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Review & Outlook In November 2019 we published a negative risk profile for Citigroup Inc (NYSE:C), one of the largest bank holding companies in the US at $2.2 trillion in total assets. We reaffirm the negative risk profile, as discussed below. Comparable Companies JPMorgan Chase Bank of America U.S. Bancorp Goldman Sachs Peer Group 1 Disclosures: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN We have written a great deal about the modern history of Citibank in The Institutional Risk Analyst , but the bank also is one of the oldest and most political banking organizations in the US . The City Bank of New York first became a depository in 1812 and helped to finance the American war with Britain, essentially acting as the de facto central bank. In more recent years, the bank has served as a convenient outpost for US officials operating in such venues as Vienna, Mexico City, Nairobi and Almaty. Earlier this month it was announced that Jane Fraser , Citigroup’s president, would replace Michael Corbat as chief executive in February next year. Corbat retires after eight years in the top job. He leaves behind a legacy of stability and rising equity values, but little change in terms of focus or, more important, a new business direction for the bank. When he joined in 2012, Michael Corbat was the first competent chief executive officer for Citi going back to before 2000. Citi continues to suffer from various operational and regulatory problems, as illustrated by the sanctions imposed on the bank for failing to update its internal systems and controls during Corbat’s tenure. The Office of the Comptroller of the Currency reportedly cited failings related to Citi’s inability to produce timely and accurate reports about the risks on its books, and other infrastructure issues. Fraser must take the top job after the imposition of a consent order by the Fed and OCC, but truth to tell, Citi has had problems with internal systems for decades, long before Fraser joined the bank in 2004. As the February 2021 transition to Fraser was announced, Sullivan & Cromwell partner Rodgin Cohen told CNBC that Fraser “would be committed to the international strategy.” In fact, Fraser has no choice but to play the current hand left by Corbat and his predecessors going back to John Reed . The former CEO, who was forced out of the bank in 1998, questioned the structure of combining retail and investment banking—basically, Citigroup’s entire strategy. “If it were up to me and I had a blank piece of paper, I would segregate the industry into compartments so that you did not have institutions that had both of these functions within them,” Reed told the Wall Street Journal in 2010. Reed observed correctly there was a culture clash when his retail-heavy Citibank N.A. combined in 1998 with Sandy Weill’s Travelers, which was also the home of a high-flying bond shop called Salomon Brothers. Reed was forced out by the scandal involving Citibank Private Banking and a politically exposed Mexican named Raul Salinas de Gortari. The departure of Reed began a long and chaotic period of weakness in the CSUITE. Reed did not think that Sandy Weill was up to running the company and he turned out to be so right. Weill was forced out by the WorldCom scandal. Of note, Reed said that Chuck Prince , who was Mr. Weill’s legal counsel and eventual successor, wasn’t qualified for the CEO job either. In 2012, Michael Corbat caught the ball dropped by former CEO Vikram Pandit , who inherited a terrible mess at Citi in December 2007 from Chuck Prince. Sanford Weill’s handpicked successor was forced out following the disclosure of huge losses in Citi’s mortgage portfolio, leaving Citi in turmoil on the eve of the 2008 financial crisis. Handpicked by Robert Rubin , Pandit’s five year tenure saw Citi’s stock lose most of its value as the bank was slowly dismantled. When Pandit was forced out by the board in 2012, the bank was on the ropes. Over the following eight years, Corbat cut expenses and increased revenue a bit. More important, the stock rebounded during his tenure, but Citi still under-performs other large banks by half because of risks such as funding, loss rates and adverse operational events. Of note, Fraser ran the bank’s mortgage unit in St Louis, MO, this after Sanjiv Das had stabilized Citi’s run away mortgage correspondent and wholesale lending business. Citi would eventually sell the mortgage servicing book to Cenlar Capital Corp . After cutting back Citi’s overgrown correspondent loan purchasing business, Das went off to start Caliber Home Loans , today one of the best nonbank issuers in the mortgage industry. In addition to time at the mortgage business, Fraser ran Citi’s problematic Mexico unit, giving her bona fides with the offshore financial community that Citi has served for decades. She also ran private banking, so again Fraser has hands on familiarity with a key business unit. But we do not look for any significant changes or acquisitions in the near term, even though both are badly needed. Citi is a very political bank. It was a convenient operating venue for former Treasury Secretary Robert Rubin, who spent a decade as political consiglieri to CEO Sandy Weill. Together they created the Citi we know today via a series of nonbank acquisitions. These transactions turned an internationally focused depository into the highest risk consumer lending and subprime mortgage banking franchise of the top-five US banks. Today, the bank known to the Street as Citigroup is a global institution with relatively little in common with its large cap peers among the top ten US banks by assets, either in terms of asset composition or how it finances these assets. In the US, JPMorgan (NYSE:JPM) , Bank of America (NYSE:BAC) and Capital One Financial (NYSE:COF) are the obvious comps. Better offshore investment banking comps for Citi are found in Europe, such as BNP Paribas (NYSE:BNP) or even the struggling Deutsche Bank AG (NYSE:DB) , which we have assigned a negative risk rating. Quantitative Factors Citi has a global payments and capital markets business, a subprime global consumer lending and credit card business, a commercial lending arm with a weak market presence, and no significant asset management business after selling its portion of Smith Barney to Morgan Stanley (NYSE:MS) in 2012. A century ago the City Bank of New York was a broad line commercial bank funded with domestic deposits. Today Citigroup is a highly specialized offshore bank with little solid anchor in the US deposit market. Source: FFIEC The chart above, using consolidated bank holding company data submitted to the Federal Reserve Board and aggregated by the Federal Financial Institutions Examinations Council (FFIEC), shows the relative interest expense differential between C and the 127 banks in Peer Group 1. In Q2 2020, the bank’s interest expense fell twice as fast as did interest income, an illustration of the powerful liquidity benefits of the Federal Open Market Committee’s open market purchases. But gradually asset returns too shall fall. The banks of Peer Group 1, JPM, BAC and U.S. Bancorp (NYSE:USB) represent the mainstream average business model archetype for large commercial banks. On the other hand, C and COF have higher average loan coupons, higher credit loss rates and also elevated funding costs, much like nonbank consumer lenders. JPM’s equity trades at a multiple to book, while C and COF trade at a discount to book value – and for good reason, namely risk adjusted returns on capital. Large domestic lenders such as USB have the lowest cost of funds in the group, but C’s cost of funds is 50% higher than the large bank average in Peer Group 1. At the end of the second quarter of 2020, C had more foreign deposits than domestic. About a third of the deposit pie comes from domestic interest bearing funds, a third from foreign interest bearing deposits and a third from repurchase agreements and other borrowed money. At June 30, 2020, Citi had just $500 billion in core deposits vs $1.1 trillion in non-core funding supporting $2.2 trillion in total liabilities and capital. Citi’s net non-core funding dependence was almost 55% vs an average of 6.8% for Peer Group 1, placing C in the top 5% of large banks in terms of this crucial liquidity measure calculated by the Fed. Like JPM and GS, C has chosen to enhance returns by using subprime lending and derivatives contracts on and off-balance sheet, creating out sized risk for the enterprise. The chart below shows the relative gross derivatives footings for C and other major banks reflecting both client and firm business. JPM and Citi are now the two leading derivatives dealers in the world.Total derivatives contracts of $44 trillion notional at the end of Q1 2020 equaled 1,800% of average assets vs an average of 54% for Peer Group 1, putting C in the top four percent of all large banks in terms of derivatives exposure but just half that of Goldman Sachs Group (NYSE:GS) . Source: FFIEC As a result of the lack of core funding, net loans and leases at C were less than 40% of total assets in Q2 2020, reflecting a predominant focus on capital markets and derivatives dealing activities in terms of asset allocation. That said, Citi took $8 billion in loan loss provisions in Q2 2020 and will likely put a similar amount aside in Q3 2020, although loss trends have been moderate so far this year. The chart below shows the gross spread on total loans and leases as reported to the FFIEC. As the chart below illustrates, Citi’s gross loan spread is far higher than its peers, but the net results for Citi per dollar of assets are far below that of its far smaller peer. Source: FFIEC Although the overall gross yield on C’s loans and leases is 200bp above Peer Group 1, as shown in the chart below, the loss rate on Citi’s loan portfolio is well-above peer by an even larger margin. To us, this is one of the basic reasons why the equity of Citigroup tends to trade at a discount to par and other comparably sized banks. Source: FFIEC The chart below shows net income vs average assets for the same group of BHCs. Note, for example, that Citi’s overall asset returns are below those for the hyper efficient USB and JPM . Again, between the outsize risk on the credit book and the poor overall returns, the market position of Citi in the equity markets is no surprise. Source: FFIEC When you look at how the marketplace values the earnings flow from JPM vs C, the difference is striking. Citi chronically trades below book value while JPM was just shy of 1.25x book value as this report was finalized. JPM trades on a 1.1 beta in terms of overall market volatility vs 1.8 for Citi. Sadly, the financial media tends to group banks in terms of size only, while frequently ignoring the significant business model differences between one institution and another. Qualitative Factors As we note at the top of this report, the fundamental issue when it comes to the qualitative analysis of Citi is the business model. Lacking a leading position in any of the markets that it serves, C is essentially a vagabond, doing business in advanced and emerging markets around the globe but with no dominant market position to serve as an anchor. C operates a global institutional business in a number of major markets, including North America, Europe, the Middle East and Africa, Asia and Latin America. Citi also operates consumer banking businesses in North America, Latin America and Asia. Citi is unlike many other large banks active in the institutional markets in that it does not have a significant wealth management business. And no longer does the global trading business lead the way on revenue for Citi, as it did years ago. Instead of the 50/50 distribution between banking and transactions at JPM, at C you see two thirds bank revenue and one-third fee income from the investment bank – this despite the fact that banking assets are less than half of the total. Robert Armstrong of the Financial Times put the situation into perspective: “While Mr Corbat declared in 2017 that 'our restructuring is over', it seems likely Ms Fraser will have to reopen the discussion. Yet there appear to be few easy options. Finding a buyer for the international retail assets would be a challenge. Adding scale in the domestic retail operation through a merger would be difficult, given the weakness of Citi’s shares as an acquisition currency — even if regulators would allow Citi to do a large acquisition, which seems unlikely.” To us, the key qualitative insight regarding C is that the bank takes outsize risks in markets around the globe, and has an unconventional funding base, yet is decidedly mediocre in terms of returns on assets and equity. The market’s judgment has been to keep the equity of C trading below par (we own the C TRUPS). Meanwhile, the legacy management and systems issues that have been a problem at Citi for decades seems to have been the catalyst for the early departure of Michael Corbat and the imposition of consent decree on the bank by the OCC. It is difficult to argue with the market’s judgment, although we do see analysts frequently try to make a bull case for Citi. Simply stated, the risk simply outweighs the reward at Citi even with the significant expense reductions made under Corbat. And even with almost a ten point advantage in terms of operating efficiency (largely in the area of occupancy expense), Citi still trades at a significant discount to JPM at 1.3x book value today. Combined with a mix of institutional products offered in various offshore banking venues, Citi has a subprime consumer and credit card business largely focused on North America, but again with global footings. In many countries where C does a consumer business, monitoring individual credit is problematic, adding to the risk profile of the bank’s consumer lending. And the entire consumer book is funded in the institutional credit markets rather than core deposits in the dozens of jurisdictions where C operates. The need to acquire and retain core funding is another piece of the puzzle and contributes to a very competitive situation for Fraser in the institutional market. This is one reason why more disciplined organizations such as number five money center USB work hard to maintain a certain assets size rather than weaken loan pricing in the name of short-term portfolio growth. Citi was terribly guilty of this in the 2000s, when the bank opened the floodgates to correspondent residential lending in competition with the likes of Countrywide Financial and eventually failed when investors demanded redemption of subprime securities. To paraphrase Jim Grant’s observation about Fed Chairman Jerome Powell , Citigroup’s new CEO Jane Fraser, like Michael Corbat before her, is a prisoner of history. Fraser did not pick the mix of businesses that are now part of the firm’s product bundle, but she does not have any easy choices to change things short of a combination with another bank. With the C stock trading at or below book value, the bank is in better shape than DB, but lacks a strong currency to use for acquisitions. And most of the large, internationally active banks that C could acquire have problems of their own. Suffice to say that the Fed’s Board of Governors would never countenance a transaction involving Citi that did not eliminate the possibility of the bank requiring another government rescue down the road. Assessment Our overall assessment of the quantitative and qualitative factors behind Citigroup is negative. The bank under-performs its peers financially, takes outsized risks compared to its large bank peers, and has no clear strategy for improving asset returns, access to funding or the bank’s overall risk profile. The bank operates in over 160 different countries and jurisdictions, multiplying its financial and operational risks. And Citigroup continues to be the largest single bank dealer in derivatives, both on and off-balance sheet, again adding another dimension of risk to the overall analysis. Consider the short-list of challenges facing C: Asset returns : C significantly underperforms its peers in terms of asset returns, efficiency and loss rates. Compared with industry leaders such as AXP, Citigroup significantly underperforms when it comes to dollar of income per dollar of assets. Remarkably, the fact of C’s significant off-balance sheet derivatives exposures does not improve the overall financial performance of the bank. Funding : The cost of funds for C is significantly higher than for most of the bank’s US asset peers. More, the fact that just one quarter of the bank’s funding comes from core deposits is a reason for concern in the event of heightened market volatility. One of the key factors that must change in order for C to improve its financial performance is to access more stable, cheaper sources of funding. Most of the banks that have solid core funding, however, trade at a significant premium to C. Growth : Many if not all of the market segments addressed by the bank are already overbanked. The fact that the US Treasury chose to rescue Citigroup rather than break up the bank a decade ago has left a significant amount of over-capacity in institutional capital markets. Since political leaders in the industrial nations are loathe to liquidate poorly performing banks such as DB or HSBC, the likelihood is that C will continue to muddle along until such time as it is forced to combine with another bank, likely under less than attractive terms for shareholders. Unless and until the management team led by Corbat and eventually Jane Fraser finds a way to enhance the bank’s financial performance and/or funding, we expect the bank to continue to underperform its asset peers in terms of market valuations. Superior operating leverage achieved under Corbat is commendable, but not sufficient. We believe that a change in the operational path of C is unlikely to occur in the near term and is only likely to occur at all as and when regulators compel a combination with another large bank. Bank Group: AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Profile is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Profile. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

