private label MBS program allow us to execute consistently in the market. We issued new transactions in the market soon after the liquidity crisis passed and have been off to the races since then. The IRA: There are growing signs of life in certain parts of PLS. Banks are again buying third party jumbo production after a six month hiatus. Talk a bit about how the market managed through 2020 and what you expect to see going forward. We hear a lot of traders complaining how tough it is to source new collateral for agency and private issuance. Is the secondary market tight along with the MBS markets more generally? Abate: Because PLS markets were not supported by last spring’s substantial stimulus efforts, there was an immediate pause in issuance activity that caused issuers to seek alternative financing for loan pools that were prepped for securitization. Beginning in the late spring, with yields compressing significantly in areas supported by the government, we began to see the markets open back up as investors needed to put money to work. With substantial cash still on the sidelines, the market continued to strengthen through Q3 and Q4; in the fourth quarter alone we completed four securitizations across our jumbo and single-family rental platforms backed by loans originated since the pandemic began. Our recent deals achieved better execution than our early 2020 transactions, prior to the market dislocation. The IRA: So the general bull market in 1-4s c/o the Powell FOMC will extend across the credit spectrum? Abate: Given the housing market’s tailwinds, including low borrowing costs and investor demand for housing credit, we expect 2021 to be a record year for PLS issuance. As you note, a potential headwind for issuers may be the ability to consistently source collateral – essentially, the difference between a robust flow purchase program such as ours, versus reliance on the bulk market. The depth of our seller base and our discipline of being in the market every day with reliable flow pricing is an important competitive advantage for us. This is especially true now, given increased demand from traditional balance-sheet lenders trying to grow net interest margin while replenishing record amounts of runoff. And as a direct lender to investors in single-family real estate through our CoreVest platform, we can craft our products to fit borrower needs and drive higher client retention rates. The IRA: So feast to famine and back to even bigger feast in just 12 months? What does the product mix at RWT look like in 2021? Abate: The vast majority of our jumbo volume since mid-2020 has been traditional prime jumbo (Redwood Select), however we’ve begun to see increased engagement from sellers on our expanded prime and non-QM program, Redwood Choice. More broadly, the expanded credit sector remains a niche part of the market. Given capacity constraints at originators, the market’s been challenged to source these higher-yielding credits. This will likely evolve further in 2021 – particularly given the revised QM rule, which we expect to survive in the Biden Administration. We still aren’t convinced the rule change is the right one, but it will definitely push more non-QM loans to QM safe harbor. That will help the banks and hurt the predominant non-QM originators. The IRA: Looking ahead over the year, how does the scene look next January for the hybrid REITs and particularly the PLS issuers? Abate: By January 2022, the hybrid REITs will likely diverge between more traditional, passive investors, and those with more focused mortgage banking activities. For now, many remain busy securitizing pre-pandemic collateral and cleaning up their balance sheets. But with the current yield environment, investing in third party assets will become progressively more difficult as more capital piles into the sector. We saw an auction in early January for newly-issued subordinate RMBS bonds in which 25 bidders participated. A year ago, you would have been lucky to see 5-10 bidders. In my view, it’s going to put the focus on accessing the loan “raw material” at the originator level to be able to procure investments and deploy significant sums of capital. That said, we’ve seen what a difference a year can make in this business. The IRA: That is an understatement. And we agree, the crowd around the hoop for all of these secured mortgage assets and derivatives is growing thanks to QE. We'll see what happens as and when the Fed tries to taper. Be well Chris.

