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In this issue of The Institutional Risk Analyst, we feature a comment by Jim Parrott of Urban Institute in Washington. You can download the full paper with footnotes on Jim's page at www.urban.org. As you read Mr. Parrott's concise description of the latest Preferred Stock Purchase Agreement (PSPA) with the US Treasury, ponder whether the new terms make it more or less likely that the GSEs will be released -- or instead put into receivership. Parrott writes: "By increasing the capital levels again and allowing the GSEs to pay yet more of their dividend in senior preferred shares, the taxpayer appears to come out on the short end of the stick." We noted last week the GSEs will never be worth more than about $250 billion (H/T DL) regardless of how much additional taxpayer money is contributed to the capital of Fannie Mae and Freddie Mac . As Parrott told The IRA, "The real question is whether this ultimately puts them into the hands of private shareholders or those of the government." The Trump Administration Plays Its Last Cards on Fannie Mae and Freddie Mac Jim Parrott Urban Institute January 15, 2021 On Thursday evening, January 14, the US Treasury and the Federal Housing Finance Agency (FHFA) took the last steps on housing finance reform we will see from the Trump administration, an effort they committed to early and mapped out in a 2019 white paper. In this brief, I summarize how the administration modestly increases momentum for the eventual release from conservatorship of Fannie Mae and Freddie Mac (the government-sponsored enterprises, or GSEs) but largely leaves their fate to the incoming administration. The Trump Administration’s Final Push on Reform Treasury and FHFA have changed the contracts by which Treasury supports Fannie Mae and Freddie Mac (the senior preferred stock purchase agreements, or PSPAs), in a manner designed to create momentum for the GSEs’ eventual release from conservatorship and constrain their activities well after their release. Creating Momentum for the GSEs’ Release Treasury and FHFA have amended the PSPAs to allow the GSEs to build the level of capital required under FHFA’s recently released capital requirements (see Parrott, Ryan, and Zandi 2020), or $283 billion. This is a sixfold increase in the current capital limits of $25 billion for Fannie Mae and $20 billion for Freddie Mac. The GSEs will still owe taxpayers a quarterly dividend on their senior preferred shares equal to the entirety of the GSEs’ quarterly profits, as they have since 2013, but the GSEs will be able to pay that dividend through dollar-for-dollar increases in the taxpayers’ senior preferred position rather than cash, allowing them to use their profits to build capital until they meet their required capital levels. Once they hit these capital levels, they will again pay their dividend in cash, but the dividend amount owed will instead be the lesser of either their quarterly profits or 10 percent of the taxpayers’ senior preferred position. Unless the taxpayers’ senior preferred position is written down significantly, the 10 percent option will never be the lesser of the two options. To reach the $283 billion capital requirement, the GSEs will need to build another $248 billion above what they have today and, in doing so, compensate taxpayers with a $248 billion increase in the taxpayers’ senior preferred position. This will bring the taxpayers’ total senior preferred position to an astounding $477 billion, putting a 10 percent dividend well beyond the GSEs’ means. Once the GSEs reach their required capital levels and the cash dividend kicks back in, they will thus once again pay Treasury all their quarterly earnings. Treasury and FHFA also agree that FHFA may release the GSEs from conservatorship once the litigation related to the conservatorship is resolved and the GSEs have built equity capital equal to percent of the GSEs’ total assets (see section 5.3(b) as amended). This authority is limited indirectly by a separate provision prohibiting the GSEs from raising additional equity capital until the litigation is resolved and Treasury has exercised its warrants on 79.9 percent of the GSEs’ common equity. Constraining the GSEs’ Activities after Conservatorship In addition to putting the GSEs on a clearer path out of conservatorship, Treasury and FHFA are amending the PSPAs to constrain the GSEs’ business practices upon their release from conservatorship. The PSPAs now reduce the caps on the GSEs’ investment portfolios from $250 billion to $225 billion, giving the GSEs enough room to manage nonperforming loans that need to be pulled from pools but not enough room to take the investment risk they did in the run-up to the crisis. Treasury and FHFA also codify in the PSPAs the small lender protections that FHFA has put into place by directive during the conservatorship. The GSEs will be prohibited from offering volume-based pricing discounts or more favorable treatment for pools of loans than loans sold through the cash window, and they will also be required to limit the volume of loans that any one lender can sell through their cash window. These steps are intended to level the playing field in the GSE channel between the large and small lenders. The final way that Treasury and FHFA amend the PSPAs to constrain the GSEs’ practices is by imposing limits on the support the GSEs can provide for various products, limits intended to capture roughly the levels of support they are providing in these markets today. The PSPAs now limit support of multifamily lending to $80 billion a year, half of which must be mission-driven as defined by FHFA. They limit the GSEs’ purchase of “high-risk” single-family loans to 6 percent of their purchase money mortgages and 3 percent of their refinancing mortgages. These are defined as loans with at least two of the following characteristics: the loan is more than 90 percent of the home’s value, the borrower’s debt is more than 45 percent of their income, or the borrower has a credit score below 680. They limit support of second homes and investor properties to 7 percent of their acquisitions. And they limit GSE acquisitions to loans deemed qualified mortgages under the ability to pay rule, with a few modest exceptions. The GSEs appear to be inside of these caps already, so while the new limits will impede an expansion of access to credit, they should not contract it. A Quick Take on the Implications While it will take time to digest the full import of these changes, there are a few implications worth noting. First, while it might appear that the agreement has put the GSEs’ release from conservatorship out of the Treasury’s control, it has not. Second, the modifications to the dividend will mean that in the end, taxpayers are likely to either go unpaid for a large share of its investment or in effect take over the GSEs. And third, the move to lock in the GSEs’ current risk profile is likely more optics than substance. Treasury Still Has Significant Control over Whether and How the GSEs Are Released While the PSPAs now allow FHFA to release the GSEs once the litigation is resolved and they have hit 3 percent equity capital, Treasury still retains significant control over their fate for several reasons. As noted, under the agreements the GSEs cannot raise the equity capital it will need to exit conservatorship until and unless Treasury exercises its warrants on 79.9 percent of their common equity. Second, as a party to most of the litigation at issue, Treasury will have some control over when and how it is resolved. And third, Treasury’s consent will be required to make the PSPA changes needed for the GSEs to meet the 3 percent threshold within a reasonable time frame. The last of these sources of control is worth additional explanation. As of June 30, 2020, the GSEs had $6.6 trillion in combined adjusted total assets. To hold capital equal to 3 percent of those assets, they would need to build about $200 billion. They will likely want to maintain a buffer of at least 10 percent above that minimum, bringing the threshold up to $220 billion. Beginning from the $35 billion in combined capital they have today, they would thus need to build another $185 billion to get to the capital level needed for their release. Their earnings over the past two quarters imply a combined annual return of about $22 billion. That number will decline given the new capital rule and other steps that the FHFA has taken to decrease the GSEs’ risk, but even at that level, it would take the GSEs more than eight years to hit 3 percent using retained earnings alone. For the GSEs to meet that level in a more reasonable time frame by raising capital in the capital markets, Treasury and FHFA would have to amend the PSPAs again to restructure the government’s overwhelming ownership interest. This ensures that Treasury will retain a critical role in when and how their path out of conservatorship would play out. Taxpayers Are Likely to Either Get Stiffed or Walk Away Owning the GSEs The PSPAs provide two forms of compensation to taxpayers, one backward-looking and one forward-looking. Taxpayers are supposed to receive a dividend for their investment to date and a commitment fee for the backstop they provide going forward. The latter has never been applied because the GSEs have never been able to afford it given their dividend obligations. Once they can afford both, however, Treasury and FHFA are obligated to set the level of the commitment fee and begin charging the GSEs for the backstop. The dividend was first set at 10 percent of the senior preferred position. Once it became clear in 2012 that the GSEs could not afford it, it was converted to whatever they could pay, meaning their profits from one quarter to the next. In 2017, Treasury and FHFA allowed the GSEs to begin using their quarterly profits to build up their capital levels to $3 billion each, paying the economic equivalent owed under the dividend through increases in the taxpayers’ senior preferred position until they hit the new limits, after which the GSEs went back to paying their dividend in cash. They repeated the move in 2019, allowing Fannie Mae to build up to $25 billion and Freddie Mac to build up to $20 billion. This latest move pushes the level up once again, to the $283 billion they need to meet their requirements under the new capital rule, after which the dividend will shift to the lesser of their quarterly profits or 10 percent of the taxpayers’ senior preferred position. By increasing the capital levels again and allowing the GSEs to pay yet more of their dividend in senior preferred shares, the taxpayer appears to come out on the short end of the stick. FHFA and Treasury will have to write down the taxpayer position well below where it is today for the GSEs to attract new private capital. Thus, the additional dividend payments that taxpayers are to receive under the new terms are not going to be worth anything. And because taxpayers are not getting a commitment fee either, they are in effect no longer being paid for their support of two of the world’s largest financial institutions. The profits that the GSEs are making today and in the days ahead will benefit whoever ultimately owns the institutions, not the taxpayers to whom they are actually owed, amounting to a remarkable transfer of wealth. Unless, that is, all this winds up being a path to government ownership rather than private ownership. After all, at the end of this, taxpayers will wind up with an interest in the GSEs equal to close to half a trillion dollars and warrants on 79.9 percent of their common equity. That is a good deal closer to government ownership than private ownership, so the next administration could decide that it is easier, and better policy, to simply convert the well-capitalized GSEs into government-owned utilities. And this is indeed what several of us have proposed as the best course of policy (Parrott et al. 2016). The Moves on Risk May Not Mean Much Finally, the steps taken to lock in the GSEs’ current risk profile will simply codify in contract risk measures that the current FHFA would have maintained anyway through rule and directive. And just as policies in place by rule or directive will be changed by a new FHFA director where they do not fit the new director’s vision for what the GSEs should be doing, presumably a new director will also work with the new Treasury to change PSPA terms that do the same. So, it is unclear how the moves to embed these policies in the PSPAs will change the GSEs’ behavior, either during the tenure of Director Calabria or after. Conclusion The steps that Treasury and FHFA have taken amount to a legacy statement on how they think Fannie Mae and Freddie Mac reform should proceed in the years to come. While they increase momentum down their preferred path, whether the GSEs continue down that path or change course entirely has been left largely to the incoming administration.