New York | This week we give our readers a little taste of the new content in the Premium Service of The Institutional Risk Analyst . For this purpose, we focus on the latest member of The IRA Bank Dead Pool, namely Ally Financial Inc. (NASDAQ:ALLY) . We assign a negative risk rating, as discussed below. Disclosures: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN Review & Outlook ALLY has all of the required attributes for inclusion in The IRA Bank Dead Pool, including poor equity market performance, wide credit spreads, a weak funding profile and a lack of clarity in terms of forward business model. The market’s assessment, as usual, is correct as illustrated by the fact that ALLY trades at a bit more than half of book value. Like most banks, the ALLY common equity is down 30% YTD. Comparable Companies American Express Company Capital One Financial Citigroup Peer Group 1 Ally Financial describes itself as “is a leading digital financial-services company with $180.6 billion in assets as of December 31, 2019” in its most recent 10-K. Like many SEC filings you can see today, a good deal of the ALLY 10-K document is marketing fluff with little meaning much less relevance to investors. The recent IPO of Rocket Mortgage (NYSE:RKT) shares this unfortunate characteristic of fluff over substance in public company disclosure. Note, first and foremost, that Ally has grown assets modestly in the past decade, even as the composition of those assets has changed. But the bank is still basically a monoline auto finance provider. Here’s what the ALLY 10-K said regarding the business back in 2011: “Global Automotive Services and Mortgage are our primary lines of business. Our Global Automotive Services business is centered around our strong and longstanding relationships with automotive dealers and supports our automotive manufacturing partners and their marketing programs. Our Global Automotive Services business serves over 21,000 dealers globally with a wide range of financial services and insurance products... In addition, we believe our longstanding relationship with General Motors Company (GM) and our recent relationship with Chrysler Group LLC (Chrysler) has resulted in particularly strong relationships between us and thousands of dealers and extensive operating experience relative to other automotive finance companies. Our mortgage business is a leading originator and servicer of residential mortgage loans in the United States.” The focus on automotive in early 2012 was deliberate, of course, since the ResCap unit of General Motors (NYSE:GM) had become the Chernobyl of the mortgage world. Laden with late vintage Alt-A no doc loans, the ResCap book set new standards for fraud. The May 2012 bankruptcy filing by the ResCap unit of ALLY was an important event in the resolution of the subprime mortgage mess . The ResCap bankruptcy also enabled ALLY finally to break free of GM, which had been rescued by the Treasury in 2009 after filing for bankruptcy itself in June of that year. In a 40-day whirlwind process, GM intimidated the firm’s creditors and swiftly emerged from bankruptcy as a ward of US Treasury under Secretary Timothy Geithner . Our testimony in 2009 to the Senate Oversight Committee chaired by Elizabeth Warren (D-MA) was that it would be difficult for ALLY’s predecessor to make the transition to an independent company. ALLY was the captive financing unit of the world’s biggest automaker, GM, but today is a monoline issuer of auto loans/leases, credit cards, unsecured loans for consumers and insurance and floorplan financing for independent dealers. A decade later, our judgment seems to be borne out in the financial performance of the 21st largest bank holding company (BHC) in the US. The major automakers simply must capture the spread paid on financings in order to survive themselves. This leaves precious little market left over for firms such as ALLY, that seek to finance some of the other independent dealers and compete with the major banks for auto leases. Quantitative Factors A review of public benchmarks suggest that the performance of ALLY is mediocre. In addition to trading at a book value multiple of equity ~ 0.6x, ALLY has a beta of 1.6x the average market volatility and a forward dividend yield of 3.25%, according to CapIQ . At the close on Friday September 25th, ALLY had an implied credit default swap (CDS) spread of 132bp over the curve or twice the spread for the largest banks. That CDS spread generated by Bloomberg maps to about +BB plus in a rating agency equivalent. Looking at ALLY’s credit portfolio of $118 billion, $65 billion is in loans to individuals, $30 billion in C&I and $20 billion in real estate loans, mostly 1-4s. The net default rate at 71bp is a good bit higher than the average for Peer Group 1 but well below more aggressive (and efficient) issuers such as American Express (NYSE:AXP) and Capital One Financial (NYSE:COF) , as shown in the chart below. Source: FFIEC Ponder the fact that AXP has a net default rate that is 3x Citigroup (NYSE:C) , which we have rated negative, but has an equity book value multiple of 3.6x or 7x that of the larger Citi. The reason that AXP shareholders pay a 3.6x book value multiple for its equity comes down to basic factors such as operating efficiency and risk management. The reason that Citi, COF and ALLY trade below book is the same. In both cases, the market is right. In business model terms, ALLY, AXP and C are more finance company than traditional depository. One of the key indicia of this risk factor is the gross spread on the loans and leases of the bank. By examining the gross spread on a bank’s lending book, you can pretty quickly determine the business model. This is a little qualitative nuance we developed with Dennis Santiago years ago at Institutional Risk Analytics . The chart below shows the gross loan spread of ALLY and the comparable companies in this report. Source: FFIEC Notice a couple of things about this chart. First, COF has a gross spread that is almost double digits and suggests a “B” rating equivalent for the bank’s loan book. Three of the four issuers have seen their loan spreads compress in the past several quarters, but AXP has actually expanded its gross loan yield. Finally, note that ALLY’s loan pricing is just a bit over the Peer Group 1 average and well below Citi, AXP and COF. The pricing that a bank gets for its loans & leases says a lot about the internal credit targets of the bank and also its competitive position. For example, the pricing on ALLY’s book is decidedly prime, but can the bank make money at these spreads? When you factor in SG&A and, most important, funding costs, we get an answer to that question. The chart below shows the relative funding costs of ALLY and the comparable banks. Source: FFIEC As we like to say, the data tells the story. The chart above suggests that ALLY has gotten little if any benefit from the decline in interest rates over the past several quarters. Hello. Meanwhile, most of the 126 other banks in Peer Group 1 seem to be benefitting significantly based upon the unweighted average calculated by the FFIEC. A couple of points: First, ALLY has core deposits of $108 billion or a little more than half of the balance sheet. The rest of the balance sheet is funded in the markets. ALLY has just a tiny bit of term debt at just $3 billion. ALLY just priced three-year debt at +110bp over the Treasury curve. Second, the bank has no – zero – non-interest bearing deposits, the mother’s milk of money center banks. The free float from typical commercial balances is a vital source of revenue and liquidity for any bank and a key component of a successful C&I lending strategy. ALLY does not seem to be following that script. Third, there appears to be some idiosyncratic factor, perhaps an inappropriate interest rate hedge or other expense, that is increasing ALLY’s funding cost even as the peer group sees interest expense fall dramatically. This is a big issue for the bank, both with respect to auto lending and its venture into lending to private equity portfolio companies. Indeed, since 2017, funding costs have risen twice as fast as financing revenue. ALLY states: “Interest expense was $2.7 billion for the year ended December 31, 2019, compared to $2.5 billion for the year in 2018. The increase was primarily due to higher funding costs and growth in our consumer automotive loan portfolio.” So, when we consider that ALLY has lower gross spreads on its loans and higher funding costs than do these larger banks, what conclusion does that suggest? Again, the data from FFIEC tells the story as shown in the chart below. Source: FFIEC The data shows clearly that ALLY has tracked below Peer Group 1 in terms of this key measure of profitability and asset returns. AXP is still profitable as is Citi and Peer Group 1, but ALLY and COF have reported losses in recent quarters due to higher loan loss provisions. These two banks simply lacked the earnings power to offset rising credit costs. Qualitative Factors Looking at the qualitative factors of ALLY, the emphasis on credit card and individual lending is a negative given the small market share and pricing of the bank’s products. The overhead expenses of ALLY are dead center of the peer average, but frankly the risk of the franchise is higher than your typical commercial bank. In the bank’s most recent 10-K, it talks about “our ability to innovate, to anticipate the needs of current or future customers, to successfully compete, to increase or hold market share in changing competitive environments, or to deal with pricing or other competitive pressures,” but ALLY management never discusses overall market share. The word “competitor” never appears in the ALLY document. In the 10-K, ALLY provides this description of their business: “Our automotive finance services include purchasing retail installment sales contracts and operating leases from dealers, extending automotive loans directly to consumers, offering term loans to dealers, financing dealer floorplans and providing other lines of credit to dealers, supplying warehouse lines to automotive retailers, offering automotive-fleet financing, providing financing to companies and municipalities for the purchase or lease of vehicles, and supplying vehicle-remarketing services. We also offer retail VSCs and commercial insurance primarily covering dealers’ vehicle inventories. We are a leading provider of VSCs, GAP, and vehicle maintenance contracts (VMCs).” This sounds an awful lot like a captive financing unit of a major automaker, again raising the question about the core business model. Note that the relationships with GM and Chrysler are now discussed in the past tense and the client list includes Ford Motor (NYSE:F) and a variety of offshore automakers: “The Growth channel was established to focus on developing dealer relationships beyond those relationships that primarily were developed through our role as a captive finance company for General Motors Company (GM) and Fiat Chrysler Automobiles US LLC (Chrysler). The Growth channel was expanded to include direct-to-consumer financing through Clearlane and other channels and our arrangements with online automotive retailers. We have established relationships with thousands of Growth channel dealers through our customer-centric approach and specialized incentive programs designed to drive loyalty amongst dealers to our products and services. The success of the Growth channel has been a key enabler to converting our business model from a focused captive finance company to a leading market competitor. In this channel, we currently have over 11,800 dealer relationships, of which approximately 88% are franchised dealers (including brands such as Ford, Nissan, Kia, Hyundai, Toyota, Honda, and others), or used vehicle only retailers with a national presence.” In one of the few bits of detail on ALLY’s actual business, the bank provides these details: “For consumers, we provide automotive loan financing and leasing for new and used vehicles to approximately 4.5 million customers. Retail financing for the purchase of vehicles by individual consumers generally takes the form of installment sales financing. We originated a total of approximately 1.4 million automotive loans and operating leases during both the years ended December 31, 2019, and 2018, totaling $36.3 billion and $35.4 billion, respectively.” Those volume numbers in the last sentence reveal a key aspect of the ALLY business model, namely that the assets run off fast and must be replaced with new production. One of the interesting measures of this is loan commitments, which totaled $29 billion as of June 30, 2020, up from $19 billion a year ago. Yet as a percent of total assets, loan commitments by ALLY are actually below the Peer Group 1 average, suggesting poor volume and utilization of assets compared to its peers. Look at COF, for example. Forward loan commitments were 96% vs average assets, almost 100% turnover as you’d expect from a national credit card business. ALLY was 16% at June 30 vs 21% for all of Peer Group 1. AXP, by comparison, had loan commitments equal to 167% of total assets at June 30, 2020. The same measure for Citi was 50% of total assets. Thankfully ALLY has virtually no derivatives exposure, but neither does it have any meaningful participation in the largest consumer markets of all, namely 1-4 family mortgages, which are currently booming. The bank’s capital at 10% is in the bottom quartile of Peer Group 1, which is a concern because the credit profile of ALLY has losses significantly above peer. The bank has almost $9 billion in insurance assets (P&C) that generate some income. Most of ALLY’s small servicing book is in auto loans and a small amount in 1-4s. The bank’s sales of prime auto loans, which tend to generate a net loss, have been trending lower along with the larger trend in the industry toward lower loan sales. Again, the poor execution available in the secondary market for auto loans informs our view of the ALLY business and the industry, where many small banks have fled prime auto in recent years. Assessment We assign a negative risk profile to ALLY based upon the poor pricing of its products, modest market share and the relatively high cost of credit and funding. ALLY competes with the captives of the major automakers and the larger banks, a fact that is reflected in its poor loan and lease pricing. The decision by ALLY a decade ago to exit the toxic business of sub-prime, no-doc mortgage loans may have been appropriate at the time, but we cannot help but think that ALLY would benefit from a solid government loan business in the Ginnie Mae market right about now. A merger with a broad-line mortgage lender with a strong retail base and a Ginnie Mae seller/servicer ticket might make sense for ALLY. Think of ALLY as a SPAC with a banking license. Overall, we believe that ALLY needs to find ways to lower its funding costs and at least track its peers in terms of interest rate sensitivity. The fact that ALLY’s funding costs are going sideways while the rest of the industry benefits from the FOMC’s aggressive actions is a concern. In our view, this monoline BHC needs better liability management and a more aggressive approach to generating and pricing new assets. Don't hold your breath waiting for Sell Side Street analysts to ask about any of these issues. Indeed, as credit costs rise in 2021, the lack of basic net profitability at ALLY may become an issue. Right now ALLY CFO Jen LaClair says that " we are still expecting kind of that 1.8% to 2.1% retail auto [net charge off] NCO rates that we put out in the first quarter." Cross your fingers. The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Profile is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Profile. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

