SEARCH

New York | In the Black Friday edition of The Institutional Risk Analyst , we survey the political economy in the wake of the 2020 election in the US. It seems that Americans no longer will have the convenient distraction of President Donald Trump upon which to blame various woes, meaning that the grim financial and economic reality facing society is now front and center. And one of our favorite examples of the growing financial malaise in America is housing finance. The prospective ejection of the GSEs, Fannie Mae and Freddie Mac , from government control seems finally to be dead for the next four years. While Federal Housing Finance Agency head Mark Calabria has made a lot of noise about ending the conservatorship of the GSEs, in fact the possibility was never real. All that noise just provided opportunities for insider trading, Washington’s favorite choice of entertainment and enrichment. When rumors emerged a week or so ago that the Lame Duck Trump Administration might release the GSEs from conservatorship, we laughed. The actual release was never a real possibility. This nonsense talk did, however, provide a nice pop in the prices of GSE common and preferred equity. This glad fact allowed some hedge funds and MCs to take a few more dollars off the table before the coffin is sealed. All of the announcements about the GSEs over the past four years could be generously described as securities market manipulation. Why the Securities and Exchange Commission does not investigate the correlation between these leaks regarding the supposed “release” and trading in GSE securities we’ll never know. Yes, it is true that there were discussions in the Trump White House about a Lame Duck release strategy, but the career staff at the US Treasury and the Office of Management and Budget, for starts, would never allow such a crazed scheme to proceed. As with the case of the government equity stake in General Motors (NYSE:GM) , the government must be repaid for its investment in Fannie Mae and Freddie Mac. And no, the sweep payments are not a repayment of the investment by US taxpayers. When the GSEs are released and the government’s shares are acquired by private investors , then the US government will be made whole. And at the moment, we doubt that the Treasury could get anything like book value for the shares of either GSE. In the meantime, the sweep of income to the Treasury compensates taxpayers for guaranteeing the $6 trillion in GSE debt and, significantly, to also wrap the two corporate entities in "AAA" ratings. Upon release, lest we forget, the GSEs must compensate the Treasury for continuing to wrap the existing $6 trillion in MBS in a “AAA” rating. Say renting Uncle Sam's full faith and credit costs 15bp per year on that $6 trillion in existing debt. This is based on the work by Wells Fargo (NYSE:WFC) on credit risk transfer (CRT) deals over the past few years. Of note, this credit wrapper for the MBS won’t buy the corporate entities a “AAA” rating, meaning that the GSEs would be effectively out of the guarantee business. And thanks to the chaotic and at time contradictory policies of Director Calabria at the FHFA, the GSEs will not longer be selling risk to investors. These are two little details that are never discussed in Washington, part of what is called a “competitive analysis" in the world of public issuers. The folks at Citigroup (NYSE:C) last week noted that under the capital rule most recently adopted by the FHFA, the GSEs would be required to have $280 billion in capital and maintain a bank-like 4% leverage ratio. According to their analysis, the GSEs would need to increase their guarantee fees by 40bp to almost 1% in order to remain profitable. Our reaction: Really? As we’ve noted ad nauseum , the GSEs are not banks and cannot support this sort of capital structure. And the GSEs certainly can’t raise guarantee fees and remain competitive with other private mortgage insurers and banks. But we think that Director Calabria is smart enough to know this already. It is no accident that Freddie Mac CEO David Brickman has announced his departure. You see, nobody in the bond market cares about a guarantee from a “AA” or “A” Fannie Mae at 1% annually, especially if they can buy a “AAA” wrapper from the US Treasury for 15bp. Right? You begin to see the problem? This is why “release” can never happen. Once you separate the GSEs in credit terms from the $6 trillion in "AAA" agency MBS, the GSEs become superfluous and likely insolvent. Take another example. How about buying credit enhancement from “AA” rated JPMorgan (NYSE:JPM) at 30bp for private label conforming MBS? Most banks would probably look to retain duration at the present time, but suffice to say that the big banks could offer credit enhanced MBS that would be more than competitive with the “private” GSEs. Once you take the insurance business away from the GSEs, neither is viable from a competitive perspective, yet nobody in Washington ever talks about this question. Therefore, ask not when the GSEs will be released from conservatorship. Ask instead why apparently intelligent people in Washington actually spend time talking about release as though it were a real possibility. First and foremost, Director Calabria seems more interested in crippling the GSEs operationally than making a release from government control truly possible. Former Freddie Mac CEO Don Layton , writing for the Harvard Joint Center on Housing , notes that the capital rule for the GSEs " 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." He continues: "While the FHFA is, not surprisingly, claiming that the capital rule strictly reflects professional policy considerations, I believe that this is not really true and that anti-GSE ideology is too much in the driver’s seat." Layton then summarizes the situation going forward under the FHFA's ill-considered capital rule for the GSEs: " The rule will also generate immediate pressure for a major increase in guarantee fees, which are currently based on a much lower capital requirement. Such an increase, if pursued by the FHFA, would generate incredible noise and friction in the industry and in Washington — it is not obvious how that would all play out, except to increase the desire of the Biden administration to replace Director Calabria as soon as it can." Ditto Don.

New York | In this latest edition of the Premium Service of The Institutional Risk Analyst , we take a look at the Q3 2020 results for PennyMac Financial Services (NYSE:PFSI ) , which is the manager of the REIT, PennyMac Mortgage Investment Trust (NYSE:PMT) . PFSI is one of the best performers in the residential mortgage industry. The firm's stock routinely traded at or above book value even before the current low interest rate environment. Mortgage Group: ACGL, AGNC, AI, BKI, BXMT, CIM, CLGX, COOP, ESNT, FAF, FBC, FMCC, FNF, FNMA, IMH, LADR, MFA, GHLD, NLY, NRZ, NYMT, OCN, PFSI, PMT, RKT, RWT, STWD, TWO At the end of last week, PFSI was trading at or about 1.3x book in the New York equity markets, more or less the same multiple as that enjoyed by money center JPMorgan (NYSE:JPM) . The stock trades on a beta slightly above “1” and its implied credit default swap (CDS) spread was ~ 140bp at the end of last week vs 41bp for JPM. It is important to maintain perspective, especially on credit. Has this apparent equivalence in equity market valuation multiples between JPM and PFSI always existed? No, indeed it has not. Even with PFSI now showing a total portfolio of $400 billion in unpaid principal balance (UPB) of loans, it remains a tiny finance company compared with a money center bank. Thus the triple-digit CDS spread and "BB" equivalent rating from Moody's . The current high tide in the market valuations of PFSI and other nonbank mortgage lenders and servicers is caused by the actions of the Federal Open Market Committee, but the peak in new 1-4 family lending margins was probably back in Q2 2020. While we have seen three quarters in a row of nearly $1 trillion in total mortgage backed securities (MBS) issuance in the US this year, spreads are falling rapidly. The disclosure from PFSI’s Q3 2020 earnings deck is shown below. The obvious takeaway from the chart is that business volumes have exploded 5x since the start of 2020, mostly on the back of the open market purchases of Treasury paper and agency and government MBS by the Federal Reserve. Points: We believe that estimates from the Mortgage Bankers Association for 2021 are too conservative and that we could easily see $3.2 trillion plus in 1-4 family production next year. PFSI will continue to see strong volumes. As we noted in previous comments in The IRA , the FOMC is now buying UMB 1.5% coupons for the system open market account. Next stop for SOMA is a 1% coupon for Fannie Mae and Freddie Mac production. Spreads will tighten a lot, but volumes will remain strong. The profitability of PFSI and other mortgage lenders is, of course, wonderful to see after years of adverse conditions for nonbank lenders. Beneath the surface, however, there are some large and important flows of liquidity that are neither well-understood nor adequately disclosed in filings with the SEC. Going back to this summer, we wrote about the need for large government lenders like PFSI to finance the advance of principal and interest to bond holders when borrowers elect to request forbearance under the Cares Act. Nobody in Congress, it seems, thought to ask how the US would avoid a debt default if private servicers could not make the contractually required payments on “AAA” rated Ginnie Mae securities. See our comment in National Mortgage News : (" Election won’t impact mortgage industry like CARES Act problems will "). Looking at PFSI, the remarkable thing is that advances on delinquent loans had basically not gone up at all through June, this despite the fact that the level of delinquency on its government portfolio has risen and Cares Act forbearance has also clearly increased by billions of dollars. Advances started to rise in the third quarter, but still not nearly enough to explain how PFSI is funding advances on its FHA loan and Ginnie Mae MBS exposures. Says PFSI: “Servicing advances outstanding were approximately $346 million at September 30, 2020 versus $237 million at June 30 – Advances are expected to continue increasing over the next 6 to 12 months – No P&I advances have been made in 2020, as prepayment activity continues to sufficiently cover Ginnie Mae’s requirement .” That last sentence from the PFSI earnings materials is very significant, thus our added underline. Translated into plain terms, it says that the escrow float from loan prepayments on the $215 billion UPB PFSI GNMA book are being used to finance the missed loan payments due to Cares Act forbearance and other delinquency. Like the rest of the industry, the FHA delinquency numbers for PFSI (15%) are large. The delinquency data suggests mid-triple digit millions of dollars is being financed by PFSI off the books using escrow funds that ultimately belong to bond holders and Ginnie Mae. And there is no actual disclosure from PSFI as to exactly how much of the firm’s default advances are being financed with bondholder escrow funds. When we compare the treatment of the escrow issue in the IPO filings of AmeriHome and Caliber Home , for example, the difference is striking. While none of these issuers has provided quantitative data regarding the use of escrows to fund default advances, there is at least a frank statement of the fact and cautionary language regarding future liquidity risks as and when these escrow balances are no longer available. If you look at the 100% plus expansion of bank advance financing for PFSI needed to accommodate new lending volumes over the past 9 months, would warehouse lender banks be willing to also accommodate a large shift in default advances w/o cutting back on production volumes? The other remarkable aspect of the Q3 2020 earnings from PFSI was the discussion of the risk and return of the firm’s Ginnie Mae MSR, as shown in the chart below: At present, the strong performance of the lending side of the house has more than offset the losses in UPB due to mortgage prepayments. PFSI reported that “in 3Q20, MSR fair value decreased modestly.” That said, as with Rocket Companies (NYSE:RKT) , we urge investors and risk managers to cut the “fair value” PFSI MSR in half to truly reflect the torrential prepayments visible in the markets today. The US mortgage market is the only bond market where securities may be issued above par and with the embedded call option already in the money. This is the grim reality that faces PFSI and other lenders, and also owners of assets such as MBS and MSR. The borrower getting a 30-year mortgage at 2.97% today may be writing a 2.25% or 2% loan in a year’s time thanks to the "go big" strategy of the FOMC. For owners of MBS, the prospect for 2021 is a continuation of negative returns. Watch the spreads between the on-the-run 2s and 2.5% UMB coupons and the growing market in 1.5% coupon MBS in the GSE market and eventually in Ginnie Mae as well. At the same time as spreads are narrowing, the rising delinquency rates visible in government loans are likely to continue rising across the board into conventional loans and other real estate asset classes. COVID and the related economic dislocation does not merely impact consumers, but also carry a very real cost in terms of operating expenses and financing for lenders and investors. So far, like the rest of the industry, PFSI has managed to keep its loss mitigation expenses under control, even reduced servicing costs YOY, and has seen a decline in forbearance under the Cares Act. “ Of the 16% reduction in forbearance related to reperformance: – 9% were or became current – 7% were FHA Partial Claims or completed modifications,” PFSI reports. PFSI has also jumped into Ginnie Mae early buyouts or “EBOs” in industry parlance, an activity usually prohibited for nonbanks due to funding costs. We understand that PFSI finances their EBOs via a bank partner. The purchase of EBOs by PFSI is up 10x YOY, from $293 million in Q3 2019 to $2.7 billion in Q3 2020. Indeed, PFSI is the largest buyer of EBOs after Wells Fargo (NYSE:WFC) . Banks tend to be the largest buyers of EBOs due to their funding advantage and the fact that reperforming loans need not be resold. Source: FDIC “EBO loan-related revenue increased significantly to $170.2 million as a result of loss mitigation activity on loans emerging from forbearance while related expenses were modest as most of the loans bought out returned to performing status immediately,” PFSI reports, a truly remarkable result. It is fair to say that a good portion of those delinquent loans modified today and sold back into a Ginnie Mae MBS at 105 or 106 by PFSI will be falling back off the default waterfall next year. PFSI reported in Q3 2020 earnings: “$2.7 billion in UPB of loans were bought out of Ginnie Mae securities in conjunction with loss mitigation activities – 79% related to FHA Partial Claims, which must remain current for a minimum of six months to be eligible for resecuritization – 21% modifications, which may be resecuritized immediately.” Even as PFSI saw a $90 million drop in MSR cash flows, it reported a remarkable $170 million profit on EBOs. The term “cherry picking” comes to mind with the EBO performance of PFSI and other large GNMA issuers. Note too that third quarter delinquency numbers for FHA loans were a disaster, quoting one industry observer, with delinquency averaging 15.80% nationally, Texas at 18.29%, Maryland at 18.56%, and Louisiana at 19.56%. “At September 30, 2020, 9.0% of the loans in PFSI’s predominantly government loan portfolio were delinquent and in forbearance; elevated levels of reperformance and Beginning Period Forbearance Ending Period Forbearance resecuritization are expected to continue into 2021,” PFSI reports to investors. As we noted in our earlier comment (“ The Bear Case for Mortgage Lenders ”), the large delinquency visible in FHA loans could eventually become a significant source of risk for PFSI and other nonbank seller/servicers operating in the GNMA market. We believe that investors and risk managers need to carefully monitor PFSI’s funding and liquidity, on the one hand, and the performance of its EBO and FHA loss mitigation activities, on the other, for signs of increased stress. At the end of Q3 2020, PFSI reported record results. A year from now, depending upon whether Congress does the right thing for the industry with respect to the Cares Act, PFSI and other large Ginnie Mae issuers could be facing a very different and very difficult operating environment, and this even with record low mortgage interest rates.