New York | Across the financial world, readers of The Institutional Risk Analyst know very well, there seems to be a growing incidence of fraud and chicanery, this as the rate of interest paid on securities falls. The “bezzle,” what John Kenneth Galbraith described as the “inventory of undiscovered embezzlement,” is contracting along with the cash flow from financial assets. The European Central Bank is threatening to place limits on leveraged loans even as interest rates in Europe sink further negative. Do you think anyone at the Fed or ECB understands the connection between low interest rates and financial fraud? More than merely shifting risk preferences, low or negative interest rates create a seller's market for bad securities and, worse, nothing at all. The shrinkage in available plunder causes those living on the edge of propriety to develop ever more devious and complex games. Technology enables this wastage as do the pressing needs of the criminal world. And the ability of policy makers and regulators to keep pace with the new scammers is similar to the situation facing online security vendors. The perpetrators are just a little faster and certainly better motivated. Bitcoin: Money for Nothin' Our favorite game in recent years has been bitcoin, the first and only “independent” crypto token that also is a technologically enabled fraud. People exchange legal tender dollars or other currencies for, well, the equivalent of a bus token or lottery ticket. The value of bitcoin is based entirely upon the existence of a greater fool who will give you a thing of value in the future in exchange for this token. But not all bitcoin is bought for value, as we discuss below. Proponents of bitcoin point out that the exchange of tokens is independent of a biased political issuer like the Federal Reserve System or Bank of Japan . Yet the fact that other tokens issued by various entities around the world, particularly the shadowy Tether , can be used to buy bitcoin renders the market susceptible to manipulation. Tether is under investigation by the New York State attorney general’s office . In a must read post on Crypto Anonymous (H/T Dick Hardy), the enormous scale of the role of Tether in bitcoin price movements was described (“ The Bit Short: Inside Crypto’s Doomsday Machine ”). As the author stated: “The upshot: over two-thirds of all Bitcoin — $10 billion worth of it — that was bought in the previous 24 hours, was being purchased with Tethers. What’s more, this pattern wasn’t unique to Bitcoin. I saw the same thing for all the other popular cryptocurrencies. It seemed I’d been wrong to dismiss Tether. Tether wasn’t just in the crypto markets — Tether was the crypto markets.” The graphic above illustrates several groups of fraud victims, but the group to the right of the bitcoin market seem to be the most leveraged. At the very least, Tether seems to be the single largest source of liquidity flowing into bitcoin and other currencies. But what is Tether? Many of the users of bitcoin may believe that their market is protected from manipulation because of the use of blockchain and algorithms, yet this post suggests that both bitcoin and the other, downstream cryptos are being manipulated via Tether. And offshore, the author suggests, leverage as high as 100:1 is available on some crypto markets and with zero KYC. This makes Tether and other "issuer" cryptos perfect vehicles for money laundering. This apparent manipulation of bitcoin by Tether is significant, in our view, because US regulators have differentiated between “independent” markets such as bitcoin and other cryptos such as Tether, which to us look like issuers of securities, securities that are being issued and trade in apparent violation of US law. The technological differences of bitcoin vs other crypto tokens seem to lack any meaningful distinction in light of the role of Tether, de facto , in setting bitcoin prices. Tether reportedly accounts for some 70% of flows into crypto. This suggests perhaps that the SEC and FINRA ought to have another look at the entire bitcoin/crypto ecosystem. Maybe our pals in the financial media who have become advocates for bitcoin ought to look again as well. Q: Is the Tether/bitcoin/crypto chain the biggest fraud in recent human history? Maybe. But hold that thought. Recapitalizing the GSEs There are, of course, many types of games. Some are concealed by technological complexity as with bitcoin and Tether, but others are hidden in plain sight, under the warm blanket of public policy and legal arguments that are unfamiliar to professional managers and analysts much less individual retail investors. Consider the case of Fannie Mae and Freddie Mac , two companies that were once thought to be private but in fact never left government control. An “incomplete sale” imputes fraud conclusively, according to the US Supreme Court almost a century ago. The shareholders of the GSEs are the victims of an ancient fraud committed half a century ago by members of Congress during President Lyndon Johnson's Administration. But more recently, the long-suffering shareholders of the GSEs were victims of a new deception, this perpetrated by Wall Street funds and investment houses. These well-informed professionals floated the twin theory that 1) the US Treasury would magically forgive the more than $200 billion taxpayers have invested in the GSEs and 2) that Treasury Secretary Steven Mnuchin would then release Fannie and Freddie from government control. Neither of these statements were ever really true, but a number of individuals and firms made repeated written and verbal declarations that the GSEs would be returned to shareholder control. These false statements to investors were reported extensively in the financial media, but were rarely challenged by journalists or regulators. Federal Housing Finance Agency Director Mark Calabria participated in this grotesque act of manipulation of retail investors. In fact, neither Secretary Mnuchin nor Director Calabria ever had the authority to forgive this $230 billion in money owed to the taxpayer. As with General Motors (NYSE:GM) , Citigroup (NYSE:C) and American International Group (NYSE:AIG) , the Treasury must be repaid for moneys advanced to any private entity. Veteran Washington analyst Isaac Boltansky at CompassPoint put the situation in concise perspective for his clients last week: “At the highest level, the agreement allows GSE capital retention up to the regulatory minimum capital, including buffers, outlined in the recently released GSE capital rule. Under that rule, as of 2Q20 the GSEs in aggregate would have been required to hold $283B in adjusted total capital. In return for allowing GSE capital retention, the liquidation preference of the Treasury Department’s senior preferred will increase on a dollar-for-dollar basis until the minimum capital requirements are met. As a matter of context, the liquidation preference of the UST's aggregate senior preferred position already stands at $228.7B.” In the latest agreement with the Treasury, the GSEs will be allowed to retain more than $200 billion in capital, but the existing private shareholders are diluted further as the Treasury’s preferred equity stake grows towards a nominal half a trillion dollars. Of course, the GSEs will never be worth more than about $200 billion, so the new transfers to the GSEs engineered by Mnuchin and Calabria represent a future loss to the Treasury. The change in the capital retention of the GSEs is an act of fraud on the taxpayer. The Treasury is no longer paid for the credit support provided to the GSEs. The fact of more capital retained by the GSEs will not affect the “AAA” credit standing, which is entirely a function of government ownership. As funds are transferred to the GSEs, the government gets more preferred shares -- but no additional value for the taxpayer. “Treasury officials said Thursday they were unwilling to significantly restructure the government’s senior stakes in the firms, now valued at roughly $230 billion, saying the issue should be subject to further study,” reports Andrew Ackerman of The Wall Street Journal . “That move effectively means it will be up to a Biden-led Treasury Department to tackle the question. Reducing the stakes was a longtime goal of private shareholders that would put the companies on a path to exit government control eventually.” Not only was the promise of wiping out the GSE debt to US taxpayers never a real possibility, the idea of “releasing” Fannie Mae and Freddie Mac to private ownership was likewise never practical or possible. In the post-Basle III and Dodd-Frank world, without direct credit support from the US Treasury, the GSEs would be downgraded by the major credit rating agencies and quickly collapse. Without a “AAA” credit rating, the GSEs have no reason to exist. Of course, the retail investors in GSE common and preferred shares have no more understanding of federal finance than do policy wonks and professional investors. But the question we have is why has the SEC taken no notice of the erroneous puffery regarding GSE stocks? Retail investors who purchased GSE common and preferred shares reliant upon the numerous false statements made regarding repayment to the Treasury and/or release from conservatorship may have a cause of action – and perhaps a better legal case going after the Wall Street actors than suing the federal government. The moral of the story is that as easy ways to invest prudently dry up, investors are forced to look ever harder for acceptable returns – and may be more vulnerable to frauds like crypto currencies and promoters of penny stocks like the GSEs. As investors load up on more and more low-cost leverage on less and less real assets, it seems appropriate to ask how this will all end. Perhaps the situation was summed up best by our friend Jim Rickards in “The New Great Depression,” his timely book about the post-COVID world. “The veneer of civilization is paper-thin, and the paper is now torn,” he writes. Winter Sale on Now!

New York | Last week, JPMorganChase (NYSE:JPM) , Citigroup (NYSE:C) and Wells Fargo & Co (NYSE:WFC) reported Q4 2020 earnings. As the folks at KBW told The Wall Street Journal last week, it was a messy quarter, both for what was disclosed to investors and what was not disclosed. The major themes of fourth quarter results are 1) declining estimates for bank credit costs, partly due to the Cares Act and other consumer and business debt moratoria, and 2) weaker interest income and revenue for banks going into 2021. Financials Group: ALLY, AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, PYPL, SCHW, SQ, TD, TFC, USB, WFC JPMorgan For JPM, the bank’s net income was down 20% for the year vs 2019, a fact that did not prevent investors from driving bank shares up to pre-COVID levels. JPM closed on Friday at 1.7x book, a fairly rich valuation given the bank’s modest earnings prospects for the coming year. The Street analyst consensus has revenue at JPM falling mid-single digits in 2021. The fact of an almost 30bp decline in JPM’s interest rate spread, this even as deposits rose by more than 1/3rd, illustrates the negative impact of QE on bank earnings. The big “surprise” in JPM’s earnings was the $1.9 billion release of loss provisions back into income, a signal that on the consumer side, at least, the credit picture is relatively benign despite the damage being done to many sectors. Simply stated, the people who are suffering the most from COVID do not seem to be big users of consumer credit. Credit losses remain moderate, yet other factors pushed consumer & retail net income at JPM down 50% YOY. In commercial credit, however, the story is different. Net income for the corporate and investment bank was up 40% YOY. While JPM did release some loan loss provisions from C&I loans, the reserves for commercial loan loss exposures remain up tenfold vs the end of 2019. The big banks are not done dealing with the credit fallout from COVID in commercial exposures, we are simply pausing the credit build. We expect that JPM will maintain the current levels of provisions until the bank has greater visibility on actual commercial losses going forward. Loss provisions overall were up over 215% in 2020 after the Q4 reserve release, suggesting significant credit costs lie ahead. Net charge-offs were up 151% for 2020, but still tiny in absolute dollar terms at 0.76% of total loans vs 0.46% for Peer Group One. Citigroup Like JPM, Citi also saw a decline in net income during 2020. But Citi is trading at less than half of the book value multiple of JPM, just 0.75x book as of Friday’s close. Of greater concern, however, was the slide in operating efficiency in Q4, going from the mid-50s to almost 65% efficiency at year end. Perhaps the increase in operating costs was associated with the 5% surge in headcount? Total assets grew 16% in 2020 while tangible book value rose just 5%. While interest expense fell 61% over the course of 2020, interest income fell 30%, illustrating the wasting effect of current FOMC policy on bank margins. Net interest revenue fell 13% in 2020 while net revenue was down 10% Q4 2019 to Q4 2020. Most important, net credit losses at Citi fell 24% or $500 million in Q4, again illustrating the impact of the Cares Act and state debt moratoria on the apparent credit standing of major banks. We expect these numbers to go up as moratoria expire, but we also see a generally good credit situation vs the fears we voiced back in March and April. The imponderable is employment and the potential for a sustained dip in 2021, something that could again elevate concerns about credit. Citi released $1.8 billion from loss provisions back into earnings in Q4, leaving total reserves just shy of $16 billion vs $8 billion at the end of 2019. Even with that positive, however, Citi’s net income was down 41% vs full year 2019. If you bought the stock in 2020, you are paying 2019 prices for half the revenue. This is why we own the Citi preferred rather than the common, of note. Like JPM, Citi saw its global consumer banking segment decline broadly on the revenue line and almost reported negative earnings for the year. The institutional clients group, however, saw revenue rise almost 30% on strong North America activity but missed on earnings. Ironically, overall net revenue for C was virtually unchanged from 2019. Wells Fargo & Co After an awful year, WFC did better on earnings in Q4 2020, but that did not prevent the bank from delivering a down 90% result on the net income line for the full year. The bank’s common shares closed Friday at 0.8x book value or half the book value multiple of JPM. WFC managed a reserve release that was 1/10th the size of JPM. Even with the modest release, WFC’s loss provisions ended 2020 at $14.1 billion, up 426% for 2020. WFC shrunk in terms of revenue and operations, particularly with the announcement of the closure of the bank’s offshore advisory business. We expect to see a further charge for the shut-down of the WFC non-US advisory business, which apparently had such a large proportion of clients from Venezuela that the business was judged to be unsalable. Of note, WFC’s mortgage servicing business continues to shrink. The fair value of the WFC mortgage servicing rights declined 43% over the past year. Mortgage banking revenue was up in 2020 as you might expect given the huge boom in residential lending, but the fact remains that WFC’s once 1/3 market share in residential mortgage servicing is running off rapidly. Meanwhile, WFC loaded up on derivatives, which grew 80% YOY, and saw large gains on trading securities, up more than 500% YOY. Net interest income for WFC, however, fell 16% through Q4 2020. We expect to see depressed revenue and operating margins for much of 2021, both due to the economic malaise caused by COVID and the growing negative impact on bank earnings due to QE. Unless and until the FOMC relents and eases up on its massive purchases of Treasury securities and MBS, bank earnings are likely to decline further. The long-term damage to banks and the rest of the US financial system from the Fed's radical policies is incalculable. 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 | Whenever interest rates rise, the amen chorus on Wall Street starts to warble about the benefits to banks and bank earnings. Stock prices rise But readers of The Institutional Risk Analyst know that it is credit spreads and not market benchmark rates that actually determine bank net interest income. The chart below from our latest Premium Service profile of Bank of America (NYSE:BAC) illustrates the fact that gross spreads on bank loans and leases have been falling during the latest period of massive Fed bond purchases (aka “QE”). Also, asset returns generally at banks are in a downward spiral thanks to QE. Source: FFIEC Investment managers, however, are not the only ones confused about interest rates. Philadelphia Fed President Patrick Harker , for example, seven days ago declared that the U.S. central bank may begin paring back its bond-buying program as soon as the end of this year. Later in the day Harker, whose appointment to that post came as a surprise to many, corrected his earlier outburst, but the damage was done. The damage of the Harker Tantrum = 20bp yield move in the 10-year Treasury note in a week. Thanks so much Patrick. Suffice to say that the cash MBS outperformed the Treasury hedge by a lot. Unhappy TBA traders abound. Not to be outdone, a couple days later, Dallas Federal Reserve President Robert Kaplan said he expects broad vaccine distribution to unleash strong economic growth later this year, allowing the U.S. central bank to begin to pull back on some of its extraordinary monetary support, Reuters reports. These two bits of squawking by members of the FOMC caused markets to positively tremble. The 10-year Treasury note backed up nearly 20% in yield in a matter of days, causing many market commentators to questions whether the FOMC is actually in control of monetary policy. Note in the chart from FRED below how the Japanese yen weakens as the 10-year note rises in yield. That’s a hint. H/T Ralph. Yesterday the Board of Governors rolled out Vice Chairman Richard Clarida , who now says Fed bond purchases will keep pace through the rest of the year. Clarida said he expects the central bank to maintain the pace of its asset purchases through the rest of 2021, CNBC reports. Yet back in November, Clarida had hinted at possible changes in the Fed's bond-buying program. Were Harker and Kaplan merely parroting his earlier comments? Even after these corrections and amplifications, the confidence protection team at the Fed’s Board of Governors sent Vice Chairman Clarida out yet again, now stating emphatically that the central bank would not change policy until inflation had been at 2% for a least a year. Just to make investors feel even more confident, the Board then unleashed Fed Governor Lael Brainard , the furthest left Fed Governor on the political scale. The former bank regulator from MD declared for all to see that the U.S. economy remains “far away” from the U.S. central bank’s goals of a healthy labor market and stable inflation. As a result, says Governor Brainard, the Federal Reserve will likely continue its bond-buying program for “quite some time.” What all of this confusion illustrates is that having Fed governors and Reserve Bank Presidents airing their personal views to the market is not helpful. This is especially true when the course of US monetary policy as determined by all of the members of the FOMC is unlikely to change. Call us old fashioned, but we think that former Federal Reserve Board Chairman Alan Greenspan had it right. The Chairman of the FOMC, Jerome Powell , should comment publicly on US monetary policy and other members of the FOMC should be silent. The internal deliberations of the FOMC are confidential. Having Patrick Harker, Robert Kaplan or other Reserve Bank Presidents grandstanding for the media is inappropriate, causes confusion among investors as to Fed policy, and should result in disciplinary action by the Chairman. Likewise, Governor Brainard’s public musings are not particularly helpful either since her socialist views are unlikely to win a consensus on the FOMC. The irony of this situation is that the Fed’s massive purchases of Treasury debt and mortgage-backed securities is actually tightening credit. While yes, QE does force down bond yields, it also removes collateral from the credit markets, inhibiting the functioning of the mortgage markets and other secured financing. Today the Street is awash in cash liquidity, but collateral is scarce. One day, we hope all of the PhD economists at the Fed will realize that cash and collateral are two sides of the same coin. Even as the Harker Tantrum caused bond yields to rise significantly, this in clear opposition to the policy set by the FOMC, interest rates on MBS continue to fall under the weight of the Fed’s aggressive open market operations. The FOMC bought $1.5 trillion in MBS since the explosion of COVID from a lab in Wuhan, China . As the chart below suggests, yields on 30-year MBS were unaffected by President Harker’s erroneous comments of a week ago. Indeed, as Q4 2020 earnings begin, we expect to see net interest margins under continued pressure at US banks. Although the Fed can force funding costs lower via QE, the impact on spreads for all types of bank assets is decidedly negative. This is why, dear friends, the yield on earning assets for all US banks is continuing to fall. Indeed, coupon spreads on MBS are at record all-time lows. But do you think anyone on the FOMC understands what this signifies? Source: WGA LLC So ask not, dear friends, whether Harker, Kaplan, Brainard or anyone else at the Fed have a clue about the direction of interest rates or markets. Ask instead whether all of the members of the FOMC will end QE and normalize interest rate policy before the central bank does serious damage to US banks and other investors, such as leveraged funds and REITs. And remember, when it comes to asset returns for banks, it's all about spreads, not benchmark interest rates.