New York | In this edition of The Institutional Risk Analyst , we assign a neutral risk rating to Wells Fargo & Co (NYSE:WFC) , the fourth largest bank holding company (BHC) in the US at $1.9 trillion in total assets. We own the WFC preferred. Disclosures: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, Review & Outlook WFC has been caught in regulatory purgatory for more than five years, resulting in changes in the bank’s officers and directors that we’ll not recapitulate here. The timeline of events since 2016 created by the Congressional Research Service makes compelling reading for those not familiar with the disastrous past five years for WFC. The increase in operating expenses at WFC since last year has caused the bank’s efficiency ratio , a key operating measure of expenses vs revenue, rise 20% in the past year. This ratio measures the proportion of net operating revenues that are absorbed by overhead expenses, so that a lower value indicates greater efficiency. Most of WFC's peers have efficiency ratings in the 50s and 60s. The table below shows efficiency ratios for the lead bank units of each group. Efficiency Ratio Noninterest expense less amortization of intangible assets/ net interest income + noninterest income Source: FDIC (Q2 2020) While Citigroup (NYSE:C) is not a good business model comp for WFC, we include them in the table above to illustrate just how poorly WFC is currently performing in terms of operating efficiency vs its asset peers. The fact that Citi has a "4" handle for its efficiency ratio is a testament to the fine job done by CEO Mike Corbat . Until the management of WFC gets the bank back down into the 50s in terms of efficiency ratio, investors should not expect strong performance in either the bank’s debt or equity . Comparable Companies JPMorgan Chase Bank of America U.S. Bancorp Truist Financial Peer Group 1 The bank long favored by Warren Buffett has a problem with internal systems and controls that is partly real and partly a function of attracting the wrong attention in Washington. “If you give me six lines written by the hand of the most honest of men, I will find something in them which will hang him,” noted French Cardinal Richelieu in the early 17th Century. Those readers familiar with the saga of Ocwen Financial (NYSE:OCN) and the Consumer Financial Protection Bureau will recognize a similar narrative at work here with WFC (See “ Abuse of Power: The CFPB and Ocwen Financial Corp .”) There is nothing that has occurred or is now occurring at WFC that does not also occur at other large banks. But WFC is in the spotlight and its financial performance is suffering. The difference, of course, between WFC’s situation and OCN’s travails with the CFPB is that the former is dealing with the Federal Reserve Board and other prudential regulators, agencies which ultimately have the power to deny WFC permission to continue to act as BHCs with respect to its subsidiary banks. It is always important for investors in bank debt and equity to remember that you most often hold obligations of the corporate owner of the bank, not the insured depository institution itself. WFC's regulatory problems followed a number of combinations that fundamentally changed the bank. In 1991 in the wake of the S&L fiasco, WFC actually exited the residential mortgage sector entirely. Branch managers sent customers seeking mortgages to other banks. Yet s even years later in 1998, WFC merged with Norwest Corp , which got the conservative Wells into the retail and correspondent mortgage business in a big way. Norwest in the 1990s, lest we forget, was an aggressive bank aggregator of residential mortgages that competed with Citibank and Countrywide . The Norwest culture prevailed after the Wells purchase. A decade later, WFC acquired Wachovia as it teetered on the brink of bankruptcy in December 2008, adding even more mortgage exposure including the CA portfolio of World Savings . WFC now has over 70 million customers from coast to coast and $1.3 trillion in core deposits. WFC has roughly 10% market share in the residential lending and servicing business, the largest single piece of a fragmented $11 trillion market, but like other banks has pulled back from that market in recent years. With the period of regulatory punishment, the bank’s assets have remained just below $2 trillion and income has suffered as expenses have risen. As WFC noted in Q3 2020 earnings: "Our third quarter results also included a $718 million restructuring charge, predominantly related to severance expense, and $1.2 billion of operating losses, largely due to customer remediation accruals.” Hopefully WFC will be able to get control of these extraordinary expenses, but only time will tell how quickly and how much. Among the top banks, WFC tends to be more like Bank of America (NYSE:BAC) as opposed to JPMorgan (NYSE:JPM) , which is really only half commercial bank in terms of assets and even less in terms of risk-adjusted exposures. WFC, on the other hand, is relatively pedestrian in risk terms. WFC has virtually no dependence on volatile funding and is generally a net-supplier of liquidity to the markets. Whereas JPM and Citi are the biggest over-the-counter derivatives dealers on the planet, WFC provides retail banking, and wholesale financing and servicing to the residential and commercial mortgage markets. Boring, low-risk and profitable. WFC also has a substantial wealth management business, accumulated via a string of acquisitions. Today WFC includes over 400 direct affiliates, including five national banks and several more non-depository trust companies and broker dealers. Q uantitative Factors At the close on Friday October 16, 2020, WFC was trading at 0.6x book value with a beta of 1, meaning that it tracks the volatility of the broad equity market. In terms of credit at the close on Friday, the 5-year credit default swaps for WFC were trading wide of JPM and U.S. Bancorp (NYSE:USB) at ~ 65bp, but inside Citi and Goldman Sachs (NYSE:GS) near 100bp. We see little likelihood of default by WFC, but the CDS spreads reflect the deep discount for the public equity and market sentiment toward this credit more generally. Looking at the financial performance of WFC, the first thing that jumps out is the recent underperformance vs the strong historic performance of the bank. After reporting a loss of $2.4 billion in Q2 2020, WFC swung back into profit of $2.3 billion in Q3 2020, but half the profit of Q2 2019. More important, WFC is not performing particularly well vs the top commercial banks above $500 billion, as shown in the chart below. We have deliberately excluded Citi but added Truist Financial (NYSE:TFC) . Source: FFIEC Prior to the end of 2019, as the chart shows, WFC was performing in line with its money center peers, but since that time the earnings have suffered. In the past nine months, for example, the bank’s net interest margin has slipped 20bp. Most of the larger names along with WFC saw higher earnings in Q3 2020 because of the large number of consumer and commercial loans that are currently in some form of forbearance due to COVID. This means that the banks do not yet need to treat these forbearance loans as delinquent . But as anyone in the credit channel will tell you, there is an accumulation of past-due and doubtful credits in consumer and commercial that will likely push provisions and credit losses higher in 2021. Source: FFIEC In the chart above, we show the historical performance in terms of funding costs of WFC and the other BHCs we included in the comparable group for this report. Perhaps the key factor driving bank earnings in the past year is funding. In the past nine months, WFC has seen its interest expense cut in half, but some banks have seen even larger reductions in funding costs. Notice that WFC has benefitted from the actions of the FOMC even more than USB and Peer Group 1 more generally, but lags behind JPM, TFC and BAC in this regard. At the end of 2016, by comparison, WFC had the lowest cost of funds among large banks. In addition to income and funding costs, another important gauge of WFC’s performance is the bank’s gross spread on its $1 trillion in loans and leases. If you take the gross spread, subtract the average cost of funds, credit costs and SG&A, you basically have net income. Half of WFC’s portfolio is real estate loans, another $200 billion is in C&I loans, and almost $200 billion in “other loans and leases.” Source: FFIEC As the chart above suggests, the larger banks are seeing reduced pricing for loans even as the FOMC pushes down the cost of funds. The top performers among the banks discussed in this report are JPM and TFC followed by USB and Peer Group 1 as a group. Both WFC and BAC are in last place and both are performing below their asset peers , never a good sign. But as the chart shows very clearly, BAC has under performed their peers for years and, in the case of WFC, since 2019. WFC has seen its net interest margin compress by 50bp over the past year, ending up at just 2.13% as of September 30, 2020. The open market operations by the FOMC also compressed spreads in the debt markets. As WFC noted in their Q3 2020 results: “Net unrealized gains on available-for-sale debt securities were $4.3 billion at September 30, 2020, compared with $4.4 billion at June 30, 2020, as the impact of lower long-term interest rates was predominantly offset by tighter credit spreads.” The fourth key metric to consider is the bank’s credit performance. Historically, WFC has been quite conservative on credit, with low default rates, good recoveries and a relative conservative profile in terms of Exposure at Default or "EAD." This metric comes from Basle I and compares unused credit lines vs total loans. There are four line items for EAD reported by banks in Peer Group 1, two consumer and two commercial. As calculated by the TBS Bank Monitor, WFC’s lead bank, Wells Fargo Bank N.A. , has an EAD of just 60%, meaning if all of its unused lines were drawn and then the obligors defaulted, the hit to the bank would be about $600 billion. In the case of Citi, by comparison, the EAD is 150% of total loans, illustrating the bank’s large consumer and institutional credit book. JPM’s EAD at the end of June 2020 was 124% of total loans. Prior to 2008, WFC typically had an EAD below 50% and Citi was often above 200-250%. Again, as we never tire of noting, not all large US banks are the same in terms of business model and risk profile. The default rate for Citi is several times higher than for WFC, illustrating the subprime business model of this institution. The chart below shows the historical net loss rate for the comparable banks in this report. Source: FFIEC As the chart above suggests, WFC has historically had net credit losses that were lower than large asset peers such as JPM and USB, both of which tend to take a more aggressive posture to loan pricing and default risk – and are successful doing so. WFC was performing just above Peer Group 1, which is an unweighted average of the 127 banks above $10 billion in total assets and is thus quite conservative. But since 2019, however, the credit performance of WFC has deteriorated. Qualitative Factors As we note at the start of this report, many of the problems facing WFC are self-inflicted have been due to management missteps and a board of directors that has often seemed detached and entirely insensitive to what is happening around them, in Washington and in the media. Often times when banks get into regulatory trouble, the reasons stem from poor credit underwriting and financial factors. In this case, the officers and directors of WFC are facing sanctions from the Fed because of a breakdown in internal systems and controls. Many investors are familiar with the issue of internal systems and controls because of the 2002 Sarbanes-Oxley law. In the world of banking, however, the issue of internal controls is even more serious. State and federal regulators expect bank managers and board members to prudently and comprehensively plan and execute a bank’s business plan over a period of years. You must present a road map of goals and objectives to regulators, and then hit those hurdles. In this case, WFC has a good business model from a qualitative perspective, but has failed miserably in terms of execution by managers and oversight by the bank’s board. WFC’s managers encouraged illegal acts, tried to hide those criminal acts, and then colluded with the board to conceal the entire mess from investors and regulators. The officers and directors of federally insured depositories have an affirmative duty to identify and manage risks to the enterprise. This was not done. We also fault the Federal Reserve Board in Washington, which over the years has apparently lost the capacity to pick up the telephone and read the riot act to WFC’s CSUITE in a timely and private fashion. We asked a Fed governor recently why a more proactive approach was not taken sooner with WFC, but was told rather pathetically that “we don’t do that anymore.” Had the Fed taken action more quickly, WFC would be further along in remediating the damage. When investors and the media ask us when the Fed will let WFC out of jail, our response is simple: You are asking the wrong question. Instead, WFC will earn its way out of jail as and when the management team and the board demonstrate to the Fed and other regulators that the bank has sufficient if not superior internal systems and controls. But things could be worse. WFC could instead by Citi, which faces a far more profound problem with internal systems and controls as the new CEO Jane Fraser takes the reins in February 2021. Risk Assessment We assign a neutral risk assessment to WFC. The assessment is based upon several factors, including: Financial Performance : The bank’s earnings and other quantitative factors have deteriorated in recent quarters, although the core franchise remains stable. This bank has the potential to again become a superlative performer, but at present we are a long way from realizing that goal. Operating Efficiency : Perhaps the most basic and direct measurement of any bank’s management team is the efficiency ratio. WFC currently has an efficiency ratio in the mid-70% range, suggesting to many quantitative models an increased chance of default. We will not consider upgrading this assessment until WFC gets it’s efficiency ratio back into the low 60s or high 50s. Credibility : The most urgent but also most difficult hurdle for WFC management is to win back the confidence of regulators and key policy makers in Congress. In the event of a Biden win in November, you can expect progressive forces to continue to treat WFC as their political punching bag. In political terms, it will be difficult for the Fed to let WFC out of purgatory unless and until the bank has stayed out of the headlines for months if not years. The fate of WFC is in the hands of the current management team and board, but sadly shareholders are paying the bill. As and when WFC management start to address issues of profitability and operating efficiency, we'll reconsider our assessment. Bank Group: AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Profile is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Profile. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