New York | In this issue of The Institutional Risk Analyst , we take a look at the recently announced purchases of the US assets of Banco Bilbao Vizcaya Argentaria, S.A. (NYSE:BBVA) by PNC Financial (NYSE:PNC) , one of the better performing large bank holding companies (BHCs) in Peer Group 1. But first, to address some reader comments about our last post, yes, we do feature things other than banks and finance in The IRA . Geopolitics is a major component of risk, as with corruption and war crimes. Americans understand these things in binary, Cold War terms, but the nuances are far more profound. Long-time readers of The IRA know we are not shy about exploring the darker corners of the global political economy. Neither do Americans like to be reminded of the cost of Empire, including the cost to other nations of the "special" role of the dollar. Nations from China to Argentina finance their activities in dollars, and are short the reserve currency. Any wonder why inflation and debt defaults affect so many smaller nations? And Americans don’t like to hear of the cost in blood and lives of ill-conceived big power games, as in the case of President Barack Obama and Hillary Clinton in Syria, but this story goes back centuries. As we told one reader, go live in Syria or Lebanon for a year. If you survive the US funded terrorists, Syrian Army attacks, Russian bombing and Turkish atrocities, then we'll talk. The greenback became heir to the Pound Sterling at some point between the end of WWI and when Anthony Eden retreated West of Suez in 1956. Amid the dollar imperium that followed WWII, various foreign corporations attempted to gain footholds in the US, usually via acquisitions. But the big corporations and banks that financed WWII and defeated fascism in Germany and then communism in the Soviet bloc are formidable competitors. The Dutch are perhaps the most successful and longest-lived direct foreign investors in the US, and also among the quietest. Other nations, Japan, Germany and France most notably, have entered and exited sectors such as automobiles, banking and retail with great frequency. America’s rough and tumble market, even with accumulating layers of socialist regulation, is still the envy of the world. But sadly, America is not an easy market to penetrate successfully. The record of foreign banks entering the US market is not very impressive. BBVA first entered the US in 1970 with the creation of a US BHC. In 1995, the predecessor of BBVA USA acquired Southwest Bancshares. BBVA's first significant entry into the U.S. was in the mid-2000s in California. Their second entry was the purchase of Laredo National Bancshares in April 2005. In 2006 they bought another small bank holding company in McAllen, Texas. In that same time frame, they purchased Compass Bancshares and closed that transaction in 2007. One TX banker called the Compass acquisition "a total cultural misfit for the then existing Calif and Texas franchises." Along the way, BBVA either closed or sold the operation in CA. The institutional history of BBVA US is available here from NIC. The first thing to notice is that BBVA US is a decidedly mediocre performer. By acquiring the $100 billion asset BHC, PNC is doing the Federal Reserve Board and other regulators a favor. Whether or not the transaction will be accretive to PNC shareholders is another matter. And of course, the “progressive” politicians in Washington will demand a gratuity in the name of “consumer protection.” Based upon net income, BBVA US has ranked in the bottom quartile of Peer Group 1 for the past five years. Indeed, BBVA US reported a $2.4 billion loss at the end of Q2 2020. Today BBVA US is comprised of 44 affiliates, including a state-chartered member bank based in Birmingham, AL, and a broker-dealer. PNC, on the other hand, is an above peer performer that reported record results in Q2 2020 after the sale of its shares in Black Rock (NYSE:BLK) closed in May 2020. PNC has less credit exposure than many banks in Peer Group 1 with just 55% of total assets in loans. The 10th largest bank in the US, PNC has strong capital and lower double leverage at the parent level than most large banks as a result of the proceeds of the BLK share sale. PNC has a lower gross loan yield than its peers, but makes up for this with good operating efficiency and a larger portion of income from non-interest income. The bank’s efficiency ratio was 63% at the end of Q2 2020, roughly in the 60% percentile of Peer Group 1. The operating expenses of PNC are 20bp below the average for its large bank asset peers. So why is PNC buying BBVA US? The Wall Street Journal reports that the parent BBVA decided to sell because of scale and capital constraints. “The problem for BBVA was that while it grew in the U.S. over a 15-year period, particularly in the Southwest, it didn’t get big enough that it made sense to stay in the country.” Indeed, as with many other foreign banks in the past several decades, BBVA was forced to capture its investment in the US to support the bank’s capital position back home. So why is PNC buying this modest franchise? First, the purchase price of $11.6 billion is just a slight premium to tangible book for BBVA US as calculated by the FFIEC. Second, the acquisition expands PNC’s footprint into Texas, where BBVA had assembled a modest market share. And third, BBVA brings $80 billion in core deposits to PNC’s $330 billion in core deposit base, adding further strength to the bank’s funding profile and making it roughly the same size as U.S. Bancorp (NYSE:USB) . If the past is any guide, we expect PNC to absorb the deposits of BBVA USA and gradually reduce assets to drive operating efficiency and overall asset and equity returns. Both PNC and its closest asset peer USB have shown great discipline in the past in terms of maintain a certain asset size. But more than anything else, this transaction illustrates the intense competition for funding in today’s market. As our friend Joe Garrett of Garret McAuley & Co told his clients recently: “Gathering assets is relatively easy. Getting deposits is extraordinarily difficult.” Even in the age of QE and zero returns on risk free assets c/o the Federal Open Market Committee, dollar funding remains scarce. More on this point in our next comment.