New York | One of the hot areas to watch in terms of risk and return in the coming year is the steady migration of “fintech” companies into a commercial banking model, in some cases combined with public ownership. We view this trend as a positive development and believe it confirms our view that “fintech” is merely a marketing term and insured depository institutions have a monopoly on payments in the US. Back in January of 2020, The Institutional Risk Analyst published a comment (“ Is it FinTech or OldTech? ”) that asked the basic question, namely is there anything really “new” in the fintech model or are these just new age nonbank financial companies. Remembering that nonbank firms, are by definition, more nimble than commercial banks, but dependent upon depositories for access to the payments system, the answer seems to be that fintech is an overlay on the traditional bank model controlled by the Federal Reserve System. Once the fintech “challengers,” as the media likes to call them, outgrow the pretense of cooperating with banks, then they must become banks themselves. Our experience has been and continues to be that the term “fintech” is mostly media hype, an inflated description for technology enabled finance companies that all must eventually become, well, commercial banks. And once these fintech platforms become established and their once innovative products become commonplace, then the equity market valuations will tend to fall into line with the comps. In this regard, the evolution of fintech companies into regulated banks has implications for public market valuations. We owned PayPal (NASDAQ:PYPL) and Square Inc (NYSE:SQ) in the early days, but took the triple digit gains off the table in 2018. In retrospect that may have been a poor tactical trade, but to paraphrase Jim Cramer on CNBC , in this Fed-manipulated market it is never bad to take profits. We have added PYPL and SQ to our financials surveillance group. Financials Group: ALLY, AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, PYPL, SCHW, SQ, TD, TFC, USB, WFC Square as Bank In December, the Federal Deposit Insurance Corporation (FDIC) issued a final rule setting forth standards to apply to controlling shareholders of industrial banks that are not subject to consolidated supervision by the Federal Reserve System. The final rule will take effect April 1, 2021. On the same day that it announced the proposed rule last year, the FDIC approved preliminary applications for deposit insurance submitted by SQ and Nelnet, Inc . This action paved the way for the two companies to establish the first de novo industrial banks in over a decade in 2021. A diagram of the current SQ business model is shown below from the company’s September 2020 investor presentation. This year Square is aiming to launch an industrial bank called Square Financial Services . The non-bank will originate commercial loans to merchants that process card transactions through Square's payments system. Square Financial Services, Inc. will operate from a main office located in the Salt Lake City, UT. The bank will not take demand deposits in order to avoid being classified as a commercial bank and will be supervised by the FDIC and the Utah Department of Financial Institutions. The FDIC approval for SQ and Nelnet followed shortly after an application by Great America Financial Services , a nationwide commercial equipment leasing firm, seeking an industrial bank charter application. The Edward Jones financial advisory firm filed an industrial bank charter application with Utah in July 2020; Rakuten (OTC:RKUNY) filed an industrial bank charter application with Utah DFS in July 2020; and General Motors (NYSE:GM) filed an industrial bank charter application with Utah DFS in December. Most of these applications seek to create nonbank lenders that make loans and have access to the Fed’s payment system, thus the requirement for FDIC insurance. Even if the industrial bank does not intend to take demand deposits and thereby become a commercial bank as defined by federal statute, the fact of FDIC insurance (and regulation) allows the industrial bank to access the payments system and maintain a master account at a Federal Reserve Bank. Valuation Looking at the recent performance of SQ, the stock has risen sharply since the start of the COVID pandemic. Even the most jaded of observers, however, have begun to ask if the valuation of SQ at 52x book value is a bit excessive. Even payments market leader PYPL, for example, trades at “only” 14x book, up 100% over the past year. As SQ matures as a company, we suspect that such comparisons will become more relevant. The wave of demand due to COVID fueled SQ’s triple digit annualized revenue growth, almost 400% in Q4 2020. If this torrid growth is at an end, what does that say about this year? For 2021, the analyst consensus for revenue growth is just 30% for the year. Will the 40% five-year CAGR SQ has posted in terms of gross revenue expansion continue over the next five years? Looking at SQ as a payments company, in the first nine months of 2020, it generated an $80 million net loss. Transaction and loan losses doubled along with revenue. Note that in Q3 2020, for example, SQ basically broke even on its dealings in bitcoin. In the nine months ended September 2020, SQ generated $260 million in cash from operations, invested $530 million back into the business and raised $1.3 billion, mostly from the issuance of $980 million in senior debt and $100 million in equity warrants. Another $400 million in cash came from “proceeds from PPP Liquidity Facility advances.” Written presentations say a lot. The company led by Twitter ( NASDAQ:TWTR ) CEO Jack Dorsey has fintech approach to investor disclosure, with pages of discussion of gross profits and market prospects, but little discussion of eventual net profitability. The slide below is taken from the September 2020 SQ investor presentation and shows SQ’s version of EBITDA. In is interesting to note that one of the requirements in the preliminary FDIC Order approving SQ’s bank application is to adopt and maintain an accrual accounting system. Of note, SQ reported $1.3 billion in shareholder equity at the end of September 2020. If we treat SQ as a bank holding company and subtract the $300 million in goodwill on the firm’s books, that leaves $1 billion in Tier One capital to support the new bank. Any capital SQ invests in the new industrial bank subsidiary will be segregated from the parent company and subject to Reg W, which governs transactions with affiliates. We assume that SQ will be required to raise substantial additional equity to satisfy the FDIC’s capital requirements . Given the above comments about growth and capital, does SQ really deserve to trade at 50x book value and over $100 billion in market cap, roughly the same as Citigroup (NYSE:C) ? In this regard, we have two questions about SQ: First, is SQ really a revolutionary model or merely an early starter as a provider of payments software able to adapt better to serve customers with new technology. Just as SQ stole the march on the big banks by breaking the model for small vendor accounts, are they now prey for the larger, better financed portals and tech names? Second and more important, will SQ lose that highly valued “fintech” edge once it and other finance companies become industrial banks subject to the prudential oversight of the FDIC. The FDIC’s Order approving the SQ application for federal deposit insurance may be found here . Some of the requirements are pro forma , but others are quite serious and imply major changes in the way that SQ conducts business. For example, like a commercial bank, SQ must now maintain and manage to a written business plan for the industrial bank, as stated in the FDIC’s order, and also accept regulation of the parent company. The FDIC will also want to see a coherent, five-year business plan from Dorsey as to the management of SQ. The FDIC Order is excerpted below: “That the Bank shall operate within the parameters of the Business Plan submitted as part of the application for Federal deposit insurance and as updated. Annually, the Bank shall submit an updated Business Plan to the Regional Director of the San Francisco Regional Office for consideration by the FDIC. The Business Plan, as updated, shall be based on prudent operating policies, include current and three years of pro forma financial statements and other relevant exhibits, prescribe adequate capital maintenance standards relative to the Bank’s risk profile, and incorporate reasonable risk limits with respect to adversely classified assets, liquidity levels, and other relevant risk factors.” The FDIC final rule requires a "covered parent company" such as SQ to enter into written agreements with the FDIC and the industrial bank to: (i) address the company's relationship with the industrial bank; (ii) require capital and liquidity support from the parent company to the industrial bank; and (iii) establish appropriate recordkeeping and reporting requirements. Through the final rule on industrial banks, the FDIC seeks to accomplish two important goals: First, ensure that the parent of and industrial bank approved for deposit insurance serves as the source of for the industrial bank; and Second, provide transparency to future applicants and the broader public as to what the FDIC requires of parents of industrial banks. Specifically, the Final Rule for covered companies that own industrial banks requires that they agree to a minimum of eight commitments, which, for the most part, the FDIC has previously required as a condition of granting deposit insurance to industrial banks. These include: (i) providing a list of all parent company subsidiaries annually; (ii) consenting to examinations of the parent company and its subsidiaries; (iii) submitting to annual independent audits; (iv) maintaining necessary records; (v) limiting the parent company’s representation on the industrial bank’s board to 25 percent; (vi) maintaining the industrial bank’s capital and liquidity requirements “at such levels deemed appropriate” for safety and soundness; (vii) entering into tax allocation agreements; and (viii) implementing contingency plans “for recovery actions and the orderly disposition of the industrial bank without the need for a receiver or conservator. Conclusion We like SQ’s aggressive strategy for going to market and have long advocated that finance companies ought to consider a bank charter, yet the challenges of doing so are substantial and growing. Taking the flat, entrepreneurial management culture of a SQ and transforming it into a pyramidal management model required for the holding company of an FDIC insured depository is not an easy task and one that has discouraged many applicants in the past. This is the main reason why the FDIC lays out all of the responsibilities for owning an industrial bank in its Final Rule. Can SQ and others offer their products and services on a national basis, using the first in class the technology, algorithms, and marketing savvy they have honed, but as a bank? If SQ is successful in gaining final approval from the FDIC and UT Department of Finance to actually launch its industrial bank this year, look for some significant changes in how the company operates and also how it reports its financial information to investors. First and foremost, SQ is going to need to find a way to achieve profitability and thereby satisfy the key regulatory consideration for bank ownership, namely being able to serve as a source of financial and managerial strength to its subsidiary bank. The FDIC is not the Fed, but it will in fact serve as the prudential regulator of the parent of any federally insured industrial bank. As SQ chases growth in an increasingly crowded market, we believe that the company will encounter greater difficulty as competitors from Alphabet (NASDAQ:GOOG) to Apple (NASDAQ:AAPL) roll out payments solutions for business. Indeed, it is interesting to note while looking at SQ that payments market leader PYPL shows no inclination yet to actually become a bank. As more and more fintech companies migrate to a bank model, we suspect that investors will see more reasonable valuations. The upward skew in market valuations caused by COVID in 2020 is likely to moderate as we move through 2021 and the banks and nonbank players in the payments space intensify the competition for the new revenue that SQ seems to take for granted. Take advantage of our Winter 2021 Sale! New Copies Signed by the Author just $24.99!