New York | We start this edition of The Institutional Risk Analyst by noting a couple of important developments in the world of financials. First, Western Alliance Bancorp (NYSE:WAL) Friday announced it had purchased Galton Funding , “a rare example of a depository taking title to a nonbank, non-QM originator,” Inside Mortgage Finance reports. Rare indeed, but also a red flag. WAL is a great performer and ranks in the top decile of Peer Group 1, the 127 largest US banks about $10 billion in assets. But when you see commercial banks buying non-QM loan businesses, that does kind of give us a certain feeling of déjà vu . The reason that Citigroup (NYSE:C) still has not addressed chronic internal controls issues goes back decades ago to the acquisition of several nonbank businesses. Second, we hear from the regulatory channel in Washington that the Department of Housing and Urban Development has internal estimates of seriously delinquent loans (as opposed to merely delinquent) peaking in the 13% range during this credit cycle. We noted last week in The IRA Premium Service (“ The Bear Case for Mortgage Lenders ”), that there are a number of large servicers that could capsize in the next downturn in housing. Is it not strange that certain mortgage firms were literally on death’s door in April and now are going public in October? Hmm. Yes, there is a loving and forgiving Lord. And yes, there is a reason why the smart money on Wall Street is focused today on creating new private fund strategies focused on late vintage servicing assets, non-performing loans (NPLs) and early buyouts (EBOs). Do have a look at those FOMC-induced mortgage IPOs, but then remember where those emerging issuers stood in credit terms just six months ago. Third, we see that Morgan Stanley (NYSE:MS) has agreed to acquire Eaton Vance Corp (NYSE:EV) for $7 billion, roughly 5.5x book or 15x EBITDA. This is a premium vs the closing price last Wednesday, but is about where the stock traded in 2018. This transaction increases the size of the MS asset management business above $1 trillion in AUM and further differentiates MS from competitors like Citi and Goldman Sachs (NYSE:GS) . Both of these banks are in The IRA Bank Dead Pool. “People who hang around trying to buy great companies cheaply never get anything done,” Mr. Gorman said last week when the deal was announced. Bravo. In the nuclear winter of financial repression engineered by the Federal Open Market Committee, there are no cheap earning assets. Below we take a look at the top five US depositories as Q3 2020 earnings season begins. You’ll notice a certain subtext operating for all five names, specifically revenue and earnings estimates that fall off the edge of the proverbial table in 2021. JPMorganChase (NYSE:JPM) At 1.3x book at the close on Friday, JPM is hardly cheap as a stock, especially with the dismal outlook for earnings through the rest of 2020. The equity of this $3.1 trillion total asset behemoth is still down almost 30% from the highs this year, but the debt securities for JPM and other banks have tightened considerably from the wide spreads of April 2020. Long the debt and short the equity has been a winning trade through the first half of the year. Of note, the Street has consensus JPM earnings for 2020 at almost $11 per share, but dropping to just $6 in 2021. Five-year growth estimates are showing a negative number at present compared to 15% growth rate over the last five years. As the chart below illustrates, the net income of the top five banks is running at roughly half of the pre-crisis levels. More, the top-five banks are now constrained in terms of share repurchases (none) and dividends (limited). Source: FFIEC To buy the common equity of JPM or any top-five bank is a bet on when the credit impact of COVID will subside sufficiently to allow banks to return to profitability and resume at least normal dividends. Share repurchases could be suspended for years to come for the largest banks. For JPM, the key indicator for us is whether the bank continues to build credit loss provisions through the end of the year. We expect US banks as a group to put aside $40 billion plus in additional loss provisions in Q3 2020 . The lack of visibility on future revenue and earnings is a function of a absence of clarity on forward credit losses. Unlike the 2008 financial crisis, the 2020 COVID meltdown is about recognizing credit losses on loans and bonds rather than a sudden mark-too-market on fraudulent mortgage loans and securities. Assessing the true credit impact of corporate defaults and bankruptcies on banks, REITs, and equity and bond investors, will take years to resolve. While Wall Street wants a quick answer to the COVID credit question, this hope is unlikely to be fulfilled. The basic reason for this is that commercial loan markets move at a glacial pace, especially when the market for the collateral is falling in value. As we noted in the Q3 2020 edition of The IRA Bank Book , loss given default for commercial bank exposures was already rising before COVID exploded onto the scene. Source: FDIC/WGA LLC Bank of America (NYSE:BAC) At 0.9x book as of the Friday close, the common equity of BAC is fairly valued. With a 1.55 beta and a 2.8% dividend yield, the second largest bank by assets at $2.6 trillion has above average volatility with a moderate dividend yield, for now. The Street has a consensus estimate for earnings $2.75 per share in 2020 but just $1.64 in 2021, hardly a rousing endorsement. We own BAC preferred but not the common. BAC has actually outperformed JPM by some measures, but this is to be expected given the conservative stance taken by BAC management over the past decade. Sure, the common is still down 28% since the start of the year, but BAC has actually been outperforming the bank half of JPM on earnings and losses, as shown in the chart below. Source: FFIEC It is tempting to blame the rising tide of delinquent commercial and consumer loans on the COVID pandemic, but in fact the credit cycle was already a bit ripe when 2020 began. The Fed’s manipulation of credit markets and risk preferences has kept loss given default low so far, but if we ever see asset prices weaken, then credit will deteriorate quickly and dramatically. In any event, COVID’s devastation of many sectors of the economy means big losses for lenders and institutional investors in everything from aircraft leases to small multifamily apartments. U.S. Bancorp (NYSE:USB) USB has long been the smallest and among the best performing money center banks. The strong funding base and diverse mix of business lines, but little Wall Street exposure, has always made USB one of our favorite names. We sold our USB common equity position earlier in the year, but put the proceeds into USB preferred during the March selloff. We look for periods of volatility to add to these preferred holdings. At 1.3x book value for the equity, USB is hardly cheap and, indeed, is still down 34% YTD. That said, USB’s strong credit profile has the bank trading among the tightest credits to the swaps curve at 33bp for five-year credit swaps vs 47bp for JPM. The Street has USB reporting $4.16 per share in 2020 earnings, but falling to just $1.60 in 2021. Source: FFIEC Wells Fargo (NYSE:WFC) With the bank’s common down more than 50% YTD and wallowing at 0.65x book value, WFC might seem like a bargain. Because of the steep discount to the bank's book value of equity and the other metrics, we understand why some of our readers might be attracted by WFC. At some point, the management and board of the bank are going to turn things around. This might seem like an attractive thesis -- until we recall that the bank’s problems are largely self-inflicted. Despite the sanctions imposed by the Federal Reserve Board and the continued dysfunction of the WFC board and management team, however, the bank has continued to generate relatively strong results. The Street consensus has WFC revenue down 15% for 2020 and flat in 2021. We’d not be surprised to see WFC beat those metrics, but in any event, we think the bank’s paper is money good. We purchased some of the preferred below par during the second quarter. As Pete Najarian likes to say, “Giddy up.” Source: FFIEC Citigroup (NYSE:C) In our latest risk profile on Citi this past September , we noted that the bank is largely a prisoner of history, meaning that despite the progress made by CEO Michael Corbat , the options are limited for his successor Jane Fraser going forward. At 0.54x book for the Citi common, the stock is down 44% YTD and shows little sign of improving in the near term. We wrote: "Our overall assessment of the quantitative and qualitative factors behind Citigroup is negative . The bank under-performs its peers financially, takes outsized risks compared to its large bank peers, and has no clear strategy for improving asset returns, access to funding or the bank’s overall risk profile." The Street has C delivering $8 per share in earnings in 2020, but falling to half that amount in 2021. Again, the theme here is that things will get a good bit worse before they get better. The Street consensus on revenue growth is flat in 2020 and down small in 2021, but clearly the expectation is for credit costs to consume a bigger chuck of Citi's revenue next year. Get used to it. 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 | Watching the talking heads pondering the next move in US interest rates, we are often amazed at the domestic perspective that dominates these discussions. Just as the Federal Open Market Committee never speaks about foreign anything when discussing interest rate policy, so too most observers largely ignore the offshore markets. Yen, dollar and euro LIBOR spreads are shown below. Zoltan Pozsar , the influential money-market strategist at Credit Suisse (NYSE:CS) , warns that the short-end of the US money markets are likely to be awash in cash over the end-of-year liquidity hump. U nlike the unpleasantness in 2018, for example, we may see instead a surfeit of lending as banks scramble for yield in a wasteland bereft of duration. Would that it were so. The Pozsar view does not exactly fit well with the rising rate, end of the world scenario popular in some corners of the financial media ghetto. The 10-year note is certainly rising and with it the 30-year mortgage rate. Indeed, Pozsar reminds CS clients that yen/$ swaps are now yielding well-above Treasury yields for seven years. Hmm. We believe short-term rates will remain low in the US, even as offshore demand for dollars soars. If the 10-year Treasury backs up much further, then we’d look for the FOMC to act on some calls by governors to buy longer duration securities. That is, a very direct and large scale increase in QE and particularly on the long end of the curve. We expect that Chairman Powell knows that underneath the comfortable blanket of low interest rates lie some truly appalling credit problems ahead for the global economy, the US banking sector and also for private debt and equity investors. W e expect the low interest rate environment to drive volumes in corporate debt and residential mortgages, even as other sectors like ABS languish and commercial real estate gets well and truly crushed. “The pandemic is putting unprecedented stress on CMBS markets that even the Fed is having difficulty offsetting, writes Ralph Delguidice at Pavilion Global M arkets . “Limited reserves are being exhausted even as rent collection and occupancy levels remain serious issues… Bondholders expecting cash are getting keys instead, and in our view, ratings downgrades and significant losses are now only a formality.” We noted several months ago that the resolution of the credit collapse in commercial mortgage backed securities or CMBS will be very different from when a bank owns the mortgage. As we discussed with one banker this week over breakfast in Midtown Manhattan, holding the mortgage and even some equity in a prime property allows for time to recover value. Delguidice rightly identifies that "extend and pretend" by consuming reserves is the first and, frankly, wrong strategy. The agencies have flagged this tendency since the summer, but now comes the reckoning. When the cash is exhausted, then comes the actual default and foreclosure. Meanwhile, no funds are left for maintenance of the asset. With CMBS, the “AAA” tranche is first in line, thus the seniors have no incentive to make nice with the subordinate investors. The deals will liquidate, the property will be sold and the junior bond investors will take 100% losses. But as Delguidice and others note with increasing frequency, this time around the “AAA” investors are getting hit too. More to come. Manhattan Meanwhile, over in the relative calm of the agency collateral markets, large, yield hungry money center banks led by Wells Fargo & Co (NYSE:WFC) are deploying liquidity to buy billions of dollars in delinquent government loans out of MBS pools. The bank buys the asset and gives the investor par, with a smidgen of interest. Market now has more cash, but less cash than it had before buying the mortgage bond in the first place. Why? Because it likely took a loss on the transaction. Buy at 109. Prepayment at par six months later. You get the idea. In fact, if you look at the Treasury yield curve, rates are basically lying flat along the bottom of the chart out to 48 months. Why? Because this nice fellow named Fed Chairman Jerome Powell , along with many other buyers, are gobbling up the available supply of risk free assets inside of five years. Spreads on everything from junk bonds to agency mortgage passthroughs are contracting, suggesting that the private bid for paper remains strong. When you look at the fact that implied valuations for new production MBS and mortgage servicing rights (MSR) have been rising since July, this even though prepayment rates are astronomical, certainly implies that there is a great deal of cash sitting on the sidelines. Remember that the price of an MSR is not just about cash flows and prepayments, but it’s also about default rates and the relationship with the consumer. We described in our last missive for The IRA Premium Service (“ The Bear Case for Mortgage Lenders ”), that a rising rate environment could generate catastrophic losses for residential lenders, particularly in the government loan market. We write: “For both investors and risk professionals operating in the secondary mortgage market, the next several years contain both great opportunities and considerable risks. We look for the top lenders and servicers to survive the coming winter of default resolution that must inevitably follow a period of low interest rates by the FOMC. The result of the inevitable consolidation will be fewer, larger IMBs.” Don’t get distracted by the rising rate song from the Street. We don’t look for short or medium term interest rates to rise in the near term or frankly for years. Agency 1.5% coupons “did not find a place in the latest Fed’s purchase schedule. It is possible (they) are included in the next update,” writes Nomura this week. This seems a pretty direct prediction of lower yields. But as one veteran mortgage operator cautions The IRA: “Not just yet.” We don’t think that the Fed is going to take its foot off the short end of the curve anytime soon, in part because the system simply cannot withstand a sustained period of rising rates. In fact, we note that our friends at SitusAMC are adding 1.5% MBS coupons to forward rate models this month. But that does not necessarily mean that mortgage rates will fall any time soon. Some worry about whether there will ever be liquidity in 1.5% coupon agency MBS, but fear not. We've seen this movie. If you build that Ginnie Mae or conventional mortgage bond with a 1.5% coupon, Jay will come and buy it. And he’ll remit the interest earned on that mortgage bond to the US Treasury, less the Fed’s operating expenses of course. We hear that the Fed of New York has bought a few 1.5s in recent days, but supply is sorely lacking. You see, the mortgage industry is not quite ready to print many new 1.5% MBS coupons and will not do so anytime soon. As the chart above suggests, mortgage rates are in fact rising . Why? Is not the FOMC in charge of the U.S mortgage market? No, the market rules. Today you can make more money selling a new 1-4 family residential mortgage into a 2.5% coupon from Fannie, Freddie or Ginnie Mae at 105. You book a five point gain on sale and are therefore a hero. And a year from now, after the liquidity does in fact migrate down to 1.5s c/o the beneficence of the FOMC, you can again be a hero. Specifically, you call up that same borrower and refinance the mortgage into a brand new 1.5% Fannie, Freddie or Ginnie Mae at 105. You take another five point gain on sale. Right? And who paid for this blessed optionality? The Bank of Japan, Peoples Bank of China, and PIMCO , among many other fortunate global investors. These multinational holders of US mortgage bonds may not like negative returns on risk free American assets, but that’s life in the big city. And thankfully for Chairman Powell, it's not his problem. Many years ago, a friend in the mortgage market said of loan repurchase demands from Fannie Mae: "What do you want from me?"