In this issue of The Institutional Risk Analyst, Hans-Joachim (Achim) Dübel of Finpolconsult.de in Berlin offers a geopolitical assessment of the return to power of the war party in Washington. Look through the eyes of the tyrant, the arms merchant or oil company, and you understand the Great Game in the 21st Century. “When we decided to become a global empire after the war, it was Harry Truman who dropped two atomic bombs on Japan and made us a national security state and a militarized economy. Our citizens were not advised, they still don't know. They still think that it's a free, open country, but we decided to stay armed and to be involved in every country in the world. That was their decision - and who are 'they'? They are traditionally the very wealthy: the one per cent that my cousin Al Gore dared mention at one point in the campaign as owning practically all the property in the country.” Gore Vidal The Guardian (March 29, 2001) Berlin | A drama is unfolding for Korea. President Donald Trump was a once in a generation chance for reunification on the East Asian peninsula, as President Ronald Reagan was for Germany almost half a century ago. With the victory of Joe Biden and Kamala Harris , the pro-war tendency in America that goes back to President Harry Truman returns to power. The consequences for Korea and many other nations around the world will be terrible. It was Reagan himself, not the CIA man President George H.W. Bush, who followed him, who pushed for the first covert and then overt operation to bring the Berlin wall down. It was Reagan's Jacksonian sense of independence and his personal charm that convinced a reluctant Soviet leadership and domestic administration apparatus alike to follow. Reagan did most of the job in his second term, after he had gained control – and had survived an assassination attempt. Now the old British-American war networks that have dominated U.S. administration since the murder of President John F. Kennedy will take over again. When the debris of the wall was still lying around in Berlin, George H.W. Bush in 1991 blocked Helmut Kohl in his effort to build a joint European house together with Russia. Under President Barack Obama and Secretary of State Hillary Clinton , the tension with Russia led into the current New Cold War. The new de-facto President of the United States, Kamala Harris, will now stop every effort to bring regional peace and cooperation. Harris was the first candidate to drop out of the Democrat’s race due to her profound unpopularity, but she was always the war network’s preferred candidate. I predicted in May that the US military industrial complex would push Harris through regardless. The popular contenders such as Senator Bernie Sanders (D-VT) and President Trump were axed away with the most unfair means to clear the path for Harris to reclaim control of the US for the war network. Harris’ career is also well planned ahead. The demented and corrupt Joe Biden, who is easy to manipulate and blackmail, is for some the perfect profile of a politician. Biden will be kept as a kind of political hologram for the next four, maybe eight years, while policy will be run by Harris and the corporate networks she represents. And then she will become President herself. It is reasonable to expect Harris to run the country until 2032 or 2036. The war network appreciates continuity. The war network follows the old British imperial strategy to divide and conquer, and hence support political radicals – such as Islamists, or the radical left for that matter. The political affinity between both groups and even cooperation in conflicts such as Syria is no coincidence. The goal is to incite war and domestic conflict wherever there is an opportunity for it. In a radical departure from that policy, Trump had been halfway successful in his peace-making efforts the Middle East, and at least tried in Korea. In a second term he might have been successful in both theatres. Korea will be now on its own and need to seek for new allies, or be forced to wait for another 30 years until another great disruptor like President Trump emerges to challenge the war network. In the Middle East and Eastern Europe the conflict with Russia will be reignited, bringing more instability and internal conflict to an existentially threatened European Union. This will increase the distance between America and its allies. After the pipe dream of unipolarity is over for America, only a peacemaking role will give the country the chance to lead the world – as primus inter pares and through soft power. An America following British imperialistic dreams that provoke more conflict will soon lose even this role and vanish into oblivion. The author is an international financial sector expert with work experience in 50 countries worldwide. His father was the head of the East German exile organization in the Christian Democratic Party of Germany until reunification. More Reading The American Conservative | Why the West Fuels Conflict with Armenia https://www.theamericanconservative.com/articles/why-the-west-fuels-conflict-in-armenia/ CSPAN | Gore Vidal on the State of the Union (1991) https://www.c-span.org/video/?23286-1/state-union London Review of Books | The Vice President’s Men https://www.lrb.co.uk/the-paper/v41/n02/seymour-m.-hersh/the-vice-president-s-men Foreign Affairs | Hillary Clinton: A National Security Reckoning: How Washington Should Think About Power https://www.foreignaffairs.com/articles/united-states/2020-10-09/hillary-clinton-national-security-reckoning

New York | In this issue of The Institutional Risk Analyst , we look at the earnings release earlier this week by Rocket Companies (NYSE:RKT) . We also assess the market reception for independent mortgage banks (IMBs) more generally since the RKT initial public offering this past August. With returns on mortgage-backed securities (MBS) negative due to FOMC bond purchases and high mortgage prepayment rates, investors and lenders fight the Fed every day. Mortgage Group: ACGL, AGNC, AI, BKI, BXMT, CIM, CLGX, COOP, ESNT, FAF, FBC, FMCC, FNF, FNMA, IMH, LADR, MFA, GHLD, NLY, NRZ, NYMT, OCN, PFSI, PMT, RKT, RWT, STWD, TWO Because of forward liquidity and credit concerns, the window for IMBs to tap the public equity markets appears to have closed for now. As of this writing, there are only a handful of IMBs that have managed to follow RKT into the public markets, including Guild Holdings (NASDAQ:GHLD) . These deals and SPAC transactions for United Wholesale Mortgage and Finance of America were difficult stories to sell to investors and traded poorly in the secondary market, Barron's reports. Offerings for AmeriHome , a unit of Apollo Global Management (NYSE:APO) subsidiary Athene Holdings (NYSE:ATH) , Caliber Home Loans and, most recently, loanDepot , are still pending. With respect to UWM and its impending merger with a SPAC called Gores Holdings IV (NASDAQ:GHIV) , Barron’s reported on September 23, 2020: “Gores Holdings IV (NASDAQ:GHIV) stock fell close to 2% on Wednesday after the deal was revealed, to about $10.60. Better-known mortgage player Rocket Companies (RKT) made its debut in an initial public offering last month and faced lackluster demand from investors, having to reduce its listing price. For UWM, management’s own projections have earnings falling in the next two years, and insiders are using the SPAC merger as a chance to cash out a portion of their stake. That could explain the deal’s lukewarm reception.” Various media outlets have attributed the delay in IPOs by mortgage firms as being due to “market volatility,” but in fact we think that investment managers are smarter than the investment bankers pretend. True, most equity managers are not very good at corporate finance, but it does not take a genius to realize that the boom in mortgage lending is due to 1) low interest rates and aggressive asset purchases c/o the FOMC and 2) that all good things do, eventually, end, especially when the earnings projections for 2021 are down. The fact that forward projections for 2021 and beyond show falling volume and revenue is hardly a surprise to students of monetary mechanics. The FOMC's "go big" strategy has skewed market benchmarks to absurd levels, pushing returns on MBS negative in cash terms. A mortgage servicing right (MSR), however, due to the possibility of recapturing existing clients via a loan refinance, offers positive returns for superior lenders. RKT and other IMBs in the top five are able to monetize the optionality in residential mortgages. But despite this huge positive, we also suspect that the other serious operational issues waiting in the wings have added a dose of caution to the mix with investors. Suffice to say that our friends at SitusAMC have capitalization rates for new production Ginnie Mae 3s MSRs at over 3x annual cash flow through October, but we are a seller at 2x thank you very much. The Ginnie Mae 4% coupon MSRs are marked today at 2x annual cash flow, but all of these assets will prepay thanks to the FOMC. Ask any operator in the industry that question and you'll get the same answer. And with the FOMC now targeting Ginnie and UMB 1.5s as part of QE, anybody who tells you about rising mortgage interest rates is badly mistaken. A careful reading of the S-1s filed by AmeriHome and Caliber, for example, tell the astute credit analyst all that you need to know about the risks involved in the government mortgage business. Do equity managers understand such nuances? Yes, enough not to get stuffed with a bad offering by a bunch of investment bankers who cannot spell "option adjusted duration." The table below from the Q3 2020 RKT earning report is shown below. Focus on a couple of the more remarkable points in this relatively brief earnings summary: First, the fair value of the firm’s mortgage servicing rights declined only slightly over the past year, a testament to the excellent operational efficiency of RKT as a lender and servicer. The vast investment in operations and technology is the chief reason that RKT received a good reception from equity investors. But millions of dollars in retail advertising didn't hurt either. If you figure that at least 1/3 of the mortgage servicing rights held by RKT prepaid in the past 12 months, this means that RKT was able to replace those MSRs despite the frightening rate of loan prepayments seen since April. And RKT booked a 5% gain-on-sale on every loan. Send those "thank you" notes to Jerome Powell at the Federal Reserve Board in Washington. The second point that as is related to the first is that RKT has one of the highest rates of client retention in the industry. RTK states in its earnings release: “Our recapture rate was 82% for refinance transactions for the twelve months ended September 30, 2020 and our overall recapture rate was 73% for the same time period.” This is best in class performance, yet even with the huge expansion in lending volumes, the FV of the RKT MSR still fell as shown in the table above. Third, because of the rate of prepayments and the fact that the FOMC has begun to buy 1.5% MBS coupons as part of open market operations, risk professionals and managers must haircut the MSR of firms like RKT at least by 1/3 to get to true FV. Most banks, REITs and public companies use inflated valuation multiples for MSRs, which are inevitably marked down over time. Fourth, looking at the year-over-year change in RKT’s financials, the key takeaway for risk professionals and investors is mean reversion. The volume and profitability numbers for RKT will inevitably decline, the only question is when and how much. We believe that RKT may be able to achieve its goal of 25% national market share in terms of lending ( Wells Fargo (NYSE:WFC) reached 35% in the 2000s), but the obvious question is 25% of what and at what level of profitability? Gain on sale margins for RKT, a key indicator of industry profitability, grew 44% YOY due to the actions of the FOMC. As the industry brings more and more capacity online to capture volumes these margins will decline. Indeed, the “historically strong” 4.5% gain-on-sale reported by RKT is a 20-year record and is unlikely to be sustained, even if the FOMC continues to lower interest rates via open market purchases of MBS. Industry profits will remain strong by historical standards, but margins will compress. RKT projects that in Q4 2020, closed loan volume will be between $88 billion and $93 billion, or an increase of 73% to 83% compared to $50.8 billion in the fourth quarter of 2019. RKT projects “net rate lock volume of between $80 billion and $87 billion, which would represent an increase of 82% to 98% compared to $43.9 billion in the fourth quarter of 2019.” These results are unlikely to be repeated in 2021. “Gain on sale margins of 3.80% to 4.10%, which would be an improvement of 11% to 20% compared to 3.41% in the fourth quarter of 2019,” RKT reports, indicating that operating margins for RKT and other lenders are already under substantial downward pressure. SitusAMC, MIAC and other third-party MSR valuation houses are reporting the same trend. Bottom line: RKT is the best performer among the large IMBs operating in the residential mortgage market. Much of the increase in volumes and margins, however, are the result of actions by the FOMC and a lack of industry lending capacity coming out of the horrific year 2018, when much of the industry was unprofitable. The mortgage industry has grown headcount by roughly 50% since April of this year, thus spreads will shrink and loan quality will fall. The short-term outlook for RKT and other stronger IMBs is good, but there remain a number of challenges ahead as we noted in our last comment on the residential mortgage sector (“ The Bear Case for Mortgage Lenders ”). RKT is well positioned to take advantage of the good times and also weather the inevitable housing market correction that will come in several years. Until then, make and sell as many loans as possible. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

New York | In this issue of The Institutional Risk Analyst , we return to the fiscal situation facing New York and other major American cities in the wake of the apparent victory by Vice President Joe Biden in the 2020 Presidential election. The weak showing by the Democrats has stymied much of the promised Biden agenda, particularly trillions of dollars in aid to large cities in blue states that was seen as a given only weeks ago. The situation facing New York is perhaps worse than that facing other cities, both because the government of Mayor Bill DeBlasio already had a spending problem as 2020 began and because the impact of COVID on New York is more severe. The extended lockdown imposed by Mayor DeBlasio and Governor Andrew Cuomo caused roughly half a million people to leave New York City between April and the end of July, according to the New York Times . This figure has increased since July and does not include the disappearance of tourists and other visitors from the streets of New York. And most of midtown Manhattan remains boarded up due to fears of rioting and looting. The Rhino The grim reality facing New York is summarized in the most recent annual report for the fiscal year ended June 30th from New York Comptroller Scott Stringer , who was formerly the President of the Borough of Manhattan. New York City is one of the best managed US cities in terms of financial reporting, but less so when it comes to spending and fiscal sanity. Under the free spending Mayor DeBlasio, the city has seen revenues rise by high single digits each year and expenses have more than kept pace. In FY 2020, New York City had revenue of $95 billion and expenses of almost $99.5 billion. The details of the NYC budget are shown below from the FY 2020 annual report. Note that NYC has an accumulated deficit of over $200 billion and total long-term debt and other obligations of $270 billion. And these figures do not begin to capture the total debt and other obligations buried in the city’s over-extended financial statements. Keep in mind that the revenue numbers for NYC through June reflect the strong momentum of the city coming into 2020 and only begin to show the deterioration in the revenue of New York City since the start of FY 2021 on July 1st. Several sources have talked about a fiscal deficit of $8 billion in 2021, but we think the actual deficit number could be twice that or more. The chart below shows the city’s cash balance through June 30 (blue line) and then the estimate from Comptroller Stringer’s office. Notice that the estimated cash line from FY 2020 crosses through the cash line for FY 2019 in September and has trended below last year’s results since then. The estimates from Stringer’s office show cash balances falling below $2 billion around year end, then miraculously rising as the result of a Biden financial rescue plan. The FY 2020 annual report for NYC