New York | Earlier in the week, we wrote to our clients and colleagues in the secondary mortgage market about the growing dichotomy between urban and suburban commercial real estate exposures, and similar residential housing assets. We noted an important article in National Geographic that clearly lays out the long-term situation faced with COVID. Basically, we are years or even decades away from a solution that will restore full function to urban real estate assets: “As COVID-19 continues to run its course, the likeliest long-term outcome is that the virus SARS-CoV-2 becomes endemic in large swaths of the world, constantly circulating among the human population but causing fewer cases of severe disease. Eventually—years or even decades in the future—COVID-19 could transition into a mild childhood illness, like the four endemic human coronaviruses that contribute to the common cold.” In our view, there are two takeaways from the growing body of scientific opinion regarding COVID and the long-term nature of this global health challenge: First, it supports the bull case for suburban 1-4s, home prices and, importantly, residential mortgage servicing rights (MSRs) and eventually residential mortgage backed securities (MBS). As prepayment rates moderate, these option laden assets will appreciate. Suburban commercial assets are also likely to benefit from an extended challenge from the COVID pandemic. Second, it weakens the case for urban residential and multifamily assets, and further weakens the already distressed case for urban commercial real estate (CRE). Commercial buildings in NYC, for example, must eventually be repriced to reflect lower utilization levels. Lack of tourism as well as local use is a huge and as yet undisclosed problem for many CRE assets located in major cities. And the prospect of downward appraisals is a serious problem for the cities as well. Commercial Real Estate At year end, delinquency levels across most commercial real estate (CRE) exposures improved, with the number of properties reported in special servicing actually declining. As we noted in our comment on bank earnings, the fact of COVID forbearance such as the Cares Act and state moratoria are understating default and delinquency rates. Overall delinquency rates remain elevated, 10x pre-COVID levels, and the rate of loans rolling into delinquency also remains high. New issue levels for commercial mortgage-backed securities (CMBS) remain below 2019 levels, but the pace is accelerating. Most of the mortgage-related series is residential, but also includes CMBS. Note that the new issue market for asset backed securities in 2020 remained well-below levels of 2019, as the chart below from SIFMA suggests. Source: SIFMA While there has been short-term improvement in CMBS delinquency rates, it is important for readers to remember that commercial real estate is a chopped salad; all of the assets, locations and financing structures are different. Unlike residential 1-4s, you cannot generalize about commercial real estate or CMBS vintages. And since much of the world of office buildings and hotels is privately owned and financed, the restructuring process is also obscured from view until a major loss event occurs. Suffice to say that despite the huge rally in stocks since last April, commercial REITs were still down 15% over the past year as the markets closed last week, according to KBW. The book value multiple for commercial REITs was averaging just one times book equity. Names like KKR Real Estate Finance (NASDAQ:KREF) at 1x and Starwood Property Trust (NASDAQ:STWD) at 1.2x book are typical. TCW noted recently that single family rental (SFR) bonds actually jumped to 2.58% delinquency in December after never have seen significant delinquency previous to COVID. They also report a growing tide of CRE, SFR and multifamily loans that have received appraisal reductions. For us, 2021 will be a year of revelation and reappraisal in commercial real estate. We expect accelerating repricing and restructuring of CRE assets, particularly those located in major urban areas that have seen cap rates blown out. Yet again, remember the chopped salad metaphor because not all properties are distressed. TCW notes, for example, that hotel financials have skewed the average loan-to-value (LTV) in CMBS to 139% compared to the median of 42% for all loans sold into ABS. Likewise, Fitch Ratings found that the U.S. CMBS delinquency rate fell four bps to 4.69% in December 2020 from 4.73% in November due to strong new issuance volume. This is the second consecutive month of decline, but it is important to note that the CMBS delinquency rate was just 1.45% at the end of 2019. Although US banks were able to release loan loss reserves from consumer loan portfolios in Q4 2020, C&I loans continue to see a reserve build. The credit dynamic at work here is illustrated by the fact the delinquency in real-estate-owned (REO) in CMBS conduits was 0.5% in January of 2020 but rose to 4.5% in December. Perhaps more important, despite the high rates of delinquency, annualized default rates in CMBS and bank CRE portfolios remain very low by historical standards. Whether and to what extent more delinquencies migrate to default will be a key issue in 2021 and beyond. But the fact of a wall of money looking for assets is likely to be depressing reported default rates. New York City Spending the past year in New York City, we watched the collapse of the local, street-level economy in areas that are dependent upon business, commuters, tourism, entertainment and hospitality. Most of midtown Manhattan’s offices and other structures are unused. Commuter volumes are 10% of pre-COVID levels. We estimate that the overall utilization rate for commercial assets located between 34th Street and 59th Street is perhaps 10-15%. Manhattan streets are empty at night and there is little local pedestrian or vehicle traffic. By day, once busy areas such as Central Park South are quiet with no tourists or a large number of former residents. Open spaces provide refuge for the few remaining residents who cannot gather indoors. By evening, the midtown area is largely