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New York | Several weeks ago, we commented on how Federal Housing Finance Agency (FHFA) Director Mark Calabria never really had any intention to release Fannie Mae and Freddie Mac from government control (“ The Myth of GSE Release ”). Instead, Calabria’s true agenda seems to be to cripple the GSEs and the independent mortgage banks (IMBs) that operate in the $6 trillion conventional market. In Washington, watch what they do, not what they say . We quoted former Freddie Mac CEO Don Layton , writing for the Harvard Joint Center on Housing, who notes that the tenure of Mark Calabria “seems to me to reflect far too much antipathy to the GSEs and the politics of anti-GSE advocates who have long wanted to dramatically shrink (if not eliminate) the role the two companies play in mortgage markets." Again, we totally agree. But Calabria's antipathy for the GSEs also extends to private mortgage firms. Last week we saw the latest bizarre development from Director Calabria and the FHFA. Fannie Mae and Freddie Mac announced that, at the direction of FHFA, the two GSEs imposed new minimum liquidity requirements for IMB seller/servicers in the conventional market. Effective March 31, 2021, unused and available portions of committed lines of credit from commercial banks no longer will be considered as a component of IMBs’ liquid assets. The Fannie Mae announcement is found here and the Freddie Mac announcement can be found here . Keep in mind that these changes were made without warning or notice to the GSEs or the IMBs. It’s not even clear that the staff of FHFA or the GSEs had prior notice of the decisions. Bottom line, the change by FHFA will reduce IMB liquidity and lending volumes nationally. Our guess as to the motivation behind this action is that FHFA is trying, in Calabria’s simplistic fashion, to be dogmatically consistent with all market participants. Unused bank credit lines don’t fit the “high-quality liquid assets” definition in banking supervision and are disallowed for the GSEs themselves, and therefore will not to be used for GSE counterparty risk as well. FHFA states: “Given that the Enterprises do not have access to the Federal Reserve Discount Window or a stable customer deposit base, FHFA proposes to define high quality liquid assets as: (i) Cash held in a Federal Reserve account; (ii) U.S. Treasury securities; (iii) Short-term secured loans through U.S. Treasury repurchase agreements that clear through the FICC or are offered by the Federal Reserve Bank of New York; and (iv) A limited amount of unsecured overnight deposits with eligible U.S. banks.” Consider some context for Calabria’s latest policy surprise for the mortgage industry, this a week before Christmas. FHFA first considered this change as part of the proposed updates to the GSEs’ net worth, capital, and liquidity requirements for IMBs released in January 2020. The industry and WGA LLC provided detailed comments in response to this proposal . We discussed why this adoption of liquidity rules applicable to banks are inappropriate and would likely reduce the liquidity of both the GSEs and the IMBs in the conventional market. Calabria is essentially trying to cause, rather than prevent, systemic risk. In June 2020, FHFA announced that it would not implement the proposed changes and instead would release a new proposal for public comment at a later date to incorporate lessons learned from the pandemic. FHFA has not yet issued this re-proposal, a move that is arguably in violation of the Administrative Procedures Act. Yet last week, in a fit of Trumpian rage, Director Calabria issued this latest attack on the GSEs and the conventional mortgage market for reasons only he understands. Given that the mortgage industry is still expecting a formal re-proposal of these net worth, capital, and liquidity requirements for IMB seller/servicers to the GSEs, it is fair to say that mortgage lenders are a little disappointed by Calabria’s latest decision. The fact that the change to the treatment of unused and available portions of committed lines of credit was made without the opportunity for further public analysis and comment illustrates the reckless behavior that has come to characterize the tenure of Director Calabria at FHFA. There has been a lot of speculation as to whether President-elect Joe Biden will be able to remove Director Calabria from his post upon taking office. The question currently before the US Supreme Court is whether a President may remove the FHFA head without cause. In fact, we believe that President Biden will have more than ample reason to remove Director Calabria for cause , specifically that his intemperate and ill-considered actions violate HERA and, more broadly, are harming the