was finalized weeks before the Presidential election . But now that the election has ended with the closest race in a century and has seen the GOP pick up seats in Congress, the Democratic calculous that assumed a financial rescue by Washington needs to be reassessed. If there is no fiscal rescue plan for the states and particularly the large cities in blue states like New York, then it seems safe to predict that several large American cities may be forced into default before Joe Biden takes the oath of office in January. “ Big city mayors and Democratic state governors had been counting on a ‘blue sweep’ of national offices to help get them out of some very deep budget and pension funding holes. They also dreamt of green transport, more help with healthcare . . . the list was long,” writes John Dizard in the Financial Times . “Now there is the grim winter reality of a surviving Senate Republican majority, led by Democratic bugaboo Mitch McConnell , which keeps its veto on all that progressive spending and redistributive taxation.” Of course, Republicans in Congress have no intention of riding to the rescue of the blue states. Changing the state and local property tax (SALT) deduction was the first assault on the economic base of the Democratic Party. Step two is to push major cities like New York into bankruptcy, which would force a violent confrontation with the public sector unions. Such an apocalypse would see elected Democrats voiding union contracts and also see the end of New York’s New Deal era state constitution. Red-state Democrats in Congress are unlikely to be very enthusiastic for spending trillions of dollars to help New York City, thus Congressional Democrats have a serious problem brewing in New York and cities like Chicago. The Stringer report is quite a sobering read, particularly as it details the impact of COVID on the New York economy. For example: In New York City, employment plunged by almost 20% from February to April and grew by a smaller 3.2% from April to June. This nearly 20% decline in New York City employment was equivalent to the loss of an unprecedented 910,050 jobs between February and April. Small business revenues declined dramatically in March. Manhattan small business revenue was already declining in early March, and had declined by 70% by month’s end, as businesses shuttered and commuters stayed home. Despite some recovery, Manhattan small business revenue in early July was still down over 40% from the beginning of January. Most immediately, a failure by the Federal government to provide adequate fiscal relief to state and local governments could upend the New York State budget—and by extension, the City’s resources. New York State has threatened to reduce local aid by as much as 20% if Congress does not appropriate additional unrestricted aid to state and local governments, using executive powers included in the enacted State budget. The big problem for New York and other major cities like Chicago and Los Angeles is that the dollar of municipal revenue comes from many different sources. When the local economy is disrupted massively as in the case of New York and other blue state cities with restive populations, the impact on the different components of city revenue is magnified. The breakdown of NYC revenue for the last fiscal year is shown below. The real question facing NYC is how much will the impact of COVID and the exodus from the city due to fears of rioting and looting impact each of these revenue lines. Sales and use taxes are clearly down, and real estate taxes are also falling as more tenants and landlords default. Surviving landlords will press the city for reductions in appraisals and taxes. Last month, New York City and state both had their credit ratings lowered by Moody’s Investors Service , which said the impact from the coronavirus on the most populous U.S. city -- the core of the state’s economic engine -- is among the most severe in the nation. “In a pair of downgrades announced within an hour of each other, Moody’s dropped both the city and state by one notch to Aa2, the third-highest investment grade rating,” Bloomberg reports. But frankly neither issuer deserves an investment grade rating at this stage. With Mayor DeBlasio refusing to take action to cut city expenses to size with the new population of Gotham, and Govenor Cuomo suddenly sounding like a Republican deficit hawk from the 1990s, a default seems inevitable. The FY Q1 2021 numbers ending September 30th won’t be released until December, but suffice to say that the picture is likely to be a good bit more dire by that time. Comptroller Stringer proudly notes in the FY 2020 annual report that the city has not had to issue short-term cash notes for 16 consecutive years. When you see New York City issuing cash notes, that’s your hint that a debt default by America’s largest city is imminent. Truth is, it's already too late. Mayor DeBlasio cannot cut spending fast enough now to avoid running out of cash. Will Senator Mitch McConnell (R-KY) and Senate Republicans really push New York into default? Yeah, they probably will and more. Students of history will note the mirrored parallel between Biden and President Herbert Hoover , who FDR declined to help in 1932 as the nation's banks were collapsing. President Donald Trump will be cheering on Senate Republicans as he heads home not to New York City but to Palm Beach. For investors in municipal credit, the next couple of months will be quite an experience.

New York | In this issue of The Institutional Risk Analyst , we update readers on the progress of the Financial Stability Oversight Counsel to root out risk, real and imagined, in the world of nonbank finance. Sadly for the mortgage industry, no matter who wins the White House in 2020, the FSOC will not go away. The effort to address nonbank risk has been led by the Conference of State Bank Supervisors (CSBS) , a trade association that informally represents the various states. An equally informal group of researchers within the Federal Reserve System is also in the vanguard of those warning about nonbank risk. But so far, the warnings of the FSOC regarding nonbanks have proven empty. The FSOC's earlier protestations regarding insurer MetLife , which was forced out of the mortgage business, were also in error. FHFA Director Mark Calabria is personally responsible for elevating this issue of nonbank risk within the FSOC, particularly regarding mortgage servicers. Director Calabria is not worried about highly leveraged hybrid REITs, you understand, but mortgage servicers . Since 2015, the CSBS has been attempting to fashion a unified response by the states to the perceived risk from nonbank financial firms, aka independent mortgage banks (IMBs). Even though nonbank mortgage firms are already subject to regulation by Ginnie Mae and the Federal Housing Finance Agency , the CSBS believes that more need be done. The good news is that the CSBS, in meetings with a number of mortgage firms, has proposed a quite reasonable framework for thinking about liquidity and capital that largely mirrors the current proposal out for public comment from the FHFA and the existing rules for Ginnie Mae issuers. Also, the CSBS has advanced the marvelous idea of a streamlined state-level audit of major nonbank firms every 18 months. The regulators in different states would participate in an informal yet cooperative process, saving time and scarce resources. Again, a seemingly positive development. More, the CSBS has encouraged the Federal Reserve to create a liquidity facility for nonbank mortgage firms . Another very positive step. For the US mortgage industry and investors, there is an urgent need to ensure broad, uniform adoption of any framework proposed by state regulators. The CSBS recommendations are useful only to the extent they are implemented uniformly by the industry, the federal mortgage agencies and the states. The worst possible outcome, according to one industry briefing paper, is a patchwork regime of different standards or inconsistent regulations for liquidity and capital. While the new FHFA rules for nonbanks may not take effect for some time, the industry should encourage the CSBS process. State regulators have real world concerns about the potential blowback from a nonbank failure a la 2008, but times have changed. The nonbanks of today look nothing like rogue issuers such as Countrywide , Citigroup (NYSE:C), Lehman Brothers or Bear Stearns & Co . The key question is whether the CSBS and other regulators are willing to advance their understanding of nonbank risk to fashion a workable policy. Hint: Look for the leverage. For example, both the FSOC and the FHFA continue to focus on stress testing and capital requirements of nonbanks through the lens of commercial bank regulation. But for nonbanks and even the GSEs themselves, a bank level approach to capital and liquidity will inevitably fail to address the true risks. Why? Because c ommercial banks and other creditors ultimately control the assets and liabilities of nonbank mortgage firms. Since the SEC under Chairman Arthur Levitt wrongly amended Rule 2a-7 in the 1990s , nonbanks have been unable to sell commercial paper to money market funds. As a result, nonbank financial companies are essentially captive of the large commercial banks in terms of funding. Any risk, via secured financing facilities, is "in the bank" as we say. The secondary source for liquidity for IMBs is the high-yield debt markets. Mortgage issuers are rarely investment grade credits on an unsecured basis. The quid pro quo for warehouse lending from banks to IMBs is deposits. Nonbanks control substantial escrow balances, which are deposited with the warehouse lender banks. Needless to say, this is a very sticky business relationship. The liquidity of nonbank mortgage firms is a function of the willingness of commercial banks to lend against government-insured collateral. The FSOC and CSBS don’t seem to full grasp the significance of this point. Most nonbanks that do not retain servicing assets often function with net negative working capital . The whole point of secured finance beyond mortgage lending is to work with somebody else's money . Right? Liquidity is a function of collateral, thus expecting nonbanks to increase liquidity in a countercyclical fashion before recessions, for example, is impractical. Lending volumes typically fall as an economic expansion matures. Only after unemployment rises, the Fed has lowered interest rates and mortgage lending volumes grow do liquidity levels typically rise for IMBs. Mortgage lending is entirely cyclical, as shown over the past six months. For this reason, it is important to state that the lender banks are unlikely to abandon nonbanks, even in times of financial stress. In the dark days of 2018, when few mortgage lenders were profitable and most IMBs had breached debt covenants, the banks did not abandon the IMBs. And this past April, when many IMBs were again technically insolvent because of the Fed’s massive open market operations in response to COVID, the banks again stepped up and supported these important commercial customers. Several IMBs that went public in the Fall were literally saved by the commercial banks and TBA dealers in April. How would the CSBS and FSOC propose to model the "risk" from Fed open market operations? Why did the banks support the IMBs in 2018 and in April of this year? Because the vast majority of the “assets” of the IMBs are comprised of government-guaranteed loans and related servicing assets. These assets are money good as collateral and are easily sold in the event of default by the IMB. (See our 2017 comment, " Who's Afraid of Mortgage Servicing Rights . ") As the public record going back decades clearly indicates, the failure of an IMB is basically a non-event from either a credit or systemic perspective, especially once the loans and servicing assets are sold under the protection of the Bankruptcy Court. For some odd reason, neither the FSOC nor the CSBS nor the FHFA nor the Office of Financial Research have taken notice of the public record regarding failure of IMBs . Another area of investigation by the CSBS and FSOC is whether nonbanks should have “living wills” like large commercial banks. The answer clearly is no. First, by law the GSEs and Ginnie Mae have preemptive rights with respect to the government-insured loans and servicing assets "owned" by IMBs. If an IMB fails, the GSEs and Ginnie Mae will unilaterally transfer responsibility for servicing the loans. Then the remaining assets are liquidated. Please remember to turn off the lights. Second, in the event of a default, the Bankruptcy Court will essentially ignore the living will of an IMB. Just as the CSBS has no legal authority or sovereign immunity, a living will for an IMB is a waste of paper and toner. Keep in mind that the FDIC acting as Receiver for a failed commercial bank would ignore a living will mandated by Dodd-Frank. The millions spent preparing the living will of a large bank is completely wasted effort. A similar document for a nonbank is equally pointless. Those who work with Trustees and Receivers know these things. The Trustee in a bankruptcy is responsible to the Bankruptcy Court and the estate, not to state regulators. Historically, the GSEs and Ginnie Mae have not entered bankruptcy proceedings for IMBs or FDIC bank receiverships as parties. Without a defined receivership process as in the case of 12 USC for federally insured banks, there is no choice other than federal bankruptcy for an insolvent mortgage lender or servicer. The other bone of contention between the CSBS, FSOC and the nonbanks is the notion that, like commercial banks, IMBs ought to do annual stress tests. As we noted in our recent report in The IRA Premium Service (“ Bank Profiles: Morgan Stanley vs Goldman Sachs ”), the Fed’s stress tests are a political circus more than an analytical exercise. But this fact has not prevented the other agencies in Washington, including the FHFA, from copying the Fed’s bad example. So far, the only agency that has been able to assemble an effective stress assessment process for IMBs is Ginnie Mae and HUD. The stress testing is conducted internally by HUD with input from the issuers, rather than imposing this huge analytical burden on nonbanks directly. The Ginnie Mae process is viewed as a success by issuers and is an example of cooperation between industry and regulators to address liquidity and other issues. Since the Ginnie Mae market is by far the most demanding and high-risk agency sector from an operational perspective, it makes sense that the new capital and liquidity standards for Ginnie Mae issuers should be the basic point of departure for the CSBS and the FSOC. And as the CSBS gets better acquainted with the Ginnie Mae approach to regulation of nonbanks, they will begin to understand the riddle of liquidity. In all of the doom and gloom scenarios the come from FSOC and the CSBS with respect to nonbanks, there is no actual evidence of a mortgage lender or servicer causing systemic risk because of a liquidity problem. There are no examples of a failing hybrid REIT causing a global financial meltdown, for example, although we almost tested that in April. Wall Street investment banks like Lehman and Bear, and subprime lenders like Citibank, created and spread toxic assets throughout the financial system before 2008. Indeed, there is no evidence to support the contention by the FSOC and Director Calabria that nonbank mortgage companies pose a systemic risk. IMBs are leveraged lenders and asset managers that generate a lot of cash, at least for the moment. But the one thing you can be sure of is that if you stress test a nonbank using the same criteria as a commercial bank, all the nonbanks will fail every time. T he liquidity of nonbanks is a function of the willingness of commercial banks to lend. We can save the folks at the CSBS and FSOC a lot of time and money by giving them the answer to the stress test ahead of time. In even a modestly stressed scenario, with the fantasy land assumption that the lender banks will walk away from large commercial clients, then the nonbanks all fail. But as we already discussed, that is very unlikely to ever happen. If the banks did not walk away in 2009-2010 or in 2018, just when would that happen? The mortgage industry is going to have to work with the CSBS and FSOC to address their concerns, real or imagined. In a practical and political sense, the objective of the CSBS has been to get a seat at the table in Washington, with Ginnie Mae and the FHFA, to ensure that any risks from nonbanks are addressed in a reasonable way. The IMBs also need to get a seat at that same table. The only question is this: Who will represent the political interests of private finance companies, REITs and IMBs in Washington, separate and apart from the interests of the big banks?