New York | Many of the readers of The Institutional Risk Analyst probably hoped to see a more peaceful year in 2021. Sadly the first week in January is feeling pretty much like the last week of December. But we’re happy to note the publication of our latest bank profile in our Premium Service, with a “neutral” risk rating on that sadly under-levered institution known as Bank of America (NYSE:BAC) . We write: "The bank’s funding base and liquidity are strong and credit expenses likewise are well under control, but our concern is that BAC does not seem to have the earnings potential commensurate with its size. The second largest US bank is a low-risk counterparty but also a mediocre equity investment. Given the risk averse nature of Mr. Moynihan and his board, BAC is unlikely to take the sort of tough decisions that would restore sustained profitability, including reducing the size of the bank and asset sales.” Source: FFIEC Americans await the start of a new and hopefully more steady government under President-elect Joe Biden , but the assumption of market stability is not a given. The obvious good news is that the markets worked through the year-end without any major mishaps. Stocks generally ended 2020 on or near 52-week highs, making for a heady start of the year, while corporate credit spreads continue to dance sideways. But even as stocks move higher and benchmark bonds slip, the credit markets remain very short of collateral, a fact that may cause the next “taper tantrum,” albeit this time due to the shedding of Treasury cash balances. The 10-year Treasury note has risen in yield above 1% for the first time since March of 2020. Buy high yield spreads have still not recovered to pre-COVID levels. Rising long term rates is not the end of the world by any means, but it does mean that the Fed-fueled boom of 2020 is ending as the Democrats take control in Washington. This perhaps augurs a return to more traditional market correlations? Does Janet Yellen demand the same respect from global markets as deal guy Steven Mnuchin ? Like Alan Greenspan , Chair Yellen may be tested very soon in her tenure. Meanwhile, the short end of the yield curve is getting forced down by the unrelenting global demand for Treasury collateral and dollar credit, which is basically at zero offshore. Can the incoming Biden Administration authorize and spend another $1 trillion in the next 90 days? The answer to that question holds the attention of bond investors (See “ Wag the Fed: Will the TGA force Rates Negative? ”). Our pal @Stimpyz1 maintains that real interest rates remain “WAY too high. The Fed's own models show it. R* is negative. Shadow funds are 0%, and they were NEGATIVE 4% in 2014--when things were not NEARLY as bad then as now…” Looking at the collateral markets, he’s probably right. Of note, the FOMC minutes show the central bank remains committed to continuing QE “at least at the current pace.” While members of the FOMC openly discuss allowing inflation to go as high as 3% before taking action to stay within the second part of the Humphrey-Hawkins dual mandate, namely price stability, the central bank’s own models suggest that even today's monetary policy remains too restrictive. The prospect of the Treasury returning hundreds of billions in cash to the Street over the next quarter, may actually drive market yields down toward the Fed’s theoretical R*. Meanwhile in the mortgage sector, there is mounting evidence that the interest rate party is ending early – at least in terms of heady equity market valuations. KBW published a decidedly bearish note on Rocket Companies (NYSE:RKT) , predicting that refinance volumes are likely to fall dramatically in 2021. (See our earlier comment, “ Nonbank Update: Rocket Companies. ”) The folks at KBW are good analysts, but many people on Wall Street don't seem to recognize that the Mortgage Bankers Association (MBA's) estimates are very conservative and subject to upward revision as we go. For years we have started the year with the baseline estimates in the model, only to see open market bond purchases by the Federal Open Market Committee render the model pretty much useless as a predictive tool. Wall Street is now writing equity market research dependent upon these decidedly conservative estimates. Specifically, the MBA tends to equally weight the chance of rising rates in their forward lending volume model. Even if the 10-year note yield rises, the secondary spread for mortgages may and probably will continue to contract due to 1) competitive pressures and 2) the fact of rising FOMC purchases of 2% and 1.5% coupons in conventional and agency MBS. The most heavily purchased MBS coupon yesterday (1/6/21) was the 30-year UMBS 2% for February settle, with $1.6 billion taken, Bloomberg reports. You can expect to hear growing numbers of investors and media pick up on this bearish, falling mortgage volume narrative, but the actual results for 2021 in terms of volumes may be significantly higher than the estimates from the MBA and the GSEs. Note: We’re a buyer at $3 trillion for 2021 volumes. Could be closer to $4 trillion. And remember, the FOMC does not set secondary market spreads, lenders do. We’re not communists yet. It is interesting to hear the recent comments of former Fed governor Kevin Warsh with respect to markets and the dollar , noting the radical and bipartisan shift in the consensus regarding US monetary policy during the Trump years may not find ready market acceptance under a Democrat administration. But as we know, Wall Street can get comfortable with just about anything given sufficient yield to commission. While much of the conventional wisdom in the media believes that Biden now effectively controls the Senate, the politics of spending and regulation, for example, will put a great deal of pressure on the Democratic coalition. Indeed, as COVID becomes the exclusive problem of Joe Biden and Kamala Harris, we fully expect to see some strange alliances take shape on the floor of the Senate. Once the distraction of Donald Trump is removed from our collective misery, politics as usual will resume. Remember, the political agenda of the Democratic Party is well to the left of most Americans regardless of what you hear in the mainstream press. Without Trump pissing in the political well, as was made clear in Georgia and Washington this week, we see the potential for significant Republican gains in 2022. Meanwhile, due to the arithmetic fact of 50/50 split in the Senate, we also see the possible formation of a “tyranny of the center,” comprising members of both political parties. Discrete alliances may exercise effective control of the Senate and outside the leadership of both parties. One single vote can change policy, especially if it is the last vote purchased. In the event, the tyranny of the center might be at least one positive outcome from four painful years of President Trump, but the bond markets may think otherwise. The assumption of a stable financial and economic transition in the US during 2021 is perhaps the greatest risk facing the global markets. In Georgia, President-elect Biden promised to send every American a check for $2,000 funded entirely with debt. Really, Mr. President? Really?

“So nearly $5 billion in earnings, solid, very strong capital, very strong liquidity, continuing our responsible growth management.” Brian Moynihan President & CEO New York | In this issue of The Institutional Risk Analyst , we assign a “neutral” risk rating to Bank of America (NYSE:BAC) for the reasons discussed below. At $2.7 trillion in assets, BAC is the second largest bank holding company in Peer Group 1 after JPMorgan Chase (NYSE:JPM) and arguably has the weakest management among the top five . BAC has two bank subsidiaries, a couple of large broker dealers and many hundreds of nonbank affiliates. WGA LLC Risk Ratings Bank Group: ALLY, AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC Quantitative Factors The common equity of BAC closed at just over 1x book value at the end of Q4 2020, while the bank’s credit default swaps (CDS) ended the year below 50bp. Both indicators remain depressed compared with a year ago, this despite the fact of quantitative easing (QE) by the Federal Open Market Committee. Compared with JPM at 1.6x book and U.S. Bancorp (NYSE:USB) at 1.5x, BAC is clearly an underperformer among the top 10 largest US banks by deposits and banking assets. For Q3 2020, net income was down 21% YOY. Suffice to say that even in and era of Fed-engineered asset scarcity, BAC common shares trade at par as this report is published. The first performance metric to consider is net credit losses, where BAC is actually lower than better performing names such as USB and JPM. Under President & CEO Brian Moynihan , BAC consistently avoided risk – and shed revenue -- compared with its asset peers. Going back more than a decade ago to the decision to shutter the Countrywide correspondent lending and securitization business, Moynihan never misses an opportunity to avoid risk, often at the expense of revenue and shareholder returns. The lower net loss metrics for BAC are well-above that of Peer Group 1, but still lower than those of other large banks. Notice that BAC trails both USB and BAC by a significant margin in terms of net loss, but above Wells Fargo & Co (NYSE:WFC). As we’ll see below, this lack of credit risk ultimately results in lower income in absolute terms and relative to the size of the bank. Source: FFIEC The next metric to consider is the bank’s gross spread on loans and leases, what it earns on average for all of its extensions of credit before expense for interest, sales and administration. As the FOMC has forced down interest rates it also forces the return on earning assets lower, resulting in a lower gross spread on earnings assets for all banks. The gross spread tells you about a bank's internal default rate target and thus the business model. Notice that both WFC and BAC languish with gross spreads below the average for Peer Group 1. The subprime credit card and individual loan portfolio of Citigroup (NYSE:C) , on the other hand, pushes up the gross spread on that bank’s loans & leases almost two percentage points above its less aggressive peers. Source: FFIEC In the chart above, we see that BAC has lower pricing on its credit products than its peers. In fact, BAC is in the bottom decile of Peer Group 1 when it comes to the gross yield on loans & leases. Part of this is a conscious decision to target a certain customer default profile, part the competitive dynamics in the marketplace. But BAC's loan pricing is part of a larger approach to balance sheet management that has to date produced poor results. After considering the yield on the bank’s loans, the next factor to examine is funding costs, an area where the deposit heavy BAC should and does excel. Indeed, as of the third quarter of 2020, BAC had the lowest funding costs among the top banks and was even below the peer group average for the 130 largest US banks above $10 billion in assets. The chart below shows interest expense as a % of average assets for the selected banks and Peer Group 1. Notice how much the cost of funds has fallen for market-facing institutions such as Citi and JPM. Notice too how low interest rates have fallen for the banking industry in absolute terms. Source: FFIEC Although BAC has lower funding costs than its large bank peers, the results do not make it down to the pre-tax line because of the bank’s relatively poor operating efficiency. As of Q3 2020, BAC had an efficiency ratio of 64.7 vs 62 for Peer Group 1, only 58 for JPM, 59 for Citi and an astounding 80 for WFC. The lower the efficiency ratio, the better the bank is at generating earnings vs expenses. Excepting the unusual case of WFC and of course Citi, which we assigned a negative risk rating, BAC is just tracking above Peer Group 1 in terms of net income, as shown in the chart below. Source: FFIEC In 2016, the BAC common began to run up sharply in value due to the reduction in operating expenses that resulted when the bank settled most of its legacy claims left over from the 2008 financial crisis. Annual operating expenses fell from over $70 billion in 2014 to less than $40 billion in 2019, generating a nice windfall for long-suffering BAC shareholders. Yet since 2015, BAC has seen its interest income and non-interest income lines fall precipitously. The former is down 20% since 2015. More alarming, non-interest income is down by a third from $42 billion in 2015 to $32 billion in Q3 2020. Just about every major line item in non-interest income has seen a significant decline since 2017. During this same period, the bank has grown in asset size. More assets and less income is not a formula for generating value for shareholders. While his traditional strength in cost-cutting is apparent, CEO Brian Moynihan has been singularly unsuccessful in retaining or generating new revenue. Indeed, as mentioned above, he has instead taken revenue and risk out of the business at Bank of America. The result is an equity market valuation that remains 1/3 below of pre-2008 peak above $50 per share. One of the fascinating metrics for investors and risk managers to consider when assessing BAC is share repurchases. Under CEO Moynihan, BAC has recently spent more on share buybacks than have other large banks, but has seen little benefit in terms of the stock price. The table below shows total treasury stock repurchases for BAC and other large bank holding companies. Notice the relatively small share buybacks of USB, which trades at a 50% equity market premium to BAC. Source: FFIEC As is so often the case, the financial results from BAC tell the story when it comes to the mediocre performance of the stock. BAC has relatively low credit costs, lower funding costs than the broad group of large banks, but unexceptional pricing on earning assets and poor operating efficiency. The result is a sub-par performance that we attribute to the risk-averse strategy followed under Brian Moynihan. No wonder that the Street estimates for revenue growth at BAC are negative for this year and all of 2021. Qualitative Factors One specific qualitative