New York | This week in The Institutional Risk Analyst , we make the bear case for the housing sector as several more large mortgage issuers have announced public share offerings, joining LoanDepot and United Wholesale Mortgage . Caliber Home Loans and AmeriHome, Inc ., two very different mortgage issuers that are benefitting from the low interest rates environment, each filed IPOs last week. Mortgage Group: ACGL, AGNC, AI, BKI, BXMT, CIM, CLGX, COOP, ESNT, FAF, FBC, FMCC, FNF, FNMA, IMH, LADR, MFA, NLY, NRZ, NYMT, OCN, PFSI, PMT, RKT, RWT, STWD, TWO Caliber Home Loans is a portfolio company of Lone Star , which formed Caliber in 2013 from bits and pieces of business left over from the 2008 mortgage crisis. Under CEO Sanjiv Das , who formerly triaged and repaired the correspondent mortgage operation at Citigroup (NYSE:C) , Caliber has developed a high-touch, largely purchase mortgage business that is the antithesis of firms like Rocket Mortgage (NYSE:RKT) and AmeriHome. Most recently, Caliber has also seen an increase in refinance volumes, but the core business remains purchase loans sourced via retail branches. See our previous discussions of Ally Financial (NASDAQ:ALLY) and Citigroup for further background. AmeriHome is one of the most efficient platforms in the industry and boasts a veteran team of operators. The firm is a subsidiary of insurer Athene Holding (NYSE:ATH) , which in turn is controlled by Apollo Global Management (NYSE:APO) . Unlike Caliber which focuses on purchase business and is a large GNMA issuer, AmeriHome focuses on both purchase and refi loans predominantly in the conventional loan market. AmeriHome is an important part of the success of ATH and APO. The extraordinary boom in the US residential mortgage market has pushed up volumes for new issuance of mortgage backed securities to over $440 billion per month through August. Even as commercial banks face years of uncertainty due to the credit cost of COVID and its aftermath, nonbank mortgage lenders are today's golden children for Wall Street – at least for now. In an existential sense, the rise of the mortgage lenders and servicers since March provides a counterpoint to the travails of the commercial banks and, in particular, the mortgage REITs and funds. This latter group purchased MBS, loans and/or servicing, all with ample leverage, over the past 7 years. More recently, these firms have seen their equity market valuations crushed as the FOMC drove interest rates down. We noted in National Mortgage News (“ Banks Retreat Again from Residential Servicing ”) that simply owning mortgage assets w/o also having the ability to lend and recapture refinance events is no longer a viable trade. This is a direct reference to the entire hybrid REIT space led by the likes of New Residential (NYSE:NRZ) as well as some specialized private servicers such as Lakeview Loan Servicing . But there is even more to the risk story. The table below shows some of the largest servicers in the $1.9 trillion Ginnie Mae market. Source: Ginnie Mae There are many REITs and also some large non-bank servicers most people have never heard of that presently face massive risk in terms of prepayments and also the cost of default resolution. These REITs and servicers are mostly weak lenders and have significant leverage. COVID has further increased the risk to some participants in the mortgage market and also decreased the visibility into how loans currently in forbearance under the CARES Act will be resolved. Time and cost to resolution of delinquent loans = expense and risk for servicers. These risks are different depending upon whether we look at the conventional market build around Fannie Mae and Freddie Mac or the government market built around the FHA and Ginnie Mae. Below we outline some of the obvious risks facing investors, some of which are mentioned in the public filings of several independent mortgage banks. Other risks are not yet mentioned in public disclosure. Prepayments As we have discussed previously in The Institutional Risk Analyst and also in National Mortgage News , the rate of mortgage loan prepayments in conventional and government loans are at levels not seen since the early 2000s. The sharp decrease in interest rates two decades ago set off a bull market in residential lending in the early 2000s that is very similar to today’s market. The major differences are the lack of a private label loan market and COVID. But the risk to issuers in terms of prepayments and, as discussed below, default resolution is the same. We wrote last month in NMN: “Simply stated, banks and REITs buy loans, IMBs make loans. Holding MSRs when you cannot defend the asset by recapturing the refinance event is a losing trade. This is why, for example, that early buyouts of government loans is such a popular strategy with large banks. Buy the delinquent asset, modify or refinance the loan, and sell it into a new MBS pool or just hold the loan in portfolio.” COVID & Liquidity Risk Earlier this year, there was considerable concern about the ability of independent mortgage banks (IMBs) to finance advances of principal and interest (P&I), and taxes and insurance (T&I) on loans that have 1) received forbearance pursuant to the CARES Act or 2) are simply delinquent. Significantly, residential mortgage loans in forbearance and actual defaults are not eligible for pooling and cannot be financed, thus the servicer must bear the cost of financing both the mortgage note and the advances. The GSEs recently issued guidance limiting the number of payments a servicer must advance in the case of a forbearance, but most issuers expect that a borrower who has experienced a loss of employment or a reduction of income may not repay the missed payments at the end of the forbearance period. These loans will likely result in a default and foreclosure, resulting in an expense to the GSEs. All servicers generally have a month between the receipt of the loan payoff and the principal payment to the MBS investors. Most servicers so far successfully utilized the float from prepayments and mortgage payoffs to fund P&I advances relating to forborne loans, and have not yet advanced material amounts of associated with CARES Act forbearances. 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. As a result, issuers may need to use cash, including borrowings under warehouse lines and bond debt, to make the payments required under servicing operations. T here is no assurance as to how long the bull market in mortgage lending and specifically mortgage refinance lending will continue. Thus the availability of this float to finance forbearance and default advances is uncertain. More, the ongoing funding burden will increase as servicers and the GSEs are compelled to advance T&I as well as P&I. Also, due to the likely increase in unemployment in Q4 and 2021 due to a lack of additional stimulus spending, we expect to see loan defaults climb even as new loan volumes remain strong. In many cases, we expect that strong prices for existing homes will keep loss-given default (LGD) low or even negative, as is the case for bank owned 1-4s. Many defaults will be avoided with short-sales and other mechanisms because the home is often worth more than the unpaid principal balance (UPB) of the delinquent loan. Source: FDIC/WGA LLC Loss Mitigation As the current bull market matures, loss rates will inevitably rise even as volumes and prepayments continue to run at record levels. The added risk of COVID and related unemployment and economic dislocation must be considered as well when considering the likely future cost of loss mitigation . The most recent quarterly data for loan delinquency is shown below: Sources: MBA, FDIC In the conventional market, the major risk facing issuers and particularly IMBs is repurchase demands from the GSEs. Historically going back to the 1980s, when defaults rise in conventional loans, Fannie Mae and Freddie Mac first seek payment from the private mortgage insurers, if applicable, and then seek to force the aggregator to repurchase the “defective” loan. The aggregator then typically seeks reimbursement from the correspondent lender. As default rates rise in the conventional market, those loans that are judged to be adequately underwritten and documented will be covered by the GSE guarantee. Those loans considered to be defective, on the other hand, could become a significant expense to conventional issuers and particularly IMBs. Commercial banks will have a significant advantage in terms of liquidity and funding for loss mitigation activities, but all issuers will face significant costs, both for loan repurchases and foreclosures. Again, the fact of strong home prices is the key factor that will impact LGD for all loans. In the government market, the situation is even more complicated. First, there is limited funding available to government issuers due to the fact that Ginnie Mae is only a guarantor and has no balance sheet to use in providing liquidity to government issuers. Ginnie Mae must operate through its seller/servicers, meaning that in the event of default, Ginnie Mae must transfer the servicing (and with it the obligation to pay bold holders) to another servicer. At present, none of the large banks are willing to accept large servicing transfers of Ginnie Mae assets. In some cases, the FHA has indicated that it will allow issuers to make partial claims to offset the cost of forbearance loans. But for those loans which default and go into foreclosure, the impact on issuers and particularly IMBs could be severe. Again, the funding advantage of commercial banks is a significant factor in the world of default resolution for government loans, one reason why issuers such as Wells Fargo (NYSE:WFC) have been aggressively buying early buyouts (EBOs). Kaul, Goodman, McCargo, and Hill (2018) wrote an excellent monograph on these costs for Urban Institute . “Servicing FHA Nonperforming Loans Costs Three Times More Than GSE Nonperforming Loans,” they found. This why the FHA lenders receive 44bp for servicing vs. 25bp for conventional loans. But even the higher servicing fee does not cover all of the expense of Ginnie Mae default servicing. All Ginnie Mae issuers face a substantial cash loss for every FHA, VA and USDA loan that goes into foreclosure, a loss that can range between $5,000 to $25,000 per loan or more. A lot depends on geography -- how much property preservation expense you have to eat, any damage to the REO house, health and safety issues, city fines, if you miss "first day" legal filings under FHA rules. The list is long and the operational complexity is high. The fact that FHA lenders are reimbursed for interest expenses at the debenture rate but must advance cash for P&I at the coupon rate of the loan is another big factor. Also, foreclosures in “progressive states” such as New York, New Jersey and Massachusetts can take up to five years, greatly increasing the cost of default resolution. Nationally, foreclosures can take up to three years on average even before we talk about forbearance due to COVID. There are many variables in managing FHA loans to conveyance and final resolution, making the expense and risk difficult to define measure. Ginnie Mae issuers must also finance the entire resolution process. While banks can easily purchase EBOs using their deposits for funding, IMBs lack the cash to finance buyouts of defaulted loans from Ginnie Mae MBS. The key determinants of the issuer risk here are: The geographic location of the defaulted assets, The rate of cure, short-sale or modification for each portfolio controlled by the issuer, and The average timeline for resolution across the portfolio In recent meetings with officials at the Department of Housing and Urban Development, the top Ginnie Mae issuers were asked to model the rate of successful exit from COVID forbearance. Today FHA has an estimated 650,000 loans in forbearance and another 325,000 that are seriously delinquent (SDQ) but not in forbearance. That is $160 billion in UPB that is SDQ as of August, a figure that likely will rise. Looking at the largest Ginnie Mae loan servicer Lakeview, which services 1.3 million loans with $224 billion in UPB, we can see why the rate of successful exit is absolutely crucial. Of the 15% of Lakeview loans that are non-current either due to COVID forbearance or actual delinquency, that comes to roughly 195,000 loans that are possibly SDQ. Let’s say that half of non-current Lakeview loans exit forbearance successfully and another quarter get current and are then refinanced or modified. If a quarter of these non-current loans go through to foreclosure, that could in theory result in total unreimbursed expenses averaging approximately $12,000 per loan or $570 million in cash expenses to Lakeview. Under the same scenario, Penny Mac Financial Services (NYSE:PFSI) would face almost $500 million in cash expenses due to foreclosure. On an industry level, if you figure Lakeview has about 11% market share in Ginnie Mae servicing, if one quarter of SDQ loans go through to foreclosure and REO, that suggests a roughly $4-5 billion loss spread across all Ginnie Mae issuers. Wells Fargo and Truist Financial (NYSE:TFC) , on the other hand, will see far lower default resolution losses because their delinquency rate is far lower than the IMBs. The table below shows the projected cash loss upon foreclosure for the top Ginnie Mae issuers, assuming that 25% of non-current loans today eventually go to foreclosure and a $12,000 non-reimbursed expense per foreclosure. Keep in mind that both the total number of loans outstanding and the rate of delinquency is likely to grow, this even as overall volumes also climb. Sources: Ginnie Mae/WGA LLC While some of the more efficient issuers in this group may be able to use profits from strong new loan origination volumes to offset cash losses on delinquent loan resolutions, less efficient players are facing a double whammy. High prepayments are destroying the value of MBS, whole loan portfolios and MSRs. Meanwhile, rising credit and servicing costs are consuming cash. For both investors and risk professionals operating in the secondary mortgage market, the next several years contain both great opportunities and considerable risks. We look for the top lenders and servicers to survive the coming winter of default resolution that must inevitably follow a period of low interest rates by the FOMC. The result of the inevitable consolidation will be fewer, larger IMBs. But we also look for some significant business failures over the next several year from those owners of Ginnie Mae and conventional assets that are weak lenders and servicers. We've said it before and we'll say it again, if you as a lender don't have retention rates for refinance events well above 50% and default resolution costs in the bottom quartile of the MBA survey, then you need to sell your MSRs and get out the the kitchen before you get burned. 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. 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“Investors must now attempt to reconcile this contradiction between soaring asset prices and an economy whose productive potential and consumer demand have both collapsed. ” Gordon Li , CFA TCW No matter how many books we open and articles we peruse, there is really no replacement for the opening lines of A Tale of Two Cities to describe the current predicament. Charles Dickens wrote in 1859: “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair…” Although things may seem a trifle upside down at present, as the citation from Gordon Li at TCW suggests, there are signs of hope. For example, just about every company in the world of mortgage finance seems to be for sale thanks to the beneficence of the Federal Open Market Committee. Witness the unnatural fact that nonbank mortgage servicers and lenders have outperformed the S&P 500 for several months. First we saw Rocket Mortgage (NYSE:RKT) take the plunge into public ownership, an exercise that seems motivated as much by estate planning as the bull market in residential mortgages that continues to build. As we noted previously, the new mortgage securities issuance numbers from SIFMA are over $400 billion per month and growing. More recently, we saw United Wholesale Mortgage take the plunge via a SPAC transaction led by no less than Alex Gore . UWM, for those unfamiliar with mortgage finance, specializes in the wholesale channel, a murky world of low margin busines where independent mortgage brokers sell “warm leads” to aggregators like UWM. Whereas firms like RKT and PennyMac Financial (NASDAQ:PFSI) focus on call center and refinance as primary channels, UWM has just one focus, wholesale. In good times it’s great, in times of weak volumes not so much. If RKT is the bluefin tuna of the mortgage world and PFSI the swordfish, hard-working UWM is the monkfish. Now in the dreadful days of 2018, neither RKT nor UWM would have even dreamed of going public. But in the fantastic world of QE in 2020, anything is possible. Fed Chairman Jerome Powell merely puts his finger on the great scale of financial valuations and, viola, we turn complete dross into a beautiful golden cloth. By skewing the risk curve, the FOMC is able to convince investors that deepest black is in fact shining white. And Chairman Jay Powell made this possible! All hail Jay! All Hail Jay! Our friends at Grant’s Interest Rate Observer remind us of the FOMC’s August 27th statement, where Powell & Co promised to “use its full range of tools to achieve maximum employment and price stability goals.” Think how fabulous to see the FOMC inflate the economy and keep prices stable, all at the same time! Yet we do note that the Federal Housing Administration reports that American home prices are rising about 1% per month nationally. Jim Grant , who most recently published a biography of Walter Bagehot , likes to remind us too of the auto-quotation from the famous writer: “John Bull can stand many things but he can’t stand 2%.” Bagehot continued: “People won’t take 2 percent; they won’t bear a loss of income. Instead of that dreadful event, they invest their careful savings in something impossible – a canal to Kamchatka, a railway to Watchet, a plan for animating the Dead Sea, a corporation for shipping skates to the Torrid Zone.” Much like the opening lines of A Tale of Two Cities , people generally only quote the first several lines of famous pronouncements. Only when you include the entire statement, however, can we appreciate the full import of the Bagehot view of markets. Bagehot’s observation, in fact, predicted QE and the FOMC’s obsession with making credit progressively cheaper, to the detriment of savers. When Bagehot wrote those immortal words, banks had to offer attractive rates to entice investors to deposit gold in their vaults. Gold in the vault allowed banks to increase leverage by issuing paper. If rates got too low, Bagehot suggests, then John Bull would sell paper and take his gold, leading to deflation in banks and the financial markets. When Bagehot wrote those lines 150 years ago, gold was money and paper was a derivative. Since the New Deal when FDR confiscated gold in 1933, however, the role of money in the US has inverted, with a worthless paper dollar now legal tender and the unit of account. George Selgin writes in Alt-M : “[T]he recovery that followed FDR's assumption of office was fueled almost exclusively by growth in the Federal Reserve's gold holdings. As the following FRED chart shows, those holdings almost tripled during the four years following the nationwide bank holiday, allowing the M2 money stock to concurrently grow to 150 percent of its pre-holiday level. The result was a ‘Great Expansion’ of real GNP that more than offset the ‘Great Contraction’ of the preceding three years.” The trouble, of course, is that almost a century later, there is no easy fix for the deflation that now menaces the US economy and the rest of the world. The FOMC indeed has managed to skew risk preferences and asset prices, but still insists that more need to be done to fulfill the mandate of price stability and full employment. Meanwhile, the deflationary impact of COVID continues to ripple through the global financial system. David Kotok at Cumberland Advisors writes this week : “Negative interest rates impact all yield curves and eventually force them into a parallel shape…. Essentially, the starting point of the negative interest-rate policy is to cause the negative-rate yield curve to slope into more-negative rates as one extends maturities. The reverse happens with positive-rate yield curves. This creates a tension, and currency-hedged adjustments and derivatives eventually resolve that tension. As that resolution occurs, all yield curves gravitate toward a parallel slope. Furthermore, the yield spreads between various currency yield curves become the currency futures differentials.” Ponder that reality while considering your asset allocation choices in the days and weeks ahead. In an upcoming issue of The Institutional Risk Analyst, we’ll be taking a look at four banks in the world of specialty finance and asset management – including American Express (NYSE:AXP), Capital One (NYSE:COF), and Charles Schwab (NASDAQ:SCHW). This report will be available to subscribers to the Premium Service of The Institutional Risk Analyst.