New York | In this issue of The Institutional Risk Analyst , we compare Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) . We have a negative risk assessment on GS that has been in place since 2019. Of interest, Moody’s has put the senior unsecured debt ratings of GS (A3) and MS (A2) on review for possible upgrades. When we look at these two $1 trillion asset bank holding companies (BHCs), it is tempting for analysts and investors to see their business models as similar. After all, both are in the business of investments and securities, right? But this is not the case. Other than the fact that the two BHCs are primarily focused on securities dealing and investment advisory services, and are roughly the same size, the similarities between GS and MS are outweighed by the differences. GS and MS are two of the oldest financial firms in the US. The legacy of Goldman is that of a 19th Century commercial paper discount house that became known as a trusted investment banker after WWI and then evolved into a global trading and investment advisory firm until 2008. In the case of MS, the firm split off from the predecessor of JPMorgan (NYSE:JPM) after the passage of the Glass-Stegall law in 1933 separating banking and securities. In the dark days after the great financial crisis, GS, MS and other near-bank securities firms often owned nonbank depositories in UT and other venues. GS and MS became full-blown commercial banks after 2008 in order to gain access liquidity from the Fed. MS acquired the Smith Barney brokerage business from Citigroup (NYSE:C) , while GS has chosen to grow its banking and asset management business organically. Today both firms own federally insured depository institutions, but have core deposit and loan portfolios a fraction of the size of JPM and other money center banks. Quantitative Factors The comparable public companies used for our analysis are shown below at the close on Friday, October 30, 2020. We also use the averages for Peer Group 1 , which includes the 127 largest US banks by assets. F irst let's look at GS and MS as banks on a consolidated basis and then discuss their nonbank operations. Source: Bloomberg (10/30/20) The first metric to consider is the composition of the assets of the two firms. While GS is slightly larger than MS in terms of its balance sheet, MS has a bigger loan book and bigger deposit franchise. MS had almost $175 billion in core deposits at the end of June 2020 vs $128 billion for GS. More important, MS had just $330 billion in noncore funding vs over $500 billion for GS at the end of June 2020. Overall, interest expense at GS exceeded 1% of total average assets vs. 0.62% for MS and 0.61% for Peer Group 1. As shown in the chart below, GS has a higher cost of funds than Citi and is just under American Express (NYSE:AXP) in this regard. MS, on the other hand, tracks Peer Group 1 in terms of funding cost. Source: FFIEC The next thing to consider after funding is how the bank prices its loan portfolio, an important measure that captures both the bank’s competitive position and also its ability to generate revenue given its chosen internal default rate targets. When it comes to the pricing of its larger loan book, MS seemingly is below GS and the other comparables, but its returns net of credit costs are actually higher. Source: FFIEC As the chart above illustrates, GS has the best gross loan yield in the group after Citi and AXP. Indeed, AXP has managed to increase its gross loan spread even as other banks have been forced to give ground, a remarkable performance for the smaller AXP. Notice that MS has seen its consistently mediocre gross loan yield fall in recent quarters, but GS has seen the worst erosion of economics on its loan book of the group. After we consider funding costs and the gross yield on the loan book, the next analytical point is the cost of credit. For this purpose, we compare the net loan loss rate as a percentage of total loans. While GS is close to the top of Peer Group 1, MS is in the bottom decile of the peer group and, indeed, tracks well below the group average for loan losses. At the end of June 2020, GS reported net losses equal to 76bp vs 28bp for Peer Group 1 and just 3bp for MS. Indeed, as shown in the chart below, MS basically has reported the lowest losses of any of the banks in the group. Source: FFIEC As you will note in the chart, AXP has the highest loss rate of the group, followed by Citi and GS. Indeed, GS has just seen its net loan losses rise above that of JPM after basically tacking Peer Group 1 for the past five years. This suggests that GS is taking more risk with its loan book. Meanwhile, MS has seen its net loan loss rate actually falling in recent quarters to near-zero levels. Once we assess the bank’s funding costs, loan pricing and net credit losses, we begin to understand the components of income. Since both MS and GS depend upon non-interest fee income for the majority of their profits, the net income of the BHCs reflects both the assets of the group and the intangible relationships with customers that define the franchise of any investment bank. But the fact of the matter is that MS looks a lot better as a commercial bank than does GS. The chart below shows net income as a percentage of average assets. Aside from illustrating the superior performance of AXP, which is the best performing large bank in the US, the chart illustrates how MS manages to outperform both GS and Citi in terms of asset returns. Indeed, in recent quarters MS has outperformed both GS and Citi by a wide margin. Source: FFIEC As noted above, GS and MS generate roughly the same net operating income, but MS makes more money on its lending operations because of the relatively low cost of the funds and also the extremely low net credit losses. Indeed, while GS generates slightly more revenue in terms of gross interest income than MS, the more efficient MS manages to take almost twice as much net interest income to the bottom line. At GS, roughly 85% of net operating income comes equally from trading, and investment banking and commissions. At MS, less than a third of the firm’s operating income comes from trading while more than 50% comes from investment banking. The striking thing to note comparing the two firms is that these relationships are quite stable at MS going back years, while GS evidences significant volatility in the share of net operating income that comes from these two key areas. In terms of operating expenses as a percentage of average assets, the two securities and investment firms are relatively close to each other, with MS at 3.41% and GS at 3.12%, but far above the average for most large banks in Peer Group 1 at 2.63% of average assets. MS has slightly higher overhead expenses in dollar terms, but the superior profitability and credit performance of MS more than allows for this difference. Indeed, as of Q2 2020, GS reported an efficiency ratio of 78% to the Federal Reserve Board vs 70% for MS. The lowest efficiency ratio for the top banks is 49% for Citi. Another aspect of the quantitative analysis is the investment management arm of GS and MS. While the former has a larger pool of assets under management (AUM), MS manages to generate more revenue per dollar. With the purchase of Eaton Vance (NYSE:EV) and its $500 billion in AUM, MS has now topped $1 trillion in client assets but still does not figure in the top 10 global asset managers. Note that most of the top managers are neither investment nor commercial banks and thus tend to trade at higher equity valuations than either GS or MS. And not all AUM is the same. (Ranking as of year end 2019) Looking at the most recent results for Q3 2020, MS earns far more from its smaller investment and wealth management businesses than does the larger GS. The table below shows the three main business lines that are disclosed by both firms. In both cases, the footings attributable to the commercial bank operations are shown as part of wealth management Source: EDGAR Again, not all AUM is created equal. Even though GS claims to have twice the AUM of MS (pre-Eaton Vance acquisition), it makes less than half the revenue per dollar of client assets. Along with the disparity in the performance of the insured depository, the chief quantitative differences between GS and MS have to do with the performance of the investment and wealth management businesses. Also, the markets and investment banking lines of MS have displayed superior stability in recent years while the comparable business lines of GS evidence substantial operational risk, as discussed below. Qualitative Factors The chief qualitative issue facing both GS and MS is the sufficiency of internal controls to manage the manifold risks that come along with the investment banking business. As we noted above, the banks and broker-dealers among global financial institutions tend to trade at lower equity market valuations than do the pure asset managers. This discount arises, at least in part, due to the perceived risk of doing business with a financial institution that engages in banking and/or securities dealing activities. As the major banks of Europe, Asia and the United States seek to derisk and grow their investment management business, the natural question is when and how will this perceived gap in terms of risk and market value be eliminated? The short answer to the question is that such an improvement is unlikely to occur because the business of investment banking and capital markets dealing is intensely competitive, which tends to generate outsized risk. Whether one talks about the 1MDB affair , a Goldman Sachs-backed Malaysian fund that turned into one of the biggest scandals in financial history, or other events in the past of GS such as Abacus (2011), American International Group (NYSE:AIG) (2008), Blue Ridge and Ticonderoga (1929) and o ther regulatory and legal violations, the prominence of operational risk in the firm’s business model is unmistakable. Firms such as Bear, Stearns & Co and Lehman Brothers also took outsized risks and are no longer with us. A guilty plea and partial settlement of the 1MDB scandal cost GS two quarters worth of earnings. Since 1998, fines and settlements have cost GS shareholders over $10 billion , not including the $2.5 billion in the 1MDB settlement with Malaysia earlier this year. MS does not have a similar tale of woe when it comes to legal and regulatory matters, events which ultimately are a cost to shareholders in terms of cash losses and also reputation damage. The reason very simply is that MS as a firm manages risk and encourages bankers to hit singles and doubles, and pays well for performance. GS as a firm has needed to go for more risky business in terms of sourcing opportunities. To boil down the question of comparing MS and GS to each other to its essence, the question is this: Would MS CEO James Gorman ever have agreed to meet with the architect of the 1MDB fraud, Jho Low , much less accept him as an investment banking client? Probably not. MS is a far more conservative firm as an investment bank than GS, in ways that few on Wall Street understand. Culture matters. MS went through an existential event in 2008, a near death experience that management determined not to repeat. After years of cost cutting and restructuring under Gorman, MS emerged stronger and with one of the toughest risk management cultures on the Street. The firm ran its own internal stress assessments years before the Fed began its annual testing circus. And a decade later, Gorman has one of the most stable operating teams in the business. Another important qualitative risk factor is the company’s business strategy and execution, a metric that is partly described by quantitative measures such as efficiency as discussed above. MS has an eight-point advantage in terms of operating efficiency over GS, but is well above peer compared with other banks. Both GS and MS need to get efficiency into the 60s long term. MS has also been far more aggressive in building its business via opportunistic acquisitions. The acquisition of E*Trade in February of 2020 and more recently Eaton Vance illustrate that Gorman is serious about not only derisking the traditional MS business of investment banking and program trading, but building a successful portfolio of investment management businesses to compliment the traditional brokerage/wealth management lines. Both the E*Trade and Eaton Vance deals, of note, brought new deposits for the MS banks. Conclusion As we’ve noted in our past profiles of GS, we believe that CEO David Solomon and his board need to be more aggressive about acquisitions or risk being left behind in the global competition for banking clients and investment assets. Gorman, on the other hand, seems to understand that getting big is an expensive process in today’s market, but one that will ultimately ensure his firm’s future. And he is acting from strength in executing his strategy. We believe that at some point in the future, GS will again stumble, face another outsized operational risk event such as 1MDB and be compelled to seek a combination with another bank. The firm’s stock valuation and credit spreads are a function of this quarter’s investment banking and trading results, while the wealth management and banking lines are still too small to matter in the grand scheme. In the meantime, we expect to see MS continue to grow even if it means paying substantial multiples to book that GS could never afford to pay. Gorman has cash, but his currency in terms of MS share price is still a disappointment given the firm's impressive financial performance. By rights MS should trade above book and closer to JPM, but the dependence on investment revenue still makes investors shy. The numbers tell the story.