financial soundness of the GSEs and their counterparties in the conventional market. If you sent somebody to deliberately sabotage the US housing market, you could not find a better perpetrator than Director Calabria. Calabria’s obsessive fixation with imposing bank like restrictions on nonbank finance companies is unnecessary and actually increases systemic risk. For example, IMBs are increasingly being forced to demonstrate "cash on hand," a retrograde step that takes the industry backwards 50 years. Yet even as the mortgage industry is reeling from this latest surprise attack from Director Calabria, the industry is also engaged in an increasingly acrimonious dialog with the Conference of State Bank Supervisors (CSBS) regarding its proposal for a broader prudential framework for IMB servicers. When you consider that Senate Republicans including Pat Toomey (R-PA) supported Calabria’s nomination to lead FHFA, it is more than ironic to see Calabria leading the charge against private mortgage companies. The supposedly conservative FHFA Director is serving as a facilitator for the progressive CSBS to hijack national housing regulation. But here’s the question: Does Mark Calabria understand this little nuance? More important, does the incoming Biden Administration realize that Washington is about to lose control over housing policy to the states led by New York? We wonder if Senate Republicans understand what they have done to the US housing market by embracing Mark Calabria. Inspired by Director Calabria’s erroneous statements to the Financial Stability Oversight Council (FSOC) regarding the systemic “risk” from mortgage servicers, the CSBS proposes to impose bank like restrictions nationally on IMBs , a radical and unwarranted change that promises to further reduce the cash liquidity in the conventional mortgage market. In the request for comment by the CSBS, they state with respect to loan servicers that IMBs have “an obligation to both parties of the transaction, making servicers simultaneously responsible for efficiently servicing the market and protecting consumers.” The CSBS does not cite a statutory reference for this statement. Indeed, looking at current law and regulation, there does not seem to be any backing for the assertion of an operational responsibility for IMBs by the CSBS. While loan servicers have a contractual duty to note holders and other parties and a duty of care to consumers via the National Mortgage Settlement and the Dodd-Frank legislation, the CSBS legal construction regarding safety and soundness is tenuous at best and deserves a challenge. With the exception of the State of New York, most other member states represented by the CSBS do not have any legal authority to impose bank-like safety and soundness rules on IMBs. The CSBS may think that having such power would be preferable, but such legal powers do not yet exist. Does the CSBS propose to export New York law on a national basis? The answer to that question seems to be yes. It appears that the CSBS is essentially attempting to impose a national standard upon IMBs via an illegal regulatory action that encroaches upon the power of the federal government, and without specific legal authority from each CSBS member state to support and enforce such rules. Will the Mortgage Bankers Association take the example of Met Life with the FSOC and litigate over this aggressive power grab by the CSBS? After all, the CSBS is basically a trade association that lacks the legal authority to act as a national regulator. Will the White House join the MBA in challenging the CSBS? This is a fundamental question that the incoming Administration of Joe Biden must quickly decide. The Executive Branch should immediately quash the Calabria-inspired attempt by the states via the CSBS to subvert the supremacy of HUD and the FHFA when it comes to national housing finance policy. On his first day in office, President Joe Biden should fire FHFA Director Mark Calabria for cause based upon his tenure to date. That change alone will kill a lot of the momentum behind the FSOC and CSBS. After Director Calabria returns to the private sector, we think the MBA and individual IMBs should band together and sue the CSBS for a lack of legal authority to impose new regulations on the housing market. The IMBs and trades should hire the lawyers that represented MetLife in the FSOC litigation and go to war. Sue the CSBS until they are forced to go back to the member states for contribution to fund the expense. Just remember, more than two-third of the members states in the CSBS are controlled by Republicans. After a few years in court, when the CSBS and the states they purport to represent get tired of paying for lawyers, then perhaps a reasonable compromise will be possible.