measure of a bank’s management is operating efficiency, an area we have already identified as being weak at BAC. But the larger problem at BAC under Moynihan has been to use cost cutting as a panacea for deeper structural problems that management refuses to address. The human resources centric mindset that Moynihan brought to the bank a decade ago provides little in the way of vision for moving the business forward. Like Citi, we are concerned about the lack of a long-term plan for the business. When Moynihan talks about “responsible growth,” this seems to be a catch phrase for failure and really avoiding opportunities to better lever the business. The obsession with avoiding credit risk and the poor operational performance, illustrate the fact that BAC is not taking enough risk to drive revenue and is doing a poor job managing efficiency. This shortcoming is magnified in the present interest rate environment. Robert Armstrong wrote in The Financial Times in October: “Falling interest rates took a painful toll on third-quarter profits at Bank of America and Wells Fargo, continuing to compress lending margins, overshadowing falling credit costs and improved results from the banks’ fee-based businesses.” Aside from the particulars of BAC, the entire US banking industry faces a grave threat from the policy mix now embraced by the FOMC. Over the past half century, the chief tool of US monetary policy has been to lower interest rates to stimulate employment and aggregate demand, but at the expense of savers and capital. While the Fed aggressively seeks to fulfill the full employment mandate of the Humphrey Hawkins legislation, it does so by pretending that inflation is not a problem. This unequal distribution of the cost of fulfilling the Fed’s dual mandate, between savers and creditors on the one hand and bank equity holders and the US Treasury on the other, illustrates the concept of financial repression in the US banking sector. Source: WGA LLC Banks benefit from lower interest rates, but are also hurt by lower asset returns due to QE. In the case of mortgage-backed securities (MBS), the Fed is now imposing capital losses on banks and investors due to high prepayment rates. For BAC, the message from the Fed and the credit market is clear: run faster when it comes to generating revenue, but this is one notable area of weakness of the Moynihan regime. We are talking about a bank that keeps most of its securities portfolio in held to maturity rather than available for sale, the polar opposite of the practice at most banks, a symbolic as well as practical example of the risk-averse strategy at BAC. Frankly, the expense driven bounce in the common equity after 2015, when legacy legal expenditures from the 2008 financial crisis began to fall, may be the only real positive for Bank America in the past decade. We always argued that a quick restructuring of the festering Bank of America/Countrywide estate would have been cheaper and quicker, but instead BAC equity holders suffered through years of misery. Management made ever more clever excuses for basic under-performance and massive remediation expenses related to mortgage servicing errors. Brian Moynihan may have been the right person to clean up the mess left by his mentor Ken Lewis . And true to his background as a lawyer and personnel officer, Moynihan has de-risked and de-populated the bank to the point where it does not generate sufficient revenue for its size and compared to its peers. The average cost per employee at BAC fell from over $150k annually in 2017 to $117k in Q3 2020. Even as headcount and assets per employee grew, expenses declined, illustrating how Moynihan has achieved short-term earnings. After a decade riding the tiger, Moynihan might want to take an example from Michael Corbat at Citi, declare victory and hand off the ball. The basic question that BAC must answer, however, is how it intends to manage its balance sheet and business mix in the age of QE forever. Today the mix between BAC’s net interest income and non-interest income is evenly split in the $65 billion in pretax income that BAC reported in the third quarter of 2020. Yet somehow BAC still manages to produce less in the way of earnings than its peers. We note above that the aggregate funding cost of BAC is extremely low, a fact that comes from the $1.5 trillion in core deposits held by the bank. Matched against this funding base is a loan portfolio that is 35% real estate, 30% commercial and industrial exposures, 10% credit cards and the rest in various miscellaneous loan categories. The average real estate exposure for the 130 banks in Peer Group 1 is 50% of total loans, of note. Trouble is, the asset mix currently chosen by Moynihan does not get the job done in terms of putting BAC in the top quartile of the peer group and close to JPM and USB, to be specific, in terms of asset returns. Instead, BAC is closer to Citi in terms of key bank performance benchmarks and thus market value. Compare, for example, how JPM has created a powerful origination and sale operation for agency, government and private-label residential mortgages. At BAC, sales of 1-4s are down 66% over the past five years. More, the bank's mortgage servicing business remains unprofitable. In just the past year, Moynihan and the board of BAC have left billions of dollars on the table by withdrawing the bank and its $1.5 trillion in core deposits from conventional and government correspondent lending. If you want to know one big reason why banks like JPM and USB outperform BAC: Better asset turns. Likewise, compare how JPM has managed its interest rate exposures over the past several years compared with the “responsible growth” of Brian Moynihan. The bank bet on rising rates after 2019, when rates were clearly going lower. BAC missed on revenue in Q3 2020 by $500 million. More, Q3 saw rising expenses for that old evil, litigation “with respect to some older matters.” The more things seem to improve at BAC, the more they also seem to remind us with great frequency of the bad old days that are not yet truly gone. Assessment We assign a “neutral” risk rating to Bank of America. The bank’s funding base and liquidity are strong and credit expenses likewise are well under control, but our concern is that BAC does not seem to have the earnings potential commensurate with its size. The second largest US bank is a low-risk counterparty but also a mediocre equity investment. Given the risk averse nature of Mr. Moynihan and his board, BAC is unlikely to take the sort of tough decisions that would restore sustained profitability, including reducing the size of the bank and asset sales. We think that a strong case can be made that to enhance shareholder value, Moynihan and the BAC board ought to spin-off Merrill Lynch as a competitor to Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) . Then BAC could split into two separate commercial banks around $750 billion in assets, making two new super regionals to compete with USB, PNC Financial (NYSE:PNC) and Truist Financial (NYSE:TFC). The growth and competitive energy released by such a transaction, IOHO, would accrue to the great benefit of BAC shareholders. 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.

Central Park South December 2020 New York | As we begin 2021 after a decidedly forgettable 2020, many of the challenges and opportunities that characterized the past nine months will continue, albeit with the caveat that this economic recession is very different from 2008 in terms of the risk hot spots and, most important, the fiscal posture of the US Treasury. Whereas a decade ago private label securities backed by home mortgages were the source of market contagion, this time around the problem lies in now moribund private commercial assets mostly owned by REITs and bond and ABS investors. There is a huge opportunity in acquiring and restructuring distressed commercial assets, but few investors are able to participate directly in this institutional process. The secondary impact of restructuring trillions in commercial real estate over the next decade will be enormous and is largely ignored by mainstream economists. The conventional view of the US economy expressed by many analysts remains largely focused on domestic, consumer-focused economic factors. These assessments overlook a number of significant systemic changes, in particular 1) the size of the Treasury’s huge debt pile, 2) the impending markdown of trillions in commercial property, and 3) the deliberate asset scarcity engineered by the Federal Open Market Committee. A quarter of the Fed's balance sheet is now financing Treasury cash balances, which are part of the exploding US fiscal deficit. The chart below shows three-month LIBOR for dollars, yen and euro from FRED. Notice that euro LIBOR is half a point negative, but offshore demand for dollars has supported dollar LIBOR through year-end. This tranquil picture may not carry through the first quarter of 2021, however, depending on whether Congress agrees on a substantial spending package. Financials & Earnings With authorities in the US and EU lifting limits on quarterly share repurchases by banks, the signal coming from regulators is that commercial lenders have sufficient capital and loss reserves to handle the cost of remediating COVID related credit expenses -- at least for now. These signals confirm the positive Q3 2020 guidance from several banks and suggest that the worst-case scenarios for consumer portfolios have not been realized. Even as regulators allow the resumption of share repurchases by banks, we still expect to see higher net charge-offs in Q4 due to troubled commercial exposures. New loan loss reserves should continue to be well below peak levels seen in Q2 2020. This will drive a rebound in earnings across the industry, although perhaps not quite to 2019 levels. It is important to note that we may not see bank dividends restored to normal levels for several more quarters since bank income is falling under the pressure of FOMC policies. Source: FDIC Stronger lenders such as Truist Financial (NYSE:TFC) have already set new share repurchase programs for 2021. Look for a wave to positive share repurchase announcements to goose interest in financials. Most of the market leaders in our bank surveillance group already trade well-above par in terms of equity market valuations and at five-year lows in terms of debt spreads and credit default swaps (CDS). With Charles Schwab (NASDAQ:SCHW) trading at 2.5x book and below 50bp in five-year CDS, it is hard to get terribly constructive on the name based upon fundamentals like value or earnings. But we do believe that the scarcity of investable assets and the growing pile of low-quality offerings in the IPO market will drive investor interest further into high-quality financials regardless of the current yield. Consistent with the theme of asset scarcity, we expect to see another record year in 1-4 family mortgages, with shrinking secondary market spreads and gain-on-sale profits. We are now well-into the FOMC interest rate cycle, thus this is not the time to be increasing exposure to mortgage lenders or hybrid REITs. With 30-year conventional mortgage rates closing in on 2.5% APR and the FOMC buying 1.5% MBS coupons as part of quantitative easing, this is a good time to take cash off the table in IMBs and REITs, and go buy a well-located residential home. We own Annaly (NYSE:NLY) at 0.6x book value. It now trades just shy of 1x book. Tempting to sell it, but we wonder whether the periodic volatility tantrums will afford us another opportunity to buy a leveraged pile of agency MBS at half of par. Of note, despite the strong push from the FOMC, we do not expect to see the remaining nonbank mortgage IPOs pending to come to market in 2021. Home price appreciation will be driven by the bottle-neck in terms of new housing construction, which lags badly behind population growth and obsolescence of existing housing stocks. This means that net-loss rates on bank owned and conventional 1-4s are likely to remain depressed for several more years, but double-digit delinquency rates on FHA loans are a source of future concern. The tale of credit losses due to COVID is a barbell, with some asset classes impaired and others rising in value on a cushion of FOMC credit. As we noted in our earlier reports (“ Nonbank Update: PennyMac Financial Services ”), the funding overhang in government mortgage servicing is a particular worry as 2021 begins. So long as low interest rates drive mortgage lending volumes, the situation will be manageable. Once volumes begin to fall, however, then the funding situation with respect to Cares Act forbearance will become critical very quickly as bank lines are drawn. The top independent mortgage banks (IMBs) are offering conventional 30-year mortgages at 2.625% this week, while high-priced jumbos are just inside 3%. This is powerful economic stimulus that will propel mortgage debt issuance in 2021, but this is a banquet that will benefit nonbanks primarily even as commercial banks continue to back away from consumer exposures. Look for JPMorgan Chase (NYSE:JPM) to repeat good performance in terms of mortgage banking in Q4. The numbers could be much higher if JPM and other large banks were still buying third party production. Once large banks have better visibility on credit in 2021, we may see JPM, Wells Fargo & Co (NYSE:WFC) and other money centers jump back into the mortgage market. The lion’s share of the profits in 1-4s this cycle, however, have already been gathered by the likes of PennyMac (NASDAQ: PFSI) , Rocket Companies (NYSE:RKT) , AmeriHome and Freedom. Credit Markets The size of the $900 billion spending package signed last night by President Donald Trump eliminates much of the uncertainty behind our earlier warning regarding the possibility of a taper or outright cessation of T-bill issuance by the US Treasury. (“ Wag the Fed: Will the TGA force Rates Negative? ”). Ralph Delguidice at Pavilion Global Markets described the situation last week: “ There are dynamics in the US money market complex pushing short rates down to (and perhaps through) the zero bound. The