In this issue of The Institutional Risk Analyst, we feature a conversation with David Kotok , Chairman and Chief Investment Officer of Cumberland Advisors, that was published earlier this week. Next in the Premium Service of The Institutional Risk Analyst, we present "Alien vs Predator" by comparing Goldman Sachs (NYSE:GS) with Morgan Stanley (NYSE:MS) . Market Commentary - Cumberland Advisors - Q&A with Chris Whalen Christopher Whalen is a longtime friend and confidant, so this interview with him inevitably reflects the sorts of biases that result from engaging, enlightening conversations over many years. Many know Chris from TV appearances or press quotes or social media commentary. Others may know his three successful books: Inflated: How Money and Debt Built the American Dream (2010) , Financial Stability: Fraud, Confidence and the Wealth of Nations (with Frederick Feldkamp, 2014), and Ford Men: From Inspiration to Enterprise (2017) . I’ve read all of them. Christopher’s career includes stints in government and central banking and as head of research, and corporate and financial ratings, at Kroll Bond Rating Agency. In between working as a banker and consultant, he writes a column for National Mortgage News that often delves into obscure areas of the fixed income and mortgage markets. His impressive skill set in banking, mortgage finance and fintech enables him to delve deeply into the functioning of US and global financial institutions and how they manage risk. Chris has agreed to a Q&A, so here goes. Kotok: Chris, you have a free public newsletter that is readily available to any interested person (you can sign up to receive it here: https://www.theinstitutionalriskanalyst.com ). I read it regularly. What can our readers expect to find in it? Whalen: Thank you David. The Institutional Risk Analyst was started in 2003 when I worked with my friend Dennis Santiago in Los Angeles. The title was a bit of a tease for our friends at Institutional Investor and reflects the focus on risk in the global political economy at the time. We like to keep that emphasis on risk as a central theme, although we do wander from financials to markets to monetary policy. They all inhabit the world of financial mechanics. Kotok: You also have a premium service that is focused on banks and nonbanks. You really get specific in it. I have read that detailed reporting, and I found your analysis of Wells Fargo (NYSE:WFC) especially helpful. Please tell readers what they can expect and how they can try your service. Whalen: In 2017 we migrated our web site to WIX, which makes production and editing of the newsletter very easy. Subscribers get a reminder of new posts from WIX and we also have payments functionality via Stripe. The Premium Service of The Institutional Risk Analyst is $99 per quarter and includes our company risk profiles, market comments and the quarterly IRA Bank Book , which covers the macro view of the US banking industry. We monitor a couple of dozen commercial banks and nonbank mortgage firms. Our goal for the Premium Service is to publish a couple of profiles and market comments per month. Some of our recent risk profiles include the following assessments: Citigroup (NYSE:C) Negative Goldman Sachs (NYSE:GS) Negative Deutsche Bank AG (NYSE:DB) Negative Wells Fargo (NYSE:WFC) Neutral Ally Financial (NASDAQ:ALLY) Negative Whalen: We published the profile on Ally Financial publicly as an example of the type of work our readers may expect to receive in the Premium Service. Our goal with the profiles is to illustrate the operating performance and business model differences of the large banks and nonbanks, which are often considerable. As Dennis says, US banks are truly a coral reef of business models. Source: FFIEC Kotok: We always appreciate the operating insights and historical references in your comments. Reminding readers about the Norwest legacy at WFC was a great way to illustrate the bank’s enormous presence in the mortgage market today. Whalen: People forget that Norwest, Countrywide and Citibank were the take-out investors for subprime mortgages in the late 1990s and 2000s. The GSEs pushed the banks away from the secondary market trough in 2003-2004, then collapsed in 2007. Of note, we also published the bear case for the US mortgage market as a counterpoint to all of the IPOs announced in the wake of the Rocket Mortgage (NYSE:RKT) offering in August. The follow-on mortgage equity offerings that have priced since then have had a tough time. Selling a mortgage story to PIPE investors in the SPAC market is not an easy task. Kotok: No indeed. Let me get to a few serious and specific questions. We have the large and G-SIB banks (eight of them in America), the middle-sized or regional banks, and the community banks. You’ve described how these are now actually three different businesses. Can you give us some views on each of these cohorts? And please mention how they are coping with the current Federal Reserve posture of a near-zero interest rate policy for IOER (the interest rate on excess reserves). For the G-SIBs, please add a view on how they manage their size so as to reduce charges for capital. Whalen: George Selgin reminded me on Twitter the other day that the Fed no longer enforces reserve requirements, so it’s just reserves now. As we wrote this week, US bank balance sheets have doubled in size since 2000, refuting the official fiction regarding low inflation. All US banks have seen their returns on earning assets fall due to the Fed’s low interest rates policies. Funding costs have of course fallen, but asset returns are falling fast. Remember, banks and other investors are getting negative returns on agency and government mortgage backed securities (MBS) because of the resumption of quantitative easing or QE. The Fed, FDIC and other regulators have given banks a pass on capital to support the new short-term deposits created by QE as well as deposit insurance assessments. But we cannot “sterilize” the effect of prepayments on residential and commercial MBS. If you pay 109 for a Ginnie Mae 2% MBS and six months later get a prepayment or insurance payment at par, that hurts. Same for a commercial MBS guaranteed by Freddie Mac. These risk-free assets contain a lot of risk now thanks to QE and this impacts the performance of all banks. Source: FDIC/WGA LLC Kotok: Within that framework, we have to ask about your outlook for the future, when net interest margins (NIMs) are likely be under pressure for several years. Do you expect the number of community banks to shrink? How will the shrinkage take place? If deposit size isn’t a driver of value now because of low interest rates, what will drive values? Whalen: Market rates tell part of the story, but NIM is really about spreads over funding. What we have seen since March is that markets are pricing new assets independent of the FOMC’s actions, but spreads are contracting rapidly. The cost of funding in some markets has essentially stopped out at 1% for some government-insured products, suggesting that there is less and less elasticity of supply for funding as the FOMC buys $50 billion in new MBS each month. Prepayments are so high that it will be difficult for the Fed to keep the system open market account’s MBS at $trillion even with this level of open market purchases. This is a concern because, to recall Bagehot’s warning about low rates too long, investors can always take their cash and go home, leaving the Fed of New York standing alone. American policy makers and politicians seem determined to test the practical limits of the special role of the dollar as a reserve currency. The cost of QE to banks and depositors is enormous. Today some 90% of the interest revenue of banks now goes to equity holders instead of deposits and bond holders. That’s what we call Financial Repression . Kotok: Let’s move to housing-finance territory, which is among your areas of deep expertise. The first area is mortgage servicing and the value of servicing as interest rates change. We are at a low threshold for rates. Mortgage refis have surged, but that is only a one-time shot. Most observers do not expect rates to go any lower. Let’s make “no lower” the assumption for this question. If rates remain at present levels or start to rise, we may see a massive change in the value of servicing and a strategical low of refi activity. Do you agree? Disagree? And, either way, what do you see for the banks and related servicing enterprises? Whalen: It is the best of times and the worst of times. Some of the mortgage firms that were making IPOs in October were on the verge of failure the past April due to the FOMC’s decision to “go big” with open market purchases. Margin calls in April and May for the TBA market were more than the net worth of the industry. That problem was fixed in June as volumes surged and cash was returned. But now, the mortgage industry faces the cost of COVID and the idiocy of the Cares Act, where Congress unilaterally imposed costs upon mortgage servicers and other lenders without any thought of compensation. State governments have also imposed moratoria on auto and commercial loans. Congress and the states need to fix this deliberate act of negligence before the wave of refinance volumes subsides. As we noted in the The Institutional Risk Analyst October 5, 2020 post, “The Bear Case for Mortgage Lenders,” so long as the volume of mortgage refinance volumes remains strong, the industry will continue to use the float from mortgage prepayments and payoffs to finance COVID advances. This money, however, belongs to bond holders. Issuers will ultimately need to replace such escrowed funds to make payments to bond holders in respect of such prepayments and mortgage payoffs. That is why the outlook for mortgage production in 2021 is the key question facing policy makers at the Fed and mortgage agencies such as Ginnie Mae and the FHFA. The good news for lenders is that those Ginnie Mae 2.5% coupons that they issued this year will be ripe for a refinance when the FOMC forces rates lower next year. Bad for investors. Kotok: To focus on government-backed mortgages, we get to the perpetual unfixed issues. What happens to Fannie and Freddie? When and how, and even if, there will be some restructuring remain open questions. And these agency securities are now seriously used by the Federal Reserve as an instrument of policy implementation. FNMA and FHLMC have been in limbo for many years. Please step into your bully pulpit and give our readers a Whalen’s-eye view of how their future plays out. Whalen: Exactly nothing is going to happen to the GSEs regardless of who is in the White House. If you observe the carnage of the mortgage IPOs this month, it suggests that selling a mortgage story to equity investors is a challenge and this even with interest rates and yields on MBS at record lows. Yes, lending volumes are amazing and, in my view, will likely continue in 2021, but with shrinking spreads. We believe that the estimates out there for falling refinance volumes and rising rates in 2021 are wrong. Effective mortgage coupon rates will fall when the secondary markets want them to fall, not because of the FOMC. This is precisely why the GSEs cannot function outside of conservatorship. Stripped of their “AAA” rating from Moody’s and forced to go head-to-head with JPMorgan (NYSE:JPM) PennyMac (NASDAQ:PFSI) and AmeriHome in the secondary market, the GSEs will not survive. Nobody is going to care about paying 60bp for a guarantee from a private “A/AA” rated GSE that must compete for assets and funding with the big banks and nonbank aggregators. If FHFA even tries to take the GSEs out of conservatorship, the prospective corporate downgrade by Moody’s will kill the deal before it happens. Even if the GSEs pay Treasury to wrap the extant agency MBS with a “AAA” rating, say 15bp per year on $6 trillion in issuance, the GSEs as corporate issuers will be at a big disadvantage. If JPM or PFSI can buy that same guarantee from Treasury for residential MBS, then why exactly do we need the GSEs as issuers? Kotok: One more, if we can segue to geography. You live in New York. You and I have spoken many times about the NYC we used to know and the NYC you now see every day and I experience vicariously through our conversations. Please share with readers what COVID life is like in the city. And please offer a forecast of how you see life in NYC evolving in the months ahead before we have an effective and fully distributed treatment regimen and vaccine and then once we enter in the post-vaccine, endemic period instead of the pandemic period. Whalen: My dad’s people have lived in New York for 250 years. They came to this country from Kilkenny, Ireland, and settled in Poughkeepsie. We have been hunkered down in New York City since March and have watched an exodus of people and businesses from New York. We are missing about 500,000 people who have left and are not ready to return. The mid-town business district is largely empty, with little in the way of street traffic or tourism. Most of the hotels and entertainment venues are closed. From a credit perspective, New York City faces the prospect of default because of the sharp decline in tax revenues and the various acts of stupidity by Mayor Bill DeBlasio , Governor Andrew Cuomo and the NY state political community, which is overwhelmingly Democratic. Mayor DeBlasio increased the headcount of the city government to levels that were a problem before COVID. Now things are ridiculous and the city will likely fall under the Financial Control Board as in the 1970s and 1980s . The rent control laws imposed by the Democrat state legislature last year, for another example, have made many multifamily rental properties uninvestable. Banks will not lend on these properties because landlords cannot recover the cost of operations and maintenance. New York City and New York State face a financial and political disaster that frankly Washington cannot fix. Kotok: Chris, thank you for your time and your thoughtful responses for our readers. Please stay safe and careful. And, as we both like to say in Maine, “Tight lines.” Lunch at Ray's Camp (2019)