"Trying to understand the way nature works involves a most terrible test of human reasoning ability. It involves subtle trickery, beautiful tightropes of logic on which one has to walk in order not to make a mistake in predicting what will happen. The quantum mechanical and the relativity ideas are examples of this." Richard P. Feynman New York | Over the past week, many thousands of words have been written regarding the latest pronouncement from the Federal Open Market Committee about inflation and monetary policy. Led by Federal Reserve Board Chairman Jerome Powell , the FOMC has discarded the statutory mandate from Congress regarding “price stability” and is now pursuing a long-term average for inflation based on the central bank's shifting definition of aggregate prices. Many analysts offer as many reasons for this change, but the basic message to the markets is that interest rates now have a permanent downward bias. Whereas in the past the committee followed a measured and preemptive approach to managing inflation, now the FOMC intends to let inflation run at or above 2% for a while. How long? That is the difficult part in the new world of monetary relativity. George Selgin of CATO Institute nicely describes the FOMC’s transition to nominal GDP targeting . “Since Jay Powell announced the Fed's new average inflation targeting (AIT) strategy last week, both Scott Sumner and David Beckworth have welcomed it as a step, albeit only a tenuous one, toward their own (and my) preferred policy of NGDP level targeting,” Selgin writes. “Scott calls ‘average inflation targeting…a tiny step forward,’ though one that will allow the Fed more discretion than a move to price-level targeting would. David likewise observes that, although it isn't quite an NGDP level target, AIT "is a step in that direction." Ditto. The idea of the FOMC deciding when AIT has made up for periods of price deflation seems to stretch to the breaking point the elastic “necessary and proper” clause of the Constitution, which allows agencies of the federal government to take those actions required to implement the will of Congress. But the law still says “price stability.” Is it necessary for the FOMC to have AIT or merely convenient? “The telling part of the problem with the new strategy came during the press conference,” notes Robert Eisenbeis of Cumberland Advisors , “when Chairman Powell struggled to answer several pointed questions about how long inflation would remain above 2%, how is “moderately above 2%” for inflation defined; how maximum employment is defined, why inflation above 2% didn’t show up in the SEP, and how and under what circumstances the asset purchases program might be stopped. All in all, few if any actual specifics were provided, which leaves us to wonder whether, at this time, the Committee simply hopes it can get inflation up, hopes it can achieve a 2% average rate, and hopes it can get back to full employment sometime in the future.” Of note, the FOMC announced that it will continue its monthly asset purchases under this latest version of quantitative easing or QE. Chairman Powell, during the press conference, indicated that $80 billion would be in Treasuries across the curve and $40 billion in agency MBS, so as to support “the flow of funds to households and businesses.” As we’ve noted in the past, the FOMC policy of Financial Repression encourages debtors but punishes savers, as illustrated by the fact that the Fed remits the interest earned on $1 trillion in MBS to the Treasury, depriving private investors of this income. While the FOMC’s policies are certainly encouraging mortgage backed securities issuance, other sectors remain subdued due to the damage done to the markets by the volatility in March and April and before. Notice that new mortgage debt issuance is now over $400 billion per month. One of these days, we’d love to see Chairman Powell and the other members of the FOMC document to Congress why they think that the net, net impact of quantitative easing and low interest rates are actually a benefit to the US economy. Nathan Tankus writes in Notes on the Crisis that the FOMC’s repudiation of its earlier policy stance on inflation when it isn’t coming in “above target” is significant. He opines: “This is important because it is a concrete illustration that the Fed has shifted to a more ‘dovish’ policy and away from its historic tendency to generate unemployment to preempt rising inflation.” That the American political system cannot tolerate even a brief period of induced pain to forestall inflation illustrates a larger problem, namely that the US financial system cannot tolerate much in the way of liquidity stress either. Thus the clear message from Powell is that the circumstances that caused the committee to raise the federal funds target and shrink the system open market account in 2018 will not be repeated. The change to the Fed’s operating parameters in a financial sense is as much operational and it is monetary. The Fed has now capitulated to the debtors in the global economy and, operating through the Federal Reserve Bank of New York, will provide whatever liquidity is needed to keep the game moving in the financial markets. Powell’s action is the functional equivalent of the FOMC removing the snakes from the gameboard of Snakes & Ladders , an ancient Indian competition between the ladders of virtue ( karma ) and the dissolution and ruin of the snakes ( kama ). Going forward, the FOMC will provide whatever support is required to target nominal market stability along with NGDP. Embracing AIT takes away any practical limit on Fed liquidity injections, contrary to the intent of Congress in the Dodd-Frank law. The change in the FOMC’s stance also reflects a rebuke to the remaining conservatives within the decidedly left-of-center Fed system, the once powerful staffers and Reserve Bank Presidents who followed the legal mandate from Congress explicitly. Game over. Powell’s actions are a direct and final repudiation of the supporters of former Chairman Paul Volcker , who preemptively attacked inflation in the 1970s and 1980s. The pressure from conservative Fed cardinals in 2017 and 2018 made the FOMC to attempt to raise the federal funds market and also allow the SOMA to run off in what seems today a reckless and intemperate fashion. The market meltdown at the end of 2018 and in September 2019, as a practical matter, forced Powell et al to retreat on the target rate for federal funds and forced a re-start of QE. As former Fed Chairman Ben Bernanke warned years ago, once given the liquidity provided by QE cannot be withdrawn. The 20-30% annualized inflation of the assets of the US banking system that results from QE is now permanent. The FOMC is now compelled to continue financing ~ $6-7 trillion in US Treasury debt at no cost more or less indefinitely. Of course, conservative protestations about inflation are always wrong until they are right. Predicting these trends is the stuff of quantum mechanics, a science that is as much qualitative and quantitative. The inflation of the 1970s, for example, was driven by demographic factors that no longer pertain to the present day economy. Indeed, if the FOMC really wants to hit its 2% inflation target, it may need to change the definition of inflation, again. We believe investors and risk professionals need to focus on the actions of the FOMC and not the “disappointing” narrative from Chairman Powell, to concur with Selgin, Tankus and others who closely follow Fed monetary mechanics. Note in the SIFMA chart above the sharp upward move in Treasury issuance this quarter. Those market actions, we submit, suggest that the Treasury market doggie is wagging the FOMC monetary policy tail going forward.

“Now is not the time to worry about shrinking the deficit or shrinking the Fed’s balance sheet.” Steven Mnuchin Treasury Secretary New York | With the onset of the latest phase of quantitative easing or QE in March, the Federal Open Market Committee has pushed financial repression back up into the high 80s as measured by the Financial Repression Index . This index measures the distribution of bank interest income between depositors and other creditors, on the one hand, and bank equity holders, as shown in the graph below. Source: WGA LLC The negative impact of Fed market manipulation is profound when measured against financial repression inflicted upon savers. The Fed purchases US Treasury debt and agency mortgage backed securities, and remits back the income from this $7 trillion portfolio to the Treasury, less the Fed’s operating expenses. This example illustrates, BTW, that the central bank is an expense to and an appendage of the US Treasury. By pushing down the cost of funds for banks, the FOMC is effectively transferring income from consumers and institutional savers to the shareholders of banks. This social engineering is intentional and done without apology by the Fed much less specific authority from Congress. Savers are at the mercy of economists. In the next edition of The IRA Premium Service, we'll be publishing a new risk profile on Citigroup (NYSE:C) Fed officials argue that such machinations as diverting trillions of dollars per year from savers to debtors are "necessary and proper" to fulfill the Humphrey Hawkins mandate, but demur when it comes to the "net" benefit of taking trillions in cash away from consumers and investors. To be fair, other central banks around the world also subsidize their indebted governments by purchasing sovereign debt under the rubric of "economic stimulus." Periodically you will hear some learned economist wax on about how low interest rates have reduced the cost of servicing the Treasury’s massive debt. But the blessings of neo-Keynesian economics go only to debtors. The US government is the single biggest beneficiary of QE. The truth of the matter is that when the FOMC is buying Treasury paper and MBS at the present clip, the Treasury has no cost of funds at all. No less an authority that the Wall Street Journal noted last week that “U.S. deficit nearly tripled in first 11 months of fiscal 2020, Treasury Department says, but low rates reduce net interest costs by more than 10%.” And Chairman Powell reduced the Treasury's interest expense nearly to zero in 2020. When Fed Chairman Jay Powell is giving the Treasury the interest earned in its Treasury portfolio and also remitting back the earnings on $1 trillion in MBS, Treasury Secretary Steven Mnuchin and Congress are flying for free. Just how is this stimulative to the economy and particularly consumers Chairman Powell? The Fed is transferring hundreds of billions in income from private investors to the Treasury via QE, hardly an example of a progressive economic stimulus. Rather, it seems the monster is consuming the creator. While there are doubtless benefits for debtors in the Fed’s current scheme of forcing rates down and trying to gin-up inflation, holders of assets -- depositors of banks and bond investors -- are the sure losers. Interest earnings forgone by bank depositors run about $500 billion annually thanks to the generosity of Chairman Powell and his colleagues on the FOMC. Figure at least another buck for bond interest and interest on a trillion in agency MBS that goes directly to Secretary Mnuchin. That's $1.5 trillion a year taken from consumers and other savers thanks to QE. So even as we've see the system open market account (SOMA) grow to over $7 trillion since March, don't hold your breath waiting for it to come down a la 2018-2019. The FOMC will likely continue to purchase Treasury bonds and MBS indefinitely so as to keep the SOMA stable. This means that the double digit inflation of bank balance sheets may also be a permanent fixture in the financial world. We can all pretend that inflation is low, but consumers and institutional investors will pay the cost. Call it monetary life support. This implies a continued transfer of hundreds of billions of dollars annually from depositors and bond investors to the US Treasury, encouraging further economic profligacy in Washington and more silly walks down Wall Street. Indeed, one of the delicious ironies of the current situation as we approach the November election is that the Democrats and Republicans both assume that they can continue to expand spending and the national debt without any economic or political consequence. When former Vice President Joe Biden talks about raising and spending $3 trillion in his first year, he means it. But that may or may not be possible, regardless of what our friends on the FOMC do or do not. We're waiting for a candidate that wants to raise taxes and not raise spending. The FRBNY noted in a recent blog: “Extreme economic uncertainty caused many market participants, such as asset managers and central banks, to exit Treasury positions to raise liquidity as volatility rose sharply. Broker-dealers, such as the primary dealers, make markets in Treasury and other securities: they purchase securities from sellers, holding an inventory over time, and ultimately sell securities to market participants looking to buy. Given the substantial sales in March, dealer inventories rose notably, particularly in Treasury coupons, as shown in the chart below.” The primary dealers as a group almost got blown out in March, like most restaurants in lower Manhattan right about now. The Powell Fed knows that direct support for the Treasury market via QE is a permanent fixture on the economic scene. And they know that the dealer banks have zero appetite for supporting a failing Treasury market, meaning that the Fed of New York is the market. Indeed, the Fed’s supposed change in policy regarding inflation targeting was really just window dressing, lipstick on the proverbial pig. The economists will talk about inflation, but the reality is in more or less continuous open market operations. Just as with downside of manipulating interest expense, the economist fraternity misses the punch line. Inflation must be higher because the Fed must continue to buy trillions in Treasury debt and agency MBS each year. No matter who wins the presidential election in November, have no doubt that Chairman Powell is the most important man in town.