response of the Fed and the U.S. Treasury will likely flatten the curve once again, but not in the way, most investors are prepared for. ” Most economists and even many bond market strategists do not consider the financial relationship between the Federal Reserve and Treasury, a duality that has changed radically with the increase in the US budget deficit. We expect to see rates move steadily lower due to the FOMC’s policy mix of massive asset purchases and other measures, but the action or inaction of the Treasury is decisive. How quickly Treasury is able to spend its cash cushion will determine any market impact in terms of changes in new debt issuance. The chart below shows issuance data from the Securities Industry and Financial Markets Association (SIFMA) suggesting that mortgage issuance is slowing while Treasury issuance surged through November as the cash hoard in the TGA neared $2 trillion. The first obvious observation to make about the SIFMA data is that while mortgage debt issuance was still running $400 billion per month in November or a $4 trillion annual run rate, volumes are starting to slow. Although the immediate impact of the TGA issue may be to force the yield curve negative, the response that PavilionGM refers to in terms of an eventual yield curve flattener to rescue the money market funds may be a negative factor for financials. Second and more significantly, new issue volumes in all of the major securities asset classes other than Treasury debt are trending lower as 2021 begins. This is an ominous sign since a large part of the demand for equities has been driven by corporate debt issuance and related share repurchase activity. Issuance of asset backed and agency securities is also slowing, again suggesting another datapoint that the US economy will underperform in at least the first half of 2021. Here are several imponderables to consider in the next year: Will the desire of equity managers to own large cap bank stocks outweigh the negative impact of a flat yield curve on all financials, banks, REITs and also nonbanks? Will the shrinking net interest income of major banks due to the impact of QE dissuade investors from increasing exposures? If the FOMC is forced to put an artificial floor under short-term interest rates to rescue MM funds from disaster, will this force the FDIC to seek a similar subsidy for banks? Readers of The IRA will recall that when the Treasury extended a credit guarantee to MM funds in September of 2008, the FDIC responded and extended emergency federal deposit insurance coverage to non-interest-bearing bank transaction accounts. If the Fed rides to the rescue of MM funds in Q1 2021 (many of which are sponsored by banks, BTW) will the FDIC seek a quid pro quo to protect banks from the negative impact of NIRP? In terms of the price of risk, the markets seem so compelled by the Fed to accept inferior risk/return opportunities that the question of short-term pricing seems to be answered as asked. We fully expect to see the markets take financial debt and equity up in price in the near term, but we again think that a flattening yield curve could well spook some of the more simplistic perspectives in the bank credit market. Seeing Goldman Sachs Group (NYSE:GS) equity trading above book value and the bank's five-year CDS inside of 90bp, we think that risk is not accurately or adequately compensated – but that it precisely what the financial engineers on the FOMC want us to think. The better part of valor may be to surf the asset inflation wave, the very same wave of ersatz credit that is causing 1-4 family loan volumes to go ballistic. The fact that monthly mortgage issuance volumes hit $600 billion in October illustrates the magnitude of FOMC market manipulation. The chart below from FRED shows corporate bond spreads for the past year. While corporate default rates are rising, the spread relationships in the new issue market have barely moved. In this sense, at least, we can say that FOMC policy of massive open market purchases of securities perhaps kept corporate credit spreads from widening. The only problem with this thesis, of course, is that falling new issue volumes addressed earlier may suggest that these carefully curated risk benchmarks shown above may be wrong. Investors may not be willing to take on exposures at these apparently benign credit spreads. After all, it takes a market. Happy New Year. Mortgage Group: ACGL, AGNC, AI, BKI, BXMT, CIM, CLGX, COOP, ESNT, FAF, FBC, FMCC, FNF, FNMA, IMH, LADR, MFA, NLY, NRZ, NYMT, OCN, PFSI, PMT, RKT, RWT, STWD, TWO Bank Group: ALLY, AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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New York | Several weeks ago, we commented on how Federal Housing Finance Agency (FHFA) Director Mark Calabria never really had any intention to release Fannie Mae and Freddie Mac from government control (“ The Myth of GSE Release ”). Instead, Calabria’s true agenda seems to be to cripple the GSEs and the independent mortgage banks (IMBs) that operate in the $6 trillion conventional market. In Washington, watch what they do, not what they say . We quoted former Freddie Mac CEO Don Layton , writing for the Harvard Joint Center on Housing, who notes that the tenure of Mark Calabria “seems to me to reflect far too much antipathy to the GSEs and the politics of anti-GSE advocates who have long wanted to dramatically shrink (if not eliminate) the role the two companies play in mortgage markets." Again, we totally agree. But Calabria's antipathy for the GSEs also extends to private mortgage firms. Last week we saw the latest bizarre development from Director Calabria and the FHFA. Fannie Mae and Freddie Mac announced that, at the direction of FHFA, the two GSEs imposed new minimum liquidity requirements for IMB seller/servicers in the conventional market. Effective March 31, 2021, unused and available portions of committed lines of credit from commercial banks no longer will be considered as a component of IMBs’ liquid assets. The Fannie Mae announcement is found here and the Freddie Mac announcement can be found here . Keep in mind that these changes were made without warning or notice to the GSEs or the IMBs. It’s not even clear that the staff of FHFA or the GSEs had prior notice of the decisions. Bottom line, the change by FHFA will reduce IMB liquidity and lending volumes nationally. Our guess as to the motivation behind this action is that FHFA is trying, in Calabria’s simplistic fashion, to be dogmatically consistent with all market participants. Unused bank credit lines don’t fit the “high-quality liquid assets” definition in banking supervision and are disallowed for the GSEs themselves, and therefore will not to be used for GSE counterparty risk as well. FHFA states: “Given that the Enterprises do not have access to the Federal Reserve Discount Window or a stable customer deposit base, FHFA proposes to define high quality liquid assets as: (i) Cash held in a Federal Reserve account; (ii) U.S. Treasury securities; (iii) Short-term secured loans through U.S. Treasury repurchase agreements that clear through the FICC or are offered by the Federal Reserve Bank of New York; and (iv) A limited amount of unsecured overnight deposits with eligible U.S. banks.” Consider some context for Calabria’s latest policy surprise for the mortgage industry, this a week before Christmas. FHFA first considered this change as part of the proposed updates to the GSEs’ net worth, capital, and liquidity requirements for IMBs released in January 2020. The industry and WGA LLC provided detailed comments in response to this proposal . We discussed why this adoption of liquidity rules applicable to banks are inappropriate and would likely reduce the liquidity of both the GSEs and the IMBs in the conventional market. Calabria is essentially trying to cause, rather than prevent, systemic risk. In June 2020, FHFA announced that it would not implement the proposed changes and instead would release a new proposal for public comment at a later date to incorporate lessons learned from the pandemic. FHFA has not yet issued this re-proposal, a move that is arguably in violation of the Administrative Procedures Act. Yet last week, in a fit of Trumpian rage, Director Calabria issued this latest attack on the GSEs and the conventional mortgage market for reasons only he understands. Given that the mortgage industry is still expecting a formal re-proposal of these net worth, capital, and liquidity requirements for IMB seller/servicers to the GSEs, it is fair to say that mortgage lenders are a little disappointed by Calabria’s latest decision. The fact that the change to the treatment of unused and available portions of committed lines of credit was made without the opportunity for further public analysis and comment illustrates the reckless behavior that has come to characterize the tenure of Director Calabria at FHFA. There has been a lot of speculation as to whether President-elect Joe Biden will be able to remove Director Calabria from his post upon taking office. The question currently before the US Supreme Court is whether a President may remove the FHFA head without cause. In fact, we believe that President Biden will have more than ample reason to remove Director Calabria for cause , specifically that his intemperate and ill-considered actions violate HERA and, more broadly, are harming the financial soundness of the GSEs and their counterparties in the conventional market. If you sent somebody to deliberately sabotage the US housing market, you could not find a better perpetrator than Director Calabria. Calabria’s obsessive fixation with imposing bank like restrictions on nonbank finance companies is unnecessary and actually increases systemic risk. For example, IMBs are increasingly being forced to demonstrate "cash on hand," a retrograde step that takes the industry backwards 50 years. Yet even as the mortgage industry is reeling from this latest surprise attack from Director Calabria, the industry is also engaged in an increasingly acrimonious dialog with the Conference of State Bank Supervisors (CSBS) regarding its proposal for a broader prudential framework for IMB servicers. When you consider that Senate Republicans including Pat Toomey (R-PA) supported Calabria’s nomination to lead FHFA, it is more than ironic to see Calabria leading the charge against private mortgage companies. The supposedly conservative FHFA Director is serving as a facilitator for the progressive CSBS to hijack national housing regulation. But here’s the question: Does Mark Calabria understand this little nuance? More important, does the incoming Biden Administration realize that Washington is about to lose control over housing policy to the states led by New York? We wonder if Senate Republicans understand what they have done to the US housing market by embracing Mark Calabria. Inspired by Director Calabria’s erroneous statements to the Financial Stability Oversight Council (FSOC) regarding the systemic “risk” from mortgage servicers, the CSBS proposes to impose bank like restrictions nationally on IMBs , a radical and unwarranted change that promises to further reduce the cash liquidity in the conventional mortgage market. In the request for comment by the CSBS, they state with respect to loan servicers that IMBs have “an obligation to both parties of the transaction, making servicers simultaneously responsible for efficiently servicing the market and protecting consumers.” The CSBS does not cite a statutory reference for this statement. Indeed, looking at current law and regulation, there does not seem to be any backing for the assertion of an operational responsibility for IMBs by the CSBS. While loan servicers have a contractual duty to note holders and other parties and a duty of care to consumers via the National Mortgage Settlement and the Dodd-Frank legislation, the CSBS legal construction regarding safety and soundness is tenuous at best and deserves a challenge. With the exception of the State of New York, most other member states represented by the CSBS do not have any legal authority to impose bank-like safety and soundness rules on IMBs. The CSBS may think that having such power would be preferable, but such legal powers do not yet exist. Does the CSBS propose to export New York law on a national basis? The answer to that question seems to be yes. It appears that the CSBS is essentially attempting to impose a national standard upon IMBs via an illegal regulatory action that encroaches upon the power of the federal government, and without specific legal authority from each CSBS member state to support and enforce such rules. Will the Mortgage Bankers Association take the example of Met Life with the FSOC and litigate over this aggressive power grab by the CSBS? After all, the CSBS is basically a trade association that lacks the legal authority to act as a national regulator. Will the White House join the MBA in challenging the CSBS? This is a fundamental question that the incoming Administration of Joe Biden must quickly decide. The Executive Branch should immediately quash the Calabria-inspired attempt by the states via the CSBS to subvert the supremacy of HUD and the FHFA when it comes to national housing finance policy. On his first day in office, President Joe Biden should fire FHFA Director Mark Calabria for cause based upon his tenure to date. That change alone will kill a lot of the momentum behind the FSOC and CSBS. After Director Calabria returns to the private sector, we think the MBA and individual IMBs should band together and sue the CSBS for a lack of legal authority to impose new regulations on the housing market. The IMBs and trades should hire the lawyers that represented MetLife in the FSOC litigation and go to war. Sue the CSBS until they are forced to go back to the member states for contribution to fund the expense. Just remember, more than two-third of the members states in the CSBS are controlled by Republicans. After a few years in court, when the CSBS and the states they purport to represent get tired of paying for lawyers, then perhaps a reasonable compromise will be possible.