New York | “ On Friday, October 23, 2020, Almena State Bank was closed by the Kansas Office of the State Bank Commissioner ,” the Federal Deposit Insurance Corporation announced. “The FDIC was named Receiver. No advance notice is given to the public when a financial institution is closed. Equity Bank , Andover, KS acquired all deposit accounts and substantially all the assets. All shares of stock were owned by the holding company, which was not involved in this transaction.” When Congress made FDIC the Receiver of failed federally insured banks in 1933 it was a landmark event, an evolution of the role of the federal government in resolving matters of equity and bankruptcy nationally. The FDIC is best known as the protector of bank deposits that is backed by the US Treasury. In fact, FDIC is a public-private mutual insurance scheme supported first and foremost by the assets and income of the entire US banking industry. Contrary to the narrative of progressives like Senator Kamala Harris (D-CA) (“ Kamala Harris: Queen Of The Crony Capitalists ”) and Senator Elizabeth Warren (D-MA) , the US banking industry via the FDIC cleaned up its own mess after 2008. With the notable exception of Citigroup (NYSE:C) , which was arguably a political question, the US banking industry did not require or want a federal bailout. The bank bailout was the bright idea of President Barack Obama and Treasury Secretary Tim Geithner . But US banks cleaned up the mess, not the taxpayer. The FDIC shows how government can act with purpose and competence to ensure the safety of government insured bank deposits, the payments system and the wider economy. Indeed , the FDIC is a rare example of a public-private partnership that actually works for the benefit of society. Other federal agencies tasked with delivering different types of consumer benefits have yielded uneven results. Most economists would say that government support for housing, for example, is a net benefit to society. Federal housing agencies subsidize home ownership by low- and middle-income households to the tune of several points in annual interest payments. Without the subsidy of federally guaranteed mortgage backed securities (MBS), US consumers would see annual mortgage rates in the 5s and 6s instead of mortgage loan coupons today below three percent. But perhaps the most powerful agency in Washington, namely the Federal Reserve Board, has mixed results in terms of supporting its legal mandate to ensure full employment. We talked about how the Fed became the guarantor of full employment in a 2019 article for The American Conservative (“ When The Fed Became A Socialist Job Creator ”) . Simply stated, the 1978 Humphrey-Hawkins law and the actions taken by the FOMC to pursue the dual mandate of full employment and price stability seem instead to cause disparity in terms of real incomes and wealth in society. The excessive decline in interest rates over the past 40 years represents a vast transfer from savers and investors to debtors, particularly the US Treasury. How does thus fulfill the dual mandate? The FOMC chose to expropriate a heretofore private market price called the federal funds rate, this in order to achieve the employment imperative of the Humphrey-Hawkins law. This decision by the Fed locked the US into a bizarre policy path. Debtors are explicitly advantaged, but consumers and investors are hurt. People who work hard and save conservatively are the losers in the Fed's brave new world where inflation, not stable prices are the real object. A successful free enterprise system requires inequality, winners and losers to fuel economic growth. But a free society can only tolerate a large surfeit of losers for so long before people take to the streets in frustration and anger. The Washington fixation with using lower interest rates to stimulate short-term economic growth is as much a political expedient as a deliberate economic policy choice. And this is not a new discussion about inequality. In the decades after WWII, there was considerable pressure in Washington to guarantee a job and other benefits to every returning soldier. This demand for universal employment evolved through the Vietnam War and the social unrest of the 1960s and 1970s. Ultimately, a Democratic Congress refused to embrace universal employment. Instead, in 1978, a majority led by Rep. Augustus Hawkins (D-CA) and Senator Hubert Humphrey (D-MN) tasked the FOMC with ensuring the desired economic outcome of “full employment.” Such was the level of entitlement and hubris in Washington during the late 1970s that Americans thought they could simply legislate future economic outcomes with laws like Humphrey Hawkins. And f or half a century, the FOMC delivered the goods to Washington’s political class, but even this was not enough. B oth political parties have since embraced fiscal deficits that in the wake of COVID have grown to monstrous size. The Treasury is now the single largest factor affecting US monetary policy. The Fed, as alter ego, creates discontinuities and injects volatility into the markets as it seeks to fulfill the dual mandate. Since April of this year, the FOMC has imposed negative real returns on owners of Treasury securities and agency MBS worldwide. The de facto regime of negative returns imposed by the FOMC threatens to undermine and ultimately destroy the role of the dollar as the global reserve currency. Investors in global equities, however, continue to benefit from the FOMC’s financial largesse even as millions of Americans have lost their livelihoods due to COVID. “ In the fourth quarter of 2000, the top 1% of wealth holders had a household net worth (assets minus liabilities) of $11.82 trillion, while the top 10% had $14.62 trillion, according to Federal Reserve data,” writes Howard Gold in MarketWatch . “By the fourth quarter of 2019, before the coronavirus hit, wealth for the top 1% had more than tripled, to $36.3 trillion, and nearly tripled for the top 10%, to $41.18 trillion.” Over that same period, the total assets of the US banking system went from barely $7 trillion in 2000 to over $21 trillion two decades later, an indication of the vast asset inflation caused by the inflationary policies of the FOMC such as quantitative easing. Even as the size of US banks has grown, of note, their asset returns have fallen dramatically. Source: WGA LLC And even as bond investors take principal losses on their government guaranteed securities, low- and middle- income households have seen their access to credit reduced as prices for residential homes have soared over the past decade. While the good people on the FOMC pretend that inflation is low and thus justify further action to juice employment, Americans face soaring real prices for tangible goods ranging from homes to automobiles. Think about the vehicle that $20,000 could buy two decades ago vs the entry level car of today. An entry level Ford (NYSE:F) F-150 pickup retailed for $16,000 in 2000, but the entry level model F-150 is almost $30,000 today. Inflation manifests itself both in price and in terms of the quality of the product or service. The steady erosion in the purchasing power of the dollar, this even as global central banks try to stave off a long-delayed debt deflation, is crushing savers and consumers. But we pretend that inflation is low. The FOMC cannot publicly endorse a debt deflation as in the 1930s, thus there is no economic reset, no “bounce” in production and employment in response to lower interest rates. There is no opportunity for young families to buy a house or a business cheap and thereby start to build wealth. More, the benefits of the periods of lower interest rates and asset price inflation seem to flow overwhelmingly to the investment sector rather than to areas of the economy that promote employment and household income. See the chart below from the St Louis Fed below showing the consumer purchasing power of the dollar over the past century. The index was over 1,000 in 1913 but today is below 40. During the period of the Fed’s existence, the real value of the dollar for consumers has been decimated. Notice that half of the decrease in the dollar's purchasing power occurred in the 1920s after WWI and before the Great Depression. Looking at this chart, the Fed's focus on price stability has been a failure. Congress needs to reconsider the dual-mandate contained in the 1978 Humphrey-Hawkins legislation. The Fed’s fixation on manipulating short-term interest rates as the core tool of policy may now be doing more harm than good. The growing gap in terms of nominal wealth, for example, is less about fairness and more about pretending that inflation is not a problem. If the Fed refuses to allow asset prices to fall for prolonged periods, then American consumers are doomed to see lower and lower real purchasing power. When we hear our friends in the consumer policy community bemoan the lack of affordable housing, our answer is simple: We need to raise consumer income. Cut fiscal deficits and the FOMC can stop targeting inflation as a policy tool. Affordable housing required subsidies in the 1960s, but today the inflated cost of construction makes it a bad joke -- even with low interest rates. A number of economists have argued in favor of targeting nominal GDP rather than interest rates, an important change that should get greater attention. George Selgin, Director, Center for Monetary and Financial Alternatives at The Cato Institute, argues that a new regime might actually result in lower prices and higher real growth, particularly employment growth. In “ The Case for a Falling Price Level in a Growing Economy ” (2018), Dr. Selgin writes: “Not long ago, many economists were convinced that monetary policy should aim at achieving ‘full employment.’ Those who looked upon monetary expansion as a way to eradicate almost all unemployment failed to appreciate failed to appreciate that unemployment is a non-monetary ‘natural’ economic condition, which no amount of monetary medicine can cure.” Congressional Democrats introduced new legislation in August that would make reducing "racial inequality" in the U.S. economy an official part of the Federal Reserve’s mission. How this would be measured is hard to predict. As the political pressure for change builds, the critical focus on the FOMC’s policy tools will only grow apace. Fed Chairman Jerome Powell would do well to make changes to the Fed’s policy mix now, before radical elements in Congress impose changes that will make the Fed’s public policy mission entirely problematic. More than anything else, ending the FOMC’s use of the federal funds rate as a policy tool is the beginning of restoring equity and fairness in US monetary policy for all Americans.