Dallas | In this issue of The Institutional Risk Analyst , we take a look at Bank of America Corporation (NYSE:BAC), a t $2.4 trillion in total assets the second largest bank holding company in the US. BAC was a perennial under performer among the large cap financials for almost a decade after the financial crisis, then in October of 2016 it rocketed ahead on falling expenses. In 2017, BAC was one of the best performing large cap stocks, but since then has essentially gone sideways as the momentum of expense reductions did not carry over to higher revenue. Today BAC trades at about 1.25x book value or roughly half the valuation premium assigned to the number one US bank, JPMorgan Chase (NYSE:JPM) . The 1.6 beta suggests that BAC is more volatile than the broad market, and yet its credit default swaps (CDS) trade in line with other top bank names. We own the BAC preferred. The core strength of BAC is its enormous deposit base and relatively low cost of funds. BAC is not quite as efficient as U.S. Bancorp (NYSE:USB) , for example, but it has a larger deposit base than any other bank. This includes $1.2 trillion in core deposits and another $800 billion in non-core deposit funding. Like JPM, only about half of BAC’s balance sheet is loans with the remainder invested in securities, a quarter trillion in deposits with other banks and $400 billion in federal funds sold and reverse repurchase agreements. BAC is a vast island of liquidity and has low funding costs as a result. Source: FFIEC BAC struggles on the asset side of the ledger, however, where both the pricing and mix of assets has hurt the bank’s performance and peer comparisons. The bank’s yield on earning assets is well-below the average for Peer Group 1, which includes the 125 largest banks in the US. BAC’s mix of net interest income and non-interest income is roughly 1:1, providing the bank with a solid if less than inspiring source of earnings. Indeed, the bank’s non-interest income has fallen almost 10% over the past five years. More important, however, is the 35% decrease in overhead expenses that has occurred over the same period as legacy expenses from the subprime mortgage crisis have slowly receded. The chart below shows BAC’s gross yield on loans and leases vs JPM and other members of Peer Group 1. Source: FFIEC Part of the reason for the relatively poor asset performance by BAC stems from the decision made after the 2008 financial crisis to significantly de-risk the bank. With a return on assets of just 1.14% and ROE of 10.6% at the end of 2019, the bank trails significantly behind its peers. The 60% efficiency ratio is likewise average compared with members of Peer Group 1, but JPM is four points better at 56%. While BAC has significantly lowered its overhead expenses in recent years, it still remains less efficient than its largest peers. In the fourth quarter, BAC’s yield on $974 billion in total loans and leases was just 4.25,% but the banks larger securities portfolio pulled the yield on total earning assets down a full point to just 3.25%. The biggest loan class on BAC’s balance sheet is residential mortgages. None of its loan categories breaks 5% yield except credit cards, which is just above 10% and only accounts for $97 billion in assets. Yields on BAC’s consumer book have fallen 25bp over the past year and the yield on earning assets fell by 30bp compared with Q4 2018. The net interest yield for BAC was just 2.43% in Q4 2019. Overall, interest expenses at BAC rose 20% in 2019 compared with the year earlier, reflecting the considerable volatility in US interest rates last year. When you look at BAC overall, the bank’s net income to average assets was considerably below peer in 2019 as shown in the chart below. Source: FFIEC Part of the reason that BAC’s recent financial results don’t compare so badly with its asset peers is that the bank has managed to keep credit losses very low. As part of the campaign by management to de-risk the bank, the CSUITE at BAC has avoided taking any appreciable credit risk, resulting in lower provisions for loan losses and lower asset returns overall. The chart below shows net loan losses as a percentage of average assets. Source: FFIEC Despite the significant slippage in the asset returns for BAC, CEO Brian Moynihan remains optimistic. He told investors during the bank’s Q4 2019 earnings call: “How do you run a company, a big bank, and deal with lower rates? Well, we drive what we can control with our sempiternal commitment to responsible growth. We drive more loans, more deposits, more assets under management, and driving growth for the right pricing and at the right risks.” The bottom line with BAC is that the heady days of double digit equity market returns in 2017 and 2018, which were driven by dramatics decreases in overhead expenses, are behind us. BAC remains less efficient operationally than its large cap peers and it gets horrible pricing for its assets. More, the slippage in the bank’s asset returns over the past year suggests that BAC may be even more negatively impacted by the Fed’s low rate policy than other large banks. Brian Moynihan needs to boost the bank’s asset returns and the only way to do this is to take more risk. The re-opening of BAC's correspondent lending business is a reaction to this trend, but making more residential mortgage loans is not going to solve the problem. The commitment to responsible growth sounds good, but does not deliver the goods when it comes to earnings. We have a neutral risk assessment on BAC and will be prepared to downgrade the name to negative should asset returns continue to fall . Will FHFA create a level playing field for nonbanks? National Mortgage News

Summary The Goldman Sachs Group (NYSE:GS) had a record results in terms of non-interest income in Q2 2020, up 66% sequentially and 44% year-over-year. Net earnings doubled sequentially from Q1 2020, again due to market volatility and the impact of the Fed’s strong market intervention. The $13.3 billion in net revenues GS reported in Q2 2020 was up double digits sequentially and also year-over year, illustrating the volatility in earnings that we believe contributes to the low P/E ratio and also the discount to book value for the common shares. GS is the smallest of the global investment banks but the most highly levered of the large US banking groups, with the ratio of LT debt to equity capital of nearly 200% vs 12% for the Peer Group 1 average. The transactional business of GS continues to be both the source of outsized profits and losses, as illustrated by the settlement of the 1MDB scandal in Malaysia. The losses due to the 1MDB settlement essentially wiped out GS profits for the first half of 2020, caused a restatement event with the SEC, and the bank has still not completed the resolution of this matter. Our overall assessment of the quantitative and qualitative factors behind the performance of GS remains negative. The BHC generates more risk than return to its investors, and therefore trades at or even below book value in the equity markets. The financial comparisons between GS and its asset peers among the largest BHCs is not flattering and suggests that GS has serious risk issues due to its business model. Source: FFIEC Although the majority of Sell Side analysts believe that the valuation for GS is below “fair value,” we disagree and instead believe that the heightened risk factors that accompany the bank’s business model tell the tale. Sad to say, like many names in the financial sector, GS is an issuer that deserves to trade at a discount to par. Quantitative Factors At $2.06 trillion in total assets as of June 30, 2020, The Goldman Sachs Group (NYSE:GS) is the fifth largest bank holding company (BHC) in the United States. Less than 20% of the consolidated assets of GS are attributable to the New York state bank subsidiary, Goldman Sachs Bank (USA). GS is the smallest of the global investment banks but the most highly levered of the large US banking groups, with the ratio of LT debt to equity capital of nearly 200% vs 12% for the peer group. When comparing GS to other large US banks, the first factor that requires attention is the bank’s dependence upon non-interest fee income. As a result of the focus on trading and advisory income, GS is far less efficient in terms of asset returns than a typical large bank such as JPMorgan (NYSE:JPM) . Even compared with all of Peer Group 1, GS underperforms. And with the added burden of credit reserve expenses due to COVID-19, the entire large bank group is suffering reduced profitability, as shown in the chart below. Source: FFIEC Non-interest income for GS as a percentage of average assets was 2.74% at the end of Q1 2020 vs just 1.12% for the 123 largest banks in the US that are members of Peer Group 1. The key point is that GS is very much an investment bank and only a relatively small commercial bank, with less liquidity and greater risk per dollar of revenue. The top-level financials for GS are shown below using data published by the Federal Financial Institutions Examination Council (FFIEC) and EDGAR, In Q2 2020, GS’s results were helped significantly by the strong market intervention by the Federal Open Market Committee. The deposit growth seen in 2020 is largely due to the trillions of dollars in liquidity injected into the US banking system by the Federal Reserve. The Goldman Sachs Group (RSSD:2380443) Source: FFIEC, EDGAR GS had a record results in terms of non-interest income in Q2 2020, up 66% sequentially and 44% year-over-year. Net earnings doubled sequentially from Q1 2020, again due to market volatility and the impact of the Fed’s strong open market operations. The enormous swing in earnings results illustrates one of the key reasons why we consigned GS to The IRA Bank Dead Pool last year, namely the huge variability of the bank’s results both positive and negative. GS made some progress in terms of building its deposit base in 2020, but much of the increase was due to bond purchases by the Fed. Yet even as GS builds its Marcus retail banking platform, the loss profile of the loan portfolio displays above-peer losses typical for larger banks. The loss rate for GS is now more than two-times peer, as shown in the chart below. Source: FFIEC While the GS loan portfolio has grown, the bank’s loan pricing reflects an above-peer target coupon rate that is 150bp higher than its large bank peers. The 55bp of default in Q1 2020 maps to a “BBB-” default rate equivalent. This level of net credit loss is 2x the Peer Group 1 average and puts GS in the same neighborhood as JPM and above that of U.S. Bancorp (NYSE:USB) . Source: FFIEC Notice how the pricing of GS loans dropped nearly a point in Q1 2020, suggesting that the bank is having difficulty sourcing assets. The competition among large banks for equally large assets is intense and likely to increase as 2020 comes to a close due the the Fed’s operations. Just 40% of the GS bank unit’s assets are deployed in lending vs 25% in investing activities and the rest in “other” assets, according to the latest disclosure from the FDIC. New loans and leases were just 15% of the group’s total consolidated assets at the end of the second quarter, although the growth rate for new loans is well into double digits and more than 3x the average of 9% for the banks in Per Group 1. The larger issue raised by the slow growth of the firm’s commercial banking business has to do with the overall GS cost of funds and the firm’s refusal to consider growth through acquisitions. While in terms of total assets GS ranks fifth among large US bank holding companies, in terms of deposits Goldman Sachs Bank (USA) with $200 billion in total assets ranks 14th between Charles Schwab Bank (NYSE:SCHW) and the US unit of HSBC Holdings (NYSE:USBC). The chart below shows the relative cost of funds for selected large banks. Notice that GS has a higher cost of funds overall than Citigroup (NYSE:GS) but has a yield on earning assets that is significantly lower. Only about 1/3 of Citi’s assets are funded with core deposits, making the comparison even more striking. The fact that the cost of funds for GS is so high relative to subprime lenders such as Citi makes the point with respect to the long-term business model of Goldman Sachs. Source: FFIEC As a matter of sheer size of balance sheet, GS is simply not competitive with its larger bank peers. Viewed from the perspective of funding costs, GS is clearly not as efficient as are other BHC’s. Indeed, these larger depositories provide funding to GS and other securities dealers. The primary focus on the brokerage unit and on non-interest sources of income as part of the firm’s business model places GS at a distinct disadvantage compared with core deposit rich institutions like JPM and USB. Even Citi and CapitalOne Financial (NYSE:COF) , which use brokered deposits to fund their consumer loan books, have cheaper funding costs than GS. Source: Bloomberg (July 24, 2020) The $13.3 billion in net revenues GS reported in Q2 2020 was up double digits sequentially and also year-over year, illustrating the volatility in earnings that we believe contributes to the low P/E ratio and also the discount to book value for the common shares. Even with the selloff in March, GS continues to trade at a significant discount to its peers. JPM trading at 1.2x book value and USB flirting with 1.3x book, the fact of GS trading 20% below book value and the widest credit of the group in credit default swaps (CDS) speaks volumes as to how investors perceive the risk/reward ratio of this more than century old business. Qualitative Factors The qualitative analysis of GS starts with the conversion of an SEC-regulated investment banking firm into a Fed-supervised BHC a decade ago. This superficial change led to GS focusing time and management attention on organically growing the banking business, but only as a means of enhancing existing business lines in trading and investment banking. GS talks about “building the bank,” but the actual change in the business model falls short of the rhetoric. The transactional business of GS continues to be both the source of outsized profits and losses, as illustrated by the settlement of the 1MDB scandal in Malaysia. On July 24, 2020, GS issued an announcement that it had reached an agreement in principle with the Government of Malaysia to resolve all the criminal and regulatory proceedings in Malaysia involving the firm relating to 1Malaysia Development Berhad (1MDB). “Goldman Sachs has agreed to a $3.9 billion settlement with Malaysia as it begins to put behind it a kleptocracy scandal that changed the course of politics in the country,” reports The New York Times . While global banks face many different types of operational and reputation risks, the investment banking business of GS seems to generate these serious loss events with greater frequency and in larger size than other banks. In the recent past, GS management has expressed a desire to move more business “in the bank’ to capture internal financing revenues, interest on loans that was heretofore paid away to larger depositories. This is a fine strategy, but the GS bank unit is still too small to really fund the operations of the entirety of GS as a firm. That is essentially the quandary that faces GS. Management has made clear that the hurdle for considering “inorganic growth” is very high. This is, in simple terms, a way to say that GS will not consider significant acquisitions. We have written in the past of merger possibilities such as First Republic Bank (NYSE:FRC) with its strong asset management business. Another possibility is KeyCorp (NYSE:KEY) , a leader in commercial real estate lending and servicing, with over $100 billion in retail core deposits. The potential home run? Merge GS with U.S. Bancorp, the smallest money center with $400 billion in deposits, a significant lending, payments and trust business and the lowest cost of funds of the top ten banks. But GS management refuses to consider a transformational acquisition, apparently because it means the end of the banker/trader culture. As GS CEO David Solomon said in October 2019: “I think one of the