New York | As the very difficult year of 2020 grinds to a conclusion, the world is not much closer to dealing with COVID than it was six months ago. Leaving aside the supposed success of the Chinese police state, the rest of the world is struggling to protect vulnerable populations, but all the while destroying the economic and social lives of the entire population. Vulnerable populations do not wish to be isolated, so instead we lock down the entire community and destroy the entire economy. Go figure. New York Governor Andrew Cuomo , who is tipped to be Attorney General in a Joe Biden Administration, has again shut down the restaurants in New York City. There is no evidence that indoor dining is contributing to the significant spike in COVID cases in New York City, where roughly half the patients are coming from the city’s nursing homes. Governor Cuomo apparently cannot resist the temptation to destroy what remains of the city’s economy before heading to Washington. In this regard, we note sadly that 21 Club has closed its doors . Pondering the outlook for 2021, we first must note the buoyant state of the US equity markets, which are giving investors less and less cash flow at ever higher prices. The double-digit asset price inflation seemingly satisfies the requirement of the Federal Open Market Committee to see prices higher. But no, the US central bank continues to buy hundreds of billions in Treasury debt and mortgage-backed securities each month, creating an asset bubble that must eventually collapse into a massive correction. Students of recent history will recognize the parallel between the actions of the FOMC today and the Fed under former Chairman Alan Greenspan , who stepped on the monetary gas in the early 2000s and thereby fueled the mortgage market boom and bust that ended in 2008. This time, the Fed has increased its market manipulations by an order of magnitude, suggesting several more years of residential mortgage boom for lenders (if not MBS investors), followed by a 2008 squared correction in 2024 or 2025. If the world of residential mortgage lending is headed for another good year, the situation in the commercial real estate sector is dismal and growing worse by the day. As we noted in the latest edition of The IRA Bank Book for Q4 2020 (“ Is there a Bull Case for US Bank Stocks? ”): “We anticipate that just as the early period immediately following the Great Crash of 1929 was relatively stable, but was then followed by years of wrenching credit deflation, in 2021-2023 we are likely to see substantial restructuring of business assets and commercial real estate. These once blue-chip assets have been rendered moribund by the social distancing requirements of the response to COVID. Just imagine how empty office and retail buildings in downtown Manhattan or Chicago or Los Angeles will be revalued in the next 24 months and you begin to appreciate the future impact on commercial real estate credit and related public sector obligors." Source: FDIC The risk presented by the changes in behavior compelled by COVID have only begun to emerge into view in asset classes such as commercial real estate. Unlike residential mortgages, which are relatively homogeneous and thus may be described in aggregate, commercial real estate is a chopped salad of assets and locations that can only be understood in particular. Yes, much of the commercial real estate in New York City is impaired vs valuations of 12 months ago, but how impaired is a far more complex question. If all of this were not enough, there is another variable that has yet to be resolved as we approach year end, namely whether Congress will enact further spending to address the economic dislocation from COVID. The answer to this question will directly impact the size of the Treasury General Account or TGA , which is the buffer the Treasury uses to manage cash payments and receipts. Huther, Pettit and Wilkinson (2019) note in their fascinating paper (“ Fiscal Flow Volatility and Reserves ”): “A dollar paid to the Treasury in taxes directly reduces the amount of reserves in the banking system by one dollar, while a dollar paid by the Treasury directly increases the amount of reserves in the banking system by one dollar. This has not always been the case; prior to the financial crisis, tax receipts were held in (and expenditures paid from) the Treasury's accounts at commercial banks, a practice that left the stock of bank reserves unaffected by fiscal flows.” As the chart below illustrates, the Treasury stopped depositing funds with commercial banks since 2009, greatly magnifying the market volatility cause by changes in payments and receipts. Perhaps the decision by Treasury to let the Federal Reserve manage its cash was not well-considered. After passage of the Cares Act, the size of the TGA was expanded by Treasury from $130 billion to several trillion, but this authority is temporary and reflects the assumption of future spending -- spending that may never materialize. Should Congress fail to authorize new emergency spending outlays, Treasury will theoretically be forced to return the cash to the markets by ceasing the issuance of new debt for several months. Lorie Logan , EVP at the Federal Reserve Bank of New York, told the Money Marketeers of New York University on December 1st : "[T]he TGA has risen dramatically since March, as the Treasury Department built cash balances to prepare for potentially unprecedented outflows related to the pandemic response. Treasury’s cash management policy is motivated by precautionary risk management and calibrated to allow Treasury to cover outflows in case of a temporary interruption to market access. The TGA currently stands at roughly $1.5 trillion, nearly four times its largest size prior to this year. This balance is generally expected to fall in the coming months and, while the extent of the decline is uncertain, most expect the balance to remain well above historical norms." Just imagine what happens to interest rates and the credit markets more generally if there is no further pandemic response and Treasury must slow or even cease issuance of at least T-bills, and perhaps notes and bonds. Fed monetary policy would be rendered irrelevant as the supply of Treasury obligations available for purchase would dry up. Could the FOMC force banks and private investors to sell their Treasury holdings to fuel the fires of inflation? Bond market strategist George Goncalves tells The IRA : " The Fed is really going to be walking a tightrope between how much liquidity gets unleashed and when. Luckily we have seen this movie before, but never to the levels we are potentially faced with ahead. Each time the Treasury has faced the debt ceiling dance it has resulted in a wind down in the TGA account to the bare minimum and with it an eventual reduction in T-bill auction sizes in order to operate under the ceiling. The issue now is the size and timing of it all. In the past the Treasury had $350-400bn on average to start with in the TGA, now its well over 4x times those levels so that alone can amplify through funding markets more severely. The movement of over $1 trillion from TGA back to reserves through the reduction in T-bill supply also will reduce collateral for the most highly sought after paper in the system." If Treasury is forced to return cash now in the TGA, the ability of banks and other financial intermediaries to hedge finance risk would be entirely disrupted. Even a short hiatus in Treasury debt issuance could throw the mortgage and secured finance markets into chaos as the return of cash by the Treasury swelled bank reserves, but risk-free collateral would disappear. Goncalves continues: "The TGA issue, coupled with persistently large money market fund balances remaining into the start of the next year is a recipe to collapse short rates into negative territory in the 1 st half of 2021 and throw another wrench into the system at a time that the Fed continues to claim it won’t go down the NIRP path. There is talk of using reverse repos to try to mop up some of this up TGA/reserve switch, but they know it won’t be enough. Overall, the Fed and Treasury both over-reacted to Covid induced market vol earlier in the year and now will need to deal with the hangover into 2021." We understand from several bond market analysts that the most likely scenario would see Treasury Secretary-designate Janet "QE" Yellen forced to slow sales of Treasury bills for months, forcing short-term interest rates sharply negative as Treasury collateral disappeared. The too-be-announced (TBA) market for residential mortgages would be thrown into chaos and the repo market would be put into total disarray. The imaginary market for SOFR would also evaporate overnight. Good thing we still have LIBOR! As we’ve noted several times since the start of quantitative easing, allowing the FOMC to conduct massive open market purchases of Treasury securities and MBS has a considerable downside – especially when the Fed is also holding the Treasury’s cash in the TGA. The Fed and Treasury are alter egos, like two faces of a Hindu deity, thus the market risk is magnified when the Treasury and the Fed are pursuing divergent policy goals. The other more profound point raised by the size of the TGA is that the Treasury now accounts for about 25% of the Fed's balance sheet. Or put another way, the Treasury is funding about $1.6 trillion worth of QE. The cash deposits made by Treasury into the TGA must be collateralized with Treasury securities, meaning that $1.6 trillion worth of QE has no impact on bank reserves and is not supporting FOMC policy. As a practical as well as political matter, Treasury must reduce the size of the TGA or risk detracting from the FOMC's monetary policy actions. So, for example, if Senate Republicans led by Mitch McConnell (R-KY) say no to trillions more spending and bailouts demanded by the socialist tendency that controls the House of Representatives (and no big debt ceiling increase), does this mean the Treasury will suspend issuance of T-bills? Indeed, Treasury Secretary Steven Mnuchin is already letting the TGA run off so as to leave an empty cupboard for Chair Yellen. This bizarre situation illustrates the fact that once the FOMC turned to the dark side by embracing QE, it essentially lost control of monetary policy. More than ever before, the Treasury is the fiscal policy dog and the Federal Reserve System is the increasingly superfluous tail. Signed copies of "Ford Men" make great holiday gifts!

The IRA Bank Book Q4 2020 Review & Analysis In this edition of The IRA Bank Book for Q4 2020 , we ask a basic question: Is there a bull case for US banks? Whether from a perspective of an equity or debt investor, or a risk counterparty, the answer is unclear. Markets have taken up the valuations of bank stocks and debt because of the deliberate asset scarcity contrived by the Federal Reserve Board and other global central banks. But is there any hope of restoring US bank earnings and payouts to investors via share repurchases in the short-term? Bank Group: ALLY, AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC Suffice to say that while nominal prices for bank equity and debt have largely recovered from the difficult market environment seen in Q2 2020, investors are depending upon greatly reduced earnings and business volumes to support their investment valuations. Indeed, with the cessation of share buybacks by many banks, investors are receiving far lower cash returns than even a year ago. Share repurchases for the top 25 US banks were worth more than $120 billion annually in 2019. Dividends have been essentially tracking around 50% of bank pretax income, in some notable cases much more. To put that into round figures, the top 25 US banks were returning something approaching $350 billion annually to investors via dividends and share repurchases. In Q3 2020, bank dividends were just $14 billion for the entire industry, $13 billion in Q2 2020 and $41 billion in Q1 2020. Despite these sharp reductions in cash flow from bank stocks, since April’s market carnage investors have rushed in to buy these assets with reckless abandon. There seemingly is no longer any reliable correlation between bank stocks and financial performance, although sudden changes in bank credit loss provisions, for example, would still hurt market pricing for bank stocks and bonds. Source: FDIC The sharp decrease in bank loss provisions reported in the third quarter – from $61 billion in Q2 2020 to just $14 billion in Q3 – came about as much due to the inability to quantify future losses and also the government-mandated loan forbearance granted to millions of consumer and thousands of businesses. But the sad fact is that many small and medium size enterprises (SMEs) that stayed afloat in 2020 due to government loans and subsequent forgiveness will likely fail in 2021. We anticipate that just as the early period immediately following the Great Crash of 1929 was relatively stable, but was then followed by years of wrenching credit deflation, in 2021-2023 we are likely to see substantial restructuring of business assets and commercial real estate. These once blue-chip assets have been rendered moribund by the social distancing requirements of the response to COVID. Just imagine how empty office and retail buildings in downtown Manhattan or Chicago or Los Angeles will be revalued in the next 24 months and you begin to appreciate the future impact on commercial real estate credit and related public sector obligors. We cannot even begin to list the clients and associates at different financial firms that are planning to decentralize their operations into hotel type structures that give employees maximum flexibility and protection. And in every case, the firms are moving their employees out of major metro areas such as New York. Below we show the components of US bank income through Q3 2020. As you can see, interest expense is falling rapidly. Interest earnings are also falling. Since the Federal Open Market Committee greatly increased open market purchases of Treasury debt, and agency and government mortgage backed securities (MBS), the spreads on these assets over funding have steadily compressed, reducing the flow of income to banks. Indeed, banks and other investors are experiencing negative returns on loans, MBS and servicing assets. Source: FDIC The remarkable fact is that despite the compression of spreads of assets over funding costs, despite the other vagaries and credit expenses, the US banking industry did manage to report $128 billion in net interest income in Q3 2020. The problem, which lies 12-18 months out, is that the FOMC must eventually pull up on the monetary control stick and allow short term interest rates to trade freely or risk doing significant harm to the US banking sector. Just as a large commercial airliner flying at low altitude must maintain a minimum speed or stall, the FOMC needs to understand that the compression of bank interest margins could drive US banks into a net loss position on their interest rate book, essentially a replay of the S&L crisis of the 1980s. In the 1980s, the funding costs of S&Ls spiked over the yield on assets, causing mass insolvency in the industry that funded residential mortgages. This time around, the yield on earning assets could dip below the artificially low funding costs created by QE. As the chart below suggests, the return on earning assets (ROEA) is near a 40-year low. Source: FDIC/WGA LLC In addition to the effects of QE, US banks are fighting an environment where they are seeing portfolios running off due to loan prepayments even as deposits rise artificially due to QE. Total banking system now exceeds $21 trillion and earning assets are $19.3 trillion vs $10.5 trillion in Q1 2007. But please remember that the folks on the FOMC say that inflation is too low. The basic problem for the US banking industry is that the FOMC honestly believes that diverting the income from $6 trillion in Treasury obligations and MBS to the US Treasury is somehow a form of economic stimulus. Certainly, the impact on the US economy of a boom in 1-4 family mortgages is enormous, but we’d argue that the positive income benefit of QE and mortgage refinance opportunities on US households is offset by draining trillions of dollars annually in income for bank depositors and bond investors. For investors in MBS and whole loans, the current environment of high prepayment rates and falling bond yields promises only negative returns. And for large lenders, the lending market is daunting. Even as the FOMC has gunned deposit growth rates, bank loan portfolios are running off on net, as shown in the chart below. Source: FDIC One area where lending is surging is 1-4 family mortgages, where volumes in 2020 could come close to $4 trillion in new loans, near the 2004 record. As we’ve noted in recent comments on PennyMac Financial Services (NASDAQ:PFSI) and Rocket Companies (NYSE:RKT) , lending volumes are likely to remain strong in 2021, but secondary market spreads are likely to compress further. As SitusAMC noted in their most recent presentation on trends in the market for mortgage servicing rights (MSR), coupon spreads vs the Treasury yield index have been almost cut in half since April due to the open market operations of the FOMC. While lenders are still capitalizing the on-the-run 3% Ginnie Mae MBS coupons at 3x annual cash flow, we’d argue that a more realistic valuation is closer to 1.5x given current prepayment rates. By no surprise, the banking industry is only benefitting modestly from the mortgage boom. Banks lost important market share in April due to the decision to shut-down purchases of third-party production in 1-4s. The chart below shows the US mortgage servicing sector, representing nearly $12 trillion in unpaid principal balance (UPB) of residential mortgages. Source: FDIC, MBA, FRB As the chart illustrates, the US banking sector still controls more than 75% of the servicing of residential mortgage loans, although the