New York | During the first term of the Presidency of Donald Trump, the rhetoric on China certainly heated up a good bit, but in fact the two nations continue to grow in terms of financial ties. As Bill Witherell , Chief Global Economist & Portfolio Manager at Cumberland Advisors explains in this issue of The Institutional Risk Analyst, China and America are more linked financially than ever and despite the angry bluster of President Trump. For at least three decades, under both Republican and Democratic administrations, the United States has urged China to open up its financial markets to foreign capital and foreign financial firms. However, as part of a broader strategy to decouple relationships with China, President Donald Trump’s administration appears to want global financial firms to pull back from China. This policy reversal comes at a time when China has recently made sweeping reforms to liberalize its financial market, including removing ownership on foreign financial services companies operating in China and allowing MasterCard and PayPal to enter its payment industry and Blackrock to sell its own mutual funds in China. Under President Xi Jinping, China is pressing forward with a “linking” strategy to develop increased connections with foreign financial companies. China wishes to attract increased capital inflows and to develop their bond, pensions, and insurance markets. Chinese policymakers see benefits from having domestic financial firms gain greater exposure to major Western firms. US financial firms and US investors are clearly demonstrating that they support closer, mutually beneficial relations between the US and Chinese financial markets. The tension between the incompatible objectives of “decoupling” and “linking,” voiced in public statements made by the leaders of the world’s two largest economies, leads to fears that a financial and capital market estrangement is developing that will have negative effects for both nations. Increased competition between Wall Street, Chinese, and other financial centers is to be expected and welcomed. Developments to date, however, suggest that the two countries may avoid seeing financial relations deteriorate to the extent that relations in trade and technology have. The substantial mutual benefits to the US and China and to global financial stability from avoiding such a breakdown in relations must be apparent to policy officials. Despite the tough political rhetoric, the financial measures taken by the US thus far against China have been limited. Mainly, the US has blocked a federal government pension plan from investing in Chinese stocks, and the US Senate has passed a bill that threatens to delist Chinese firms from US stock exchanges if they don’t meet requirements. As the government pension plan accounts for just 3% of America’s pension assets, the effect on the flow of US investments into China’s equity markets is insignificant. The Chinese equity market has recovered strongly this year. The CSI 300 Index, which covers the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange, is up some 17% this year. The S&P China BMI Index, which covers the investible universe of publicly traded companies domiciled in China but legally available to foreign investors, is up some 23%. In comparison, the S&P 500 is up 10.3% year-to-date. The inflow of global funds into the two Mainland China markets this year has topped $26 billion. The Senate bill, the Holding Foreign Companies Accountable Act, prohibits the securities of any company from being listed on a US securities exchange if the company fails to comply with the Public Company Accounting Oversight Board (PCAOB)’s audit for three years in a row. The bill also requires public companies to disclose whether they are owned by a foreign government. The political statements made by Senators and others when this bill was considered and passed must have concerned Chinese firms, but the bill’s impact may be limited. Most private (i.e. non-state-owned) Chinese firms will likely arrange within the time limit to meet the PCAOB standards that all US-listed firms are required to meet. There are reports that a compromise for Chinese firms is under consideration. The attractions of listing in the US will continue to be strong: namely, better analyst coverage, deeper liquidity, and higher trading volume. The number of Chinese firms listed in the US is 220, an increase over the past year of more than 25%. The fact that the Ant Group’s IPO, which may be the largest in history, is expected to be listed in Shanghai and Hong Kong, bypassing the United States, is understandably viewed with some concern by Wall Street. A successful offering of $30 billion or more will demonstrate the capability of these markets and may lead other Chinese firms to follow Ant’s example, possibly with urging from the Chinese government. But the Ant Group is an exceptionally attractive company. On October 16 it raised the valuation target for its IPO to $280 billion. Ant views its core activity as a facilitator of e-commerce and innovative financial services. In 2019, Ant handled over 50% of China’s $8 trillion digital payments market. The attractions cited above of listing in the United States will remain powerful as long as the US does not take further actions against listed Chinese firms. Major US financial firms are not hesitating to take advantage of the reforms of China’s foreign-ownership and market-access regulations, despite Washington’s decoupling objectives. JP Morgan is completing a $1 billion buyout of its joint-venture asset-management partner and is also taking control of its Chinese securities and futures joint ventures. These actions should make JP Morgan the first major fully foreign-owned investment bank operating in China. Goldman Sachs and Morgan Stanley have taken majority control of their Chinese securities ventures, and Citi has been authorized to serve institutional investors as the first US custody bank in China. Vanguard is shifting its Asian headquarters to Shanghai. US institutional investors have just demonstrated their support for a continued strong linkage between the US and Chinese financial markets by ordering more than $27 billion in response to China’s first bond offer made directly to US buyers. The bond offer was for $6 billion, and the yield on the 10-year component was about 0.5 percentage points above the equivalent US Treasury. The huge China onshore bond market is estimated as the second largest globally. In contrast, the China offshore market is now small but has huge potential, as the bond sale to US investors suggests. Participating in and helping to develop these markets together with the Chinese pensions and insurance markets will become important for US financial firms. Tensions in the relations between the United States and China will continue whatever the outcome of the elections in the US. Both sides need to dial back the rhetoric and avoid further missteps toward a new cold war and increasing military tensions. Further moves in the direction of isolationism and protectionism by the United States will continue to be counterproductive. It is fortunate that financial relations between the US and China have not broken down in substance. Both sides have much to gain from continuing the détente that has been hard won over years. China desires continued access to US capital and to the positive contributions US firms can make to the development of its markets. As the Chinese economy continues to grow strongly and to become the globe’s largest, its financial markets will continue to grow and mature. Opportunities for US firms to earn asset management fees and securities revenue will be huge. Also, US financial firms can learn from the advances China is making in digital payments. More importantly, including China in the current global monetary system is far preferable to giving incentives to China to develop a parallel global payments system.

In this issue of The Institutional Risk Analyst, we change gears a bit to get a view from Artur Meyster, founder and CTO of Career Karma , on the challenges facing millions of American's who may need to change careers due to COVID -- or maybe should not. There are plenty of reasons to leave your current job and change careers, but there are probably even more reasons not to switch your career. Switching your career has significant consequences. Once you make a change, it can be difficult to change once you start down the path. Everyone has a different career path, and an opportunity's risks and rewards are as unique as the individuals who pursue them. COVID-19 is amplifying both the risks and rewards associated with new opportunities. Some people view the epidemic as a sponge soaking up all of the possibilities and giving them a reason to stay the course, while others see it as the perfect chance to try something new. COVID-19's impact on the economy is causing people in the food, travel and hospitality business, for example, to rethink their career choices while tech professionals are happy that the world's dependence on their devices. Plan For Hardship People stay in their current careers longer than they want because switching your career is hard. Entering a new industry with little experience often means a salary reduction and sometimes less than favorable hours. Switching careers doesn't always equate to success either. There are hundreds of variables that contribute to the success or failure of a career change. It's impossible to predict the risks associated with leaving your profession. You can only plan for so many circumstances. Being okay with variability and remaining agile in response is the only way to prevent the fear of risks from preventing you from making a career change. One way to mitigate risks is to focus on a career experiencing growth. You don't need to watch the stock market to know technology's impact on everyday lives. The pandemic increased our reliance on technology and is present in nearly every aspect of life. You don't have to live in Silicon Valley or live near a major university to learn tech skills. You can learn them by attending an online bootcamp from reputable schools like Flatiron . View Costs As An Investment A common cost of switching careers is gaining new skills through job training or the traditional method of earning another degree. Any effort to upskill will involve an investment of time and money. It's easy to think of these costs as negative aspects of changing careers, but it's essential to view these as an investment in yourself. Night school might not be your favorite place to spend Tuesday and Thursday evenings, but it will give you the flexibility and extra income in a few years to enjoy your evenings more after a day of rewarding work. The same goes for the costs of schooling. The $50,000 price tag that comes with a master's degree is a shock that can be hard to overcome. Instead of thinking of current losses, think of future gains. How quickly will you earn back that money with a pay raise or new job thanks to your higher degree? In five or ten years, will the extra money be worth it? If you are considering switching to a tech career, many of the best online coding bootcamps offer tuition deferrals or job placement guarantees to lessen the burden of upfront costs. Look Sideways Changing your career doesn't have to feel like jumping off a ledge hoping there is a safety net. Not all changes are radical. It's possible to switch your career without changing industries. You can use your current career as leverage to get into a new industry. Businesses need people with skills from a variety of backgrounds. Use your network at your current company to find roles that would be a good fit for you. Hiring managers like to hire people that don’t need training and can adapt to the company culture quickly. Know What You Don't Want Before you write your resignation letter, it's important to know what you don't want in your next career. Leaving your finance job for a teaching role might be a big regret if teaching isn't what you want. The dissatisfaction we feel at our current jobs isn't always easy to put a finger on, but slowly identifying the things you don't like about our current positions will help you find a new position that fits your needs. It May Be Risky To Stay In Your Current Career Every decision we make in life poses a risk. Even non-decisions contain risk. It could be riskier to stay at your current position than to start making moves for your next career. But the career change process starts by carefully considering your options and seeking ways to grow your value in the always changing marketplace.