things this management team is trying to do is to think broadly both about our organic growth, but also potential opportunities over time for inorganic growth. I’ve said on this call and previous calls, the bar for us to do something inorganically, especially something significant inorganically is very, very high. At the same point, it’s the job of this management team to have a point of view and to be doing work and to be thinking about opportunities that can expand our franchise.” With the bar set very, very high for a GS acquisition, this leaves only the existing GS strategy of organic growth in the bank and sticking to the existing securities and asset management businesses. This means battling just about every major financial institution for affluent retail customers with cash and investment AUM. Acquiring and retaining high net worth customers for a private bank model is expensive and extremely difficult. This particular demographic of investor does not typically provide stable deposits or assets upon which to build a banking business. The acquisitions of United Capital and, more recently, the Folio RIA platform illustrate that GS remains focused on growing the asset management businesses. In the world of capital markets, GS is the leading advisory firm but is engaged in a Darwinian struggle for survival with JPM and the other major universal banks of Europe and Asia. All of these universal banks have bigger balance sheets with bigger deposits than does GS. Many of the competitors of GS, including Morgan Stanley (NYSE:MS) and UBS Group (NYSE:USB) have chosen to emphasize asset management at least equally with transactional businesses. UBS trades significantly below book value, but MS which boasts two depositories that are twice the size of the GS bank unit trades, above book. One way to measure the outsized enterprise risk of GS is to compare its total derivative footings with other large banks such as JPM and Citigroup, and Peer Group 1. At the end of Q3 2019, the derivatives positions of GS equaled more than 5,100% of average assets. The comparable levels for derivative dealers such as JPM and C, respectively, were 1,800% and 2,400%, respectively. The averages for USB and COF were at or below 100%, suggesting that GS has deliberately chosen to take outsized risks in derivatives, mostly interest rate contracts, in order to enhance earnings and returns, and implicitly make up for its relatively small banking business. Source: FFIEC Going down the list of categories of GS non-interest income, investment banking is highly competitive with zero visibility on future revenue. More, it is from the investment banking side that arise large operational risk events such as the 1MDB fraud and resulting fiasco in Malaysia, an event that cost GS billions in losses and incalculable damage to its reputation. In the specific case of the 1MDB affair, the Goldman bankers apparently paid copious bribes to win an investment banking mandate that turned out to be a fraud. Now GS has paid a settlement and related expenses that are several time total fees earned from the fraud. The 1MDB settlement wiped out the excellent Q2 2020 results and, indeed, consumed the earnings for the first half of the entire year. What is now called Global Market is the largest line item at GS and represents the firm’s trading and services activities, really the heart of the business. Trading in equities, along with fixed income, currencies and commodities (FICC), are the stock and trade of Goldman Sachs, but also illustrates why the firm won’t buy another bank. The results in FICC are variable with the markets, but GS is a firm of the markets. In an expanded organization that encompassed a larger, retail depository, the GS FICC traders would no longer be the center of attention. Indeed, they would rightly be seen as a significant source of risk. The Asset Management line at $2.1 billion in net revenues is about the same size as Investment Banking and the Lending and Investment lines on a run rate basis. Again, this business is incredibly competitive with shrinking margins that are visible among global asset managers. With total assets under supervision of $2.1 trillion, GS Investment Management unit generated net revenue of $1.67 billion or less than 1% of AUM. This was down 18% YOY, again illustrating the volatility of financial results at GS for a line item that should be stable. Consumer and Wealth Management is the smallest line item at GS at $1.3 billion in Q2 2020, down from the previous quarter but up by the same amount YOY. The senior unsecured debt of GS is rated “A3” by Moody’s vs “A2” for larger peers such as JPM and Citi. Part of the logic of ratings is market share, which in turn informs the analysis of profitability and the stability of the enterprise. The uncertainty with respect to non-bank income, the significant op-risk and leverage, and the steady shrinkage in run-rate operating income over the past 5 years, supports a negative qualitative assessment. Assessment: Funding, Business Model & Risk Our overall assessment of the quantitative and qualitative factors behind the performance of GS remains negative. The BHC generates more risk than return to its investors, and therefore trades at or even below book value in the equity markets. The financial comparisons between GS and its asset peers among the largest BHCs is not flattering and suggests that GS has serious risk issues due to its business model. The returns on the visible business are adequate but also extremely variable, this due to the highly competitive markets where the bank operates. But it is due to the hidden, operational and reputation risks that the bank’s market valuation suffers. In addition to the outsized risk characteristics of the GS investment banking business, there are three basic factors that inform our negative view: Liquidity GS is dependent upon the capital markets and other banks for liquidity. For example, the bank’s net time deposits > $250k are actually negative due to the fact that the bank maintains more deposits at other banks than it maintains for the bank’s customers. Unlike the asset peers of GS, which can essentially fund themselves internally, GS remains more of a brokerage firm than a bank. The dependence on non-core funding at GS is over 80% of total funding, placing the BHC in the 97th percentile of Peer Group 1. To address this shortcoming, GS needs to grow the core deposit base of its subsidiary bank via acquisitions. Given the competitive landscape, it is unlikely that GS can achieve this level of deposit expansion via organic growth in the near-term. Business Model The financial results of GS are primarily determined by the performance of the Global Markets area, which accounted for over 50% of net revenue in Q2 2020. The degree of variability in such areas as trading equities and FICC due to idiosyncratic and market risk factors makes it impossible to estimate what the firm will achieve in terms of performance in future periods. Simply stated, there is no visibility on the single largest portion of the GS business and there is no real solution to change the opaque nature of the capital markets and investment banking business. Risk/Return The business model choices made by GS management evidence a tolerance for risk and an indifference to compliance norms such as know your customer that are disturbing. The 1MDB disaster is just the latest such example. As an investor with equity exposure to GS, you must be comfortable with the likelihood that new operational risk events will occur in the future. Given the negative factors of liquidity and visibility, we believe that it will become increasingly difficult for GS to grow and deliver consistent profits given the competition from JPM and other larger global universal banks. We believe that an appropriate acquisition of a regional bank with substantial core deposits would greatly enhance the stability and risk-adjusted return on capital (RAROC) of GS. Such a change, however, implies less emphasis on trading equities and FICC, the traditional core revenue lines of the firm. To us, the bottom line with GS is that CEO David Solomon et al must either 1) buy a bank of similar size deposit base or 2) be acquired by an even larger depository down the road. The former strategy path allows GS some considerable latitude in terms of the choice of merger partner. The latter path may occur at a less than optimal time when the firm is under stress. Just as the remnants of Bear, Stearns & Co & Lehman Brothers were absorbed by larger universal banks during periods of market contagion, the same fate potentially awaits GS unless they accept the fact that size (that is, liquidity) matters a decade after 2008. The major obstacle to executing on an inorganic strategy is 1) the weak market valuation of GS equity and 2) the reluctance of GS management to be absorbed into a larger banking organization. The relatively flat, non-bank configuration of a broker dealer such as GS is at odds with the pyramidal management structure found in larger federally insured depositories. The level of risk appetite permitted in the GS investment bank would likely be tempered and, indeed, would decrease to align with that of its larger peers, resulting in a slow market share decline for GS. So long as the management of GS remains unable or unwilling to change, we believe that GS is going to continue to trade at a significant discount to its asset peers among large US banks. At 0.85x book value and a 10.5 P/E ratio as of the date of this IRA Bank Profile, GS is hardly a compelling value. The three-month market beta of 1.5 illustrates the greater volatility in this issuer than the S&P 500. In terms of credit, the elevated spreads in credit default swaps, for example, again suggests that the market sees GS as a higher risk counterparty. Although the majority of Sell Side analysts believe that the valuation for GS is below “fair value,” we disagree and instead believe that the heightened risk factors that accompany the bank’s business model tell the tale. Sad to say, like many names in the financial sector, GS is an issuer that deserves to trade at a discount to par. The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. 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"Well, I woke up Sunday morning With no way to hold my head that didn't hurt And the beer I had for breakfast wasn't bad So I had one more for dessert…" Kris Kristofferson Sunday Morning Coming Down (1972) Grand Lake Stream | In a moment of serene clarity, Registered Maine Master Guide Les Williams , who has more than 50 years of guiding experience, said: “Lures are for catching people,” meaning people buy lures of many shapes and colors, but the fish mostly don’t care. And of course Les is entirely right. Witness the effectiveness of the bubble-gum colored wacky worm for snaring small mouth bass. Les is known to favor live bait, especially for catching White Perch. In the markets, much the same dynamic applies to people as applies to fish in the inland waters of Maine. The people chase the shiny object of the moment, the current object of attention, but may or may not actually catch fish in terms of value. Thus we see the divergence between bank stocks and, say, non-bank mortgage firms, which recently have been trading like 2008 never happened. In the year-to-date, the KBW bank index is down 30.11%, the S&P 500 is up 6.07% and the mortgage leader Penny Mac Financial Services (NASDAQ:PFSI) is up 48% for the year. Could it be that mortgages are correlated to interest rates? Or more specifically, is the FOMC gunning asset prices for rate sensitive exposures like housing but not boosting consumer price inflation? H/T to Lisa Abromowitz at Bloomberg News for this nice summation of the problem: “Stimulus is going into asset price inflation, not CPI. And the build-up of ever larger asset price bubbles itself pins down the rates market... This combination creates a dangerous environment” where investors are compelled to abandon fundamentals & follow the money: Citi’s Matt King Speaking of interest rates, last week we published a comment in National Mortgage News about the magical nonexistent rate know as “SOFR” or the secured overnight lending rate. SOFR does not actually trade in the markets, but the Fed till expects investors and financial institutions to accept it. As we noted earlier, Fed Chairman Jerome Powell has an opportunity for another graceful policy pirouette. How? By quietly redefining SOFR as being equal to the too-be-announced (TBA) market price for government insured MBS issued by Ginnie Mae. Problem solved. With the equity markets trading off after the latest market surge, the FOMC has its inflation target 10x, but in the wrong part of the economy. The bull market in residential home lending is one bright spot in a skyline with a lot of clouds ahead. Commercial loan losses at banks are leading the way higher -- and fast. As we note in The IRA Bank Book Q3 2020 : “Even as income growth has moderated and now turned negative, credit costs rose again sharply in Q2 2020 to over $60 billion in provisions put aside for future loss. We anticipate that provisions could remain at these elevated levels for the balance of the year or longer. This implies that industry operating income is likely to go into the red in Q3 and especially Q4, when we anticipate a significant credit loss event comparable to the end of 2009.” The FOMC can accelerate lending with low rates, but it cannot ameliorate either the negative impact on credit years from now or the torrent of loan prepayments that could actually drive some investors in agency and government MBS into a loss. Owners of legacy mortgage servicing also face the prospect of reduced or even negative returns due to the early return of capital to note holders. Meanwhile, residential mortgage markets face an extended boom. " On one hand we have the old adage, 'No tree grows to the moon," writes Rob Chrisman . "On the other hand, mortgage loan originators (MLOs) and real estate agents are licking their chops given that 52 percent of young adults live with their parents . What does that tell you about the demand for housing and loans in the coming years?" Meanwhile in Europe, the very low inflation stats for August are causing some speculation in the markets about the next move by ECB President Christine Lagarde . Most market observers believe that Lagarde will respond rhetorically, a reasonable choice for an organization that has failed miserably to achieve its stated targets for inflation and economic growth. The chart below from FRED shows dollar, yen and euro LIBOR c/o ICE . With short-term rates in the US now close to zero, this leaves room for the ECB to experiment further with negative rates, something we suspect Lagarde is too smart to actually contemplate. Both economically and politically, negative rates have been a failure. Going deeper into negative territory would be a mistake for the EU and Lagarde. If anything, both the ECB and Fed need to focus on ways to inflate the income flowing to institutions and individuals before they collapse under the deflationary weight of COVID. Reducing income to investors may drive credit creation in the near-term, but the aftermath of the FOMC’s latest cycle of irrational policy actions may be quite costly to investors and financial institutions in terms of credit losses. Volatility is the given in this market environment, so don't get nauseous when the equity markets fall 20% from recent highs. Note that as the system open market account growth slowed, the VIX spiked sharply higher and remains well above 2019 lows. Do watch those outliers. The mortgage firms like PFSI that today trade above book value may face a very different marketplace a couple of years hence. Meanwhile, the large banks move gently sideways at -30% YTD. And for good reason. There is no visibility on bank credit or earnings. But the Fed will be ready to add more fuel to the fire at a moments notice. As Kris Kristofferson wrote and Johnny Cash sang decades ago, sometimes that breakfast beer tastes so good that the only choice is a second for desert.