empty and increasingly dangerous as the streets are left to the homeless and bands of young people on motorcycles . Residential neighborhoods in NYC have fared far better, but the business ecosystem that made the city possible is now gone. In its place we have a survival economy, where prices for goods and services have doubled or trebled. Manhattan restaurants, for example, now erect huts in the street because of the ban on indoor dining and raised prices to absurd levels. Quality Meats on 58th Street We see older cities such as NYC facing a particularly difficult and protracted adjustment. The pricing of all real estate in the five boroughs was built upon a level of utilization and services that is unlikely to be restored anytime soon. Offices, theaters, restaurants and other public venues from the smallest building to Lincoln Center are predicated on a level of utilization and density that may never be restored. This suggests that much of the Manhattan real estate market needs to be repriced downward and perhaps even redeveloped for other uses. While many of the commercial and residential assets in New York are owned privately, by REITs and in CMBS, the direct and indirect economic impact of this adjustment will be substantial. In the near term, the value of both commercial and residential assets in urban areas may be significantly reduced to make financing a reality. And as the new valuation for commercial and multifamily assets in NYC is reached, the City and State of New York will see adjustments in revenues for sales, property and other taxes. Residential Real Estate In contrast with the generally negative situation with respect to urban commercial and residential assets, in the wider world of single-family and multifamily residential properties the outlook remains quite upbeat. Indeed, thanks to the continued purchases of MBS by the FOMC, home prices rose at nearly a 10% annualized rate in December. The fact of rising average loan amounts in 1-4s suggests that a large asset bubble is in formation. We suspect that this situation will persist so long as the FOMC is buying $100 billion plus per month in Treasury debt and agency MBS. Federal Reserve Board Chairman Jerome Powell stressed that a QE taper is not anywhere close. Of note, former New York Fed President William Dudley warns that the longer QE continues, the more difficult will be the taper. Ditto. The FOMC statement confirmed that the central bank will continue to increase its holdings of “agency mortgage‑backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” But a big effect of QE is asset price inflation and the positive impact on loss-given default. Rising asset prices are largely eliminating credit risk for the secured residential mortgage asset class, a situation we expect to persist until 2024 or 2025. The chart below shows loss given default for bank-owned 1-4s including jumbos and non-QM loans held in portfolio. Source: FDIC/WGA LLC In addition, the fact that the large banks led by JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) have once again started to buy third-party production in the jumbo market for 1-4s suggests that the damage done in April of last year is being somewhat reversed. Issuers such as Redwood Trust (NYSE:RWT) and New Residential (NYSE:NRZ) also have resumed originating non-QM loans for sale into private MBS, of note. The good news is that we expect to see at least $3.5 trillion in new 1-4 family mortgages originated in 2021, a bull market volume indicator. As a large portion of the borrowers that were on some type of forbearance programs cure and then refinance, we expect to see delinquency rates fall. This is not to suggest that the industry does not face a problem with delinquency, but the positive environment for home prices is likely to continue due to a shortage of supply in existing homes. There continues to be a strong pipeline for IPOs by independent mortgage banks (IMBs), but our view is that the window is continuing to close along with secondary mortgage spreads. The fact that strong issuers such as Amerihome , Caliber and loanDepot , for example, were reportedly forced to delay or downsize offerings illustrates the difficulty in obtaining support from investors. The chart below shows the MBA numbers for net profitability for IMBs (H/T to Joe Garrett ). Source: MBA While 2020 will clearly be a record year in terms of IMB profits (commercial banks are generally missing this opportunity), we expect to see the secondary market spreads continue to shrink under the weight of competition and a dwindling supply of refinance opportunities. Notice the swing in profits from 2018, when much of the industry was losing money, to 2020. Another measure of IMB profits is gain on sale, which is shown in the table below from the MBA. Source: MBA In addition to MBS, another area that is also being distorted by the FOMC's QE open market purchases is mortgage servicing rights (MSRs), a naturally occurring negative duration asset that is presently changing hands near decade lows in terms of pricing. Many investors are rightly shy of buying MSRs given high rates of prepayments, but when fear rules is when negative duration assets like MSRs are cheap. We note, however, that capitalization rates on conventional 3% coupons were rising last month, according to SitusAMC. Capitalization rates were up for the third month in a row in fact as the Fed of New York focused QE purchases on 2.5s and 2s for the most part. Ponder that. As and when prepayment rates start to slow, in part because of the industry burning through the easy loans, we believe that MSRs and also MBS could outperform other fixed income assets. Residential MBS is currently offering investors negative returns due to early loan payoffs, but could see an increase in value as prepayments slow. Any "taper" by the FOMC will only accelerate that process. Looking at the valuation multiples for new production conventional 4% MBS rising since September, which is roughly when the Fed stopped buying those coupons as part of QE, certainly makes us wonder about the unremarked optionality embedded within MSRs as well as agency MBS.