nonbank sector is growing quickly. The assets serviced for others (ASFO) remains just below $6 trillion or half of total outstanding UPB. Notice in particular that the decision by many banks to suspend third-party loan purchases via correspondent and wholesale channels is causing the $2.4 trillion bank retained portfolio of 1-4s to shrink. Nonbanks continue grow their share, largely in the Ginnie Mae market. In addition, sales of 1-4s and most other loan categories continue to fall, an ominous sign for future bank revenue and earnings. Assets Securitized & Sold Source: FDIC One reason that the banks are retreating from 1-4 family lending, loan aggregating and servicing is that the cash flows are negative. As one veteran nonbank CEO told us last week, “Servicing is problematic for the banks. The cost of forbearance or loss of cash flow and increased future expense plus runoff creates the accounting loss. If you sell servicing and retain the infrastructure, your fixed overhead becomes burdensome. The runoff of the MSR is the real GAAP issue. Critical mass is a big challenge. Banks will struggle with the choice of selling MSRs or staying in because the cash flow may remain positive, even in the face of losses.” Notice in the chart below that the FV of bank owned MSRs was stable Q2-Q3, but net servicing income plummeted in Q3 to -$2 billion – the worst performance since 2011 for industry. We suspect that the expense of COVID and the Cares Act is the culprit. Cash flush nonbanks may find some ready sellers of servicing among large commercial banks as year 2020 draws to a close. Source: FDIC While some of the stronger names in our bank coverage group such as JPMorgan Chase (NYSE:JPM) and U.S. Bancorp (NYSE:USB) have retraced much of the losses of Q2 2020, many names in the group remain depressed. Again, investors are not buying these names based upon current returns but in the hope of higher future returns . Notice that even the lowly Goldman Sachs (NYSE:GS) has managed to crawl out of the basement to book value thanks to the generosity of the FOMC. A summary of our bank coverage group is below: Source: Bloomberg (12/9/2020) Credit Analysis & Charts As we note above, credit costs for US banks moderated in Q3 2020 as provision expenses fell. Actual charge-offs of the $10.9 trillion in loans held by US banks fell, however, as the real cost of credit remains muted. Part of the reason that provisions expense fell in Q3 was that the Fed and other prudential regulators have allowed banks to slow-walk the process of recognizing losses on loans under forbearance due to COVID, the Cares Act, as well as state-mandated loan moratoria. We do not expect this seemingly benevolent situation to continue. Total Loans & Leases The Chart below shows past due loans and loans charged-off through Q3 2020 for all loans held by US banks. Notice that the non-current rate is rising rapidly compared with the downward trend of the past several years. At the same time, the actual rate of charge-offs fell in Q3 2020, reflecting somewhat the regulatory forbearance that has been rolled out due to the COVID pandemic. For the same reason that provisions for future loss have fallen in Q3 2020, the reported levels of charge-offs are also down for many loan categories. Source: FDIC In addition to the impact of regulatory forbearance by the Fed and Federal Deposit Insurance Corp, particularly with respect to the rapid growth of bank assets and the related decline in capital levels, the big positive impact on US banks from QE has been the inflation of asset values. Note that LGD for all US banks fell 5% in Q3 2020, an extraordinary skew. Although the level of loss given default (LGD) appears relatively normal, the price appreciation seen in real property, residential assets and commercial assets such as facilities of various types has greatly improved the credit exposures of US lenders. Office buildings in New York may not be particularly attractive, but other assets in superior locations are demanding premium prices. In the rare event of a loan default actually going to liquidation and sale of assets, the recovery rates are very good, sometimes more than 100% of the loan amount. The chart below shows loss given default for all US bank loans. Source: FDIC/WGA LLC Real Estate Loans In the case of real estate loans, the events of the past nine months have begun to force up default rates on real estate generally, in large part due to commercial loan defaults. The default rate on commercial and industrial (C&I) loans rose almost 40% in Q3 2020, which suggests a lot of volatility in corporate and commercial real estate credit. Since default rates on 1-4s and multifamily loans, as well as construction and development loans, are tracking near zero at present, it seems safe to assume that CRE loans are driving this increase. Notice that charge-off rates for real estate loans are still miniscule. Source: FDIC Another perspective on the changes underway in the world of commercial real estate is shown in the chart below, where LGD has spiked upward in the past several quarters. Whereas LGD on all real estate loans was actually negative at the end of 2019, today post-default loss rates on the $5.1 trillion in real estate loans are strongly positive once again at 67%, almost precisely the long-term average loss rate going back 40 years. Source: FDIC/WGA LLC 1-4 Family Loans When we next move to the $2.4 trillion in residential mortgage loans, the situation looks very similar. Non-current loans are accumulating, but charge-off rates remain very low. More important, post default loss rates are still negative, reflecting the strong market for residential homes. So long as asset prices in the residential mortgage space remain buoyant, LGDs for 1-4s are likely to remain extremely low by historical standards. As shown in the two charts below, charge-off rates for 1-4s were actually negative in Q3 2020 and LGD was -8.4% vs the 50-year average loss rate post-default of 67%. Source: FDIC Source: FDIC/WGA LLC In addition to the charts above, another significant indicator of delinquency in the 1-4 market is early buyouts (EBOs) of delinquent loans from Ginnie Mae MBS. As we noted in our recent update on PFSI (“ Nonbank Update: PennyMac Financial Services ”), buyouts of delinquent loans by Ginnie Mae issuers such as Wells Fargo & Co (NYSE:WFC) are growing rapidly, an indicator of the deterioration of underlying government-insured loans. The chart below shows Ginnie Mae EBOs by banks through Q3 2020. When a loan is repurchased out of a pool, it is considered “rebooked” and shows up on the bank’s balance sheet as an NPL. With delinquency rates on FHA and VA loans in the teens in many regions, we expect to see this indicator rising over the next few quarters. If buyers of EBOs are successful in modifying the loan, for example, they may then sell the note into a new Ginnie Mae MBS and capture the gain on sale. But EBOs also contain significant downside risk for servicers. Source: FDIC Multifamily Loans As with the single-family portfolio, the delinquency and loss rates for bank owned multifamily loans are also exhibiting considerable volatility. The $480 billion in total loans is showing virtually no net charge-offs, but the period of negative LGDs seems to be at an end, as shown in the charts below. Source: FDIC Source: FDIC/WGA LLC Commercial & Industrial Loans After real estate, the next largest loan category for US banks is the $2.5 trillion in C&I loans held in portfolio. The C&I book is less affected by the market manipulation of the FOMC, thus both the loss rates and LGD display a more normal, pre-2020 pattern. The divergence between the abnormal pattern seen in real estate exposures and the C&I book was noted in the most recent Quarterly Banking Profile from the FDIC: “The net charge-off rate declined by 5 basis points from a year ago to 0.46 percent. Net charge-offs decreased by $418.2 million (3.2 percent) year over year. The annual decrease in total net charge-offs was attributable to a $1.3 billion (15.9 percent) decline in credit card net charge-offs. This decline offset increases in charge-offs for the commercial and industrial (C&I) loan portfolio, which increased by $898.5 million (39.3 percent). The C&I net charge-off rate rose by 8 basis points from a year ago to 0.49 percent, but remains well below the post-crisis high of 2.72 percent reported in fourth quarter 2009.” Source: FDIC Notice in the chart above that the delinquency rate on C&I loans is continuing to rise, but the net charge off rate for the series actually declined like the bank loan book overall. We suspect that this decline is an anomaly and is related to regulatory forbearance from the Fed, OCC and other regulators. That said, the economic reality within bank C&I portfolios is continuing to deteriorate, as illustrated by the rising LGDs. The fact that LGD dropped from 90% loss given default in Q2 2020 to only 85% loss in Q3 does not address the more general concern. Source: FDIC/WGA LLC Credit Card Loans Like most of the other loan series discussed in this report, the $979 billion in credit cards are also displaying the impact of the Cares Act and various other types of official and unofficial loan moratoria tied to COVID. Non-current rates have fallen as a result of loan forbearance, but net charge off rates have remained steady ~ 4%. We suspect that when the legal mandates regarding COVID loan forbearance have lapsed, the net-charge off rates and LGD for credit cards will begin to rise again. More than many other loan types, credit card default rates and LGD are tied closely to levels of unemployment. Source: FDIC Source: FDIC/WGA LLC Outlook for Q4 2020 As we head into year-end for 2020, the Street has earnings estimates for most of the bank group that reflect a decidedly downbeat outlook for Q4 2020 and, more important, for 2021. But that does not mean that Street analysts are unwilling to stretch -- even as a 1930s deflation threatens the US financial system. The consensus earnings estimate for JPM, for example, has the bank delivering almost $7.50 per share in earnings in 2020 and $9 in 2021, a remarkable performance given the bank’s significant commercial exposures. USB, to take another industry exemplar as an example, is believed to be headed for $3 per share in 2020 and slightly higher in 2021. Both of these optimistic estimates depend crucially on the level of loan loss provisions for US banks in Q4 2020. Given that both USB and JPM are trading near 1.5x book value and given that cash flows to investors have basically been cut by two-thirds, these valuations are quite remarkable. And since the FOMC seems intent upon keeping interest rates low for the foreseeable future and given that asset returns and sources of fee income are also under growing pressure, we have a hard time making the bull market case for US banks at this point in time. It may be several years before that Fed and other prudential regulators allow banks to resume full dividend payments let alone share repurchases. And on the horizon, investors face the probability that major banks will be required to raise capital to support the “temporary” expansion of bank balance sheets due to the effect of QE. When the Fed buys Treasury securities or MBS from banks, they credit their master account at the central bank. But these funds are fleeting and can run off quickly as the MBS and Treasury paper is redeemed. We suspect that the FOMC will maintain the current size of the Fed’s portfolio ~ $7 trillion, meaning that continued asset purchases will artificially inflate the size of bank balance sheets but will also retard lending and asset returns. In such an environment, look for earnings to come under strong downward pressure. Also, there is likely to be significant dilution for equity investors as the banks struggle to support their bloated balance sheets with new capital, this even as net interest income falls. Investors may have convinced themselves that bank earnings will rebound in the near-term, but instead we could be headed for a protracted period of low earnings and cash returns to bank investors. 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.

New York | Earlier this week, the Federal Reserve Board and other agencies blinked on the ill-advised transition from LIBOR as a pricing mechanism for financing various types of assets and secured money market transactions. The agency statement delaying implementation to 2023 is below: “The Federal Reserve Board, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency today issued a statement encouraging banks to cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021, in order to facilitate an orderly—and safe and sound— LIBOR transition.” Unfortunately, as we wrote back in September in National Mortgage News (“ Housing market needs SOFR alternative — now ”), the proposed “replacement” for LIBOR -- the secured overnight funding rate or SOFR -- is not really a market price at all. “According to the Fed, SOFR is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities,” we wrote in NMN . “In fact, SOFR is an imaginary, backward-looking benchmark dreamed up by the economists at the Fed with no discernable market.” The 2017 decision by the Fed to do away with LIBOR is one of the most ill-considered and thoughtless actions taken by the US central bank in many years. Not only did the Fed displayed its ignorance of the workings of the US capital markets, but it also revealed its arrogance and stupidly. Simply stated, LIBOR is a price for conducting financing in dollars. SOFR is an economists’ wet dream, a backward-looking measure that may seem interesting from a research perspective, but one that lacks actual liquidity. As one reader of The IRA said this week: " Glad they realized that an unsecured loan to a possibly TBTF bank should be priced differently than Tri-party repo using "AAA" collateral and margined every night." Ditto Alan. The solution for the “problem” with LIBOR is to fix the existing benchmark, not to dream up some farcical concept and then try to bully insured depository institutions to use SOFR for actual risk taking. We understand that many banks have told regulators privately the same thing we hear from clients in the too-be-announced (TBA) market for mortgage backed securities (MBS): SOFR is a non-starter and must be discarded. As late as last week, the Fed and other regulators were trying to bully the large dealer banks to stop using LIBOR by December 31st. The resounding answer: “Foxtrot Oscar.” Indeed, a growing number of analysts seem to have reached the same conclusion that we made months ago, namely that asking banks to take tens of billions of dollars in risk every day using SOFR as the pricing mechanism would be unsafe and unsound. You see, there is no actual market for SOFR and no real trading activity in this ersatz benchmark. The Fed party line claims that SOFR is built upon "a deeply liquid market in U.S. Treasury securities," in fact the Fed's economists missed that very opportunity entirely and instead had to create a new benchmark of their own design. Any “risk” from the LIBOR transition has been created entirely by the Fed itself. Michael Held , Executive Vice President and General Counsel of the Federal Reserve Bank of New York, made these comments in September : “I have said before that the end of LIBOR presents a rather frightening—or awe inspiring, depending on your perspective—litigation risk. But it’s not just litigation risk. The LIBOR transition encompasses a whole panoply of risks. Yes, legal risk, but also operational risk, credit risk, regulatory risk, reputational risk, you name it—LIBOR has it all. So the possibility of a failed LIBOR transition is something that should keep all of us up at night.” No, what keeps us up at night is the incompetence and arrogance of the Fed and other regulators. There is no need to get rid of LIBOR. Fix the process for setting the rate in dollars and other currencies, declare success and move on to more important problems. The LIBOR transition is a “problem” that exists first and foremost because of the muddled thinking in the minds of global bank regulators. If LIBOR does need to go away, the obvious answer for the US market is to price MBS against the forward market for these securities, that is, TBAs. But this solution was apparently too obvious for the Fed’s staff in Washington. These are the same bright lights, keep in mind, that decided to “go big” in April with open market purchases and nearly tipped over several agency and hybrid REITs in the process. If we count the year-end 2018 liquidity fiasco and the September 2019 redux, the April 2020 episode with the massive resumption of QE by the Federal Open Market Committee marks the third time that Chairman Jerome Powell has almost run the US financial markets aground. While investors may think that the Federal Reserve Board is a mechanism for stability in the financial markets, we respectfully beg to differ. Forcing US banks and investors to adopt the SOFR standard would violate federal banking laws and would put US banks and the housing market at risk – and for no good reason. Fortunately, the Fed and other agencies now have an opportunity to regroup and consider some alternatives for dealing with the LIBOR problem. More than any technical factors, the Fed and other agencies were embarrassed by the LIBOR price-fixing scandal and feel inclined to kill the benchmark in order to restore their collective self-esteem. But does this really serve the public interest?? Really? First and foremost, the Fed needs to start listening to its banks and the markets more broadly. Given COVID and the economic disaster taking shape across the US, do we really need to be dealing with this now? To extricate itself from the present impasse, the Board of Governors should make clear that SOFR is not meant to be the only possible alternative to LIBOR and that US banks may select any established market benchmark as a substitute market price. But is Chairman Powell listening?