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

The IRA Bank Book Q4 2020 Review & Analysis In this edition of The IRA Bank Book for Q4 2020 , we ask a basic question: Is there a bull case for US banks? Whether from a perspective of an equity or debt investor, or a risk counterparty, the answer is unclear. Markets have taken up the valuations of bank stocks and debt because of the deliberate asset scarcity contrived by the Federal Reserve Board and other global central banks. But is there any hope of restoring US bank earnings and payouts to investors via share repurchases in the short-term? Bank Group: ALLY, AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC Suffice to say that while nominal prices for bank equity and debt have largely recovered from the difficult market environment seen in Q2 2020, investors are depending upon greatly reduced earnings and business volumes to support their investment valuations. Indeed, with the cessation of share buybacks by many banks, investors are receiving far lower cash returns than even a year ago. Share repurchases for the top 25 US banks were worth more than $120 billion annually in 2019. Dividends have been essentially tracking around 50% of bank pretax income, in some notable cases much more. To put that into round figures, the top 25 US banks were returning something approaching $350 billion annually to investors via dividends and share repurchases. In Q3 2020, bank dividends were just $14 billion for the entire industry, $13 billion in Q2 2020 and $41 billion in Q1 2020. Despite these sharp reductions in cash flow from bank stocks, since April’s market carnage investors have rushed in to buy these assets with reckless abandon. There seemingly is no longer any reliable correlation between bank stocks and financial performance, although sudden changes in bank credit loss provisions, for example, would still hurt market pricing for bank stocks and bonds. Source: FDIC The sharp decrease in bank loss provisions reported in the third quarter – from $61 billion in Q2 2020 to just $14 billion in Q3 – came about as much due to the inability to quantify future losses and also the government-mandated loan forbearance granted to millions of consumer and thousands of businesses. But the sad fact is that many small and medium size enterprises (SMEs) that stayed afloat in 2020 due to government loans and subsequent forgiveness will likely fail in 2021. We anticipate that just as the early period immediately following the Great Crash of 1929 was relatively stable, but was then followed by years of wrenching credit deflation, in 2021-2023 we are likely to see substantial restructuring of business assets and commercial real estate. These once blue-chip assets have been rendered moribund by the social distancing requirements of the response to COVID. Just imagine how empty office and retail buildings in downtown Manhattan or Chicago or Los Angeles will be revalued in the next 24 months and you begin to appreciate the future impact on commercial real estate credit and related public sector obligors. We cannot even begin to list the clients and associates at different financial firms that are planning to decentralize their operations into hotel type structures that give employees maximum flexibility and protection. And in every case, the firms are moving their employees out of major metro areas such as New York. Below we show the components of US bank income through Q3 2020. As you can see, interest expense is falling rapidly. Interest earnings are also falling. Since the Federal Open Market Committee greatly increased open market purchases of Treasury debt, and agency and government mortgage backed securities (MBS), the spreads on these assets over funding have steadily compressed, reducing the flow of income to banks. Indeed, banks and other investors are experiencing negative returns on loans, MBS and servicing assets. Source: FDIC The remarkable fact is that despite the compression of spreads of assets over funding costs, despite the other vagaries and credit expenses, the US banking industry did manage to report $128 billion in net interest income in Q3 2020. The problem, which lies 12-18 months out, is that the FOMC must eventually pull up on the monetary control stick and allow short term interest rates to trade freely or risk doing significant harm to the US banking sector. Just as a large commercial airliner flying at low altitude must maintain a minimum speed or stall, the FOMC needs to understand that the compression of bank interest margins could drive US banks into a net loss position on their interest rate book, essentially a replay of the S&L crisis of the 1980s. In the 1980s, the funding costs of S&Ls spiked over the yield on assets, causing mass insolvency in the industry that funded residential mortgages. This time around, the yield on earning assets could dip below the artificially low funding costs created by QE. As the chart below suggests, the return on earning assets (ROEA) is near a 40-year low. Source: FDIC/WGA LLC In addition to the effects of QE, US banks are fighting an environment where they are seeing portfolios running off due to loan prepayments even as deposits rise artificially due to QE. Total banking system now exceeds $21 trillion and earning assets are $19.3 trillion vs $10.5 trillion in Q1 2007. But please remember that the folks on the FOMC say that inflation is too low. The basic problem for the US banking industry is that the FOMC honestly believes that diverting the income from $6 trillion in Treasury obligations and MBS to the US Treasury is somehow a form of economic stimulus. Certainly, the impact on the US economy of a boom in 1-4 family mortgages is enormous, but we’d argue that the positive income benefit of QE and mortgage refinance opportunities on US households is offset by draining trillions of dollars annually in income for bank depositors and bond investors. For investors in MBS and whole loans, the current environment of high prepayment rates and falling bond yields promises only negative returns. And for large lenders, the lending market is daunting. Even as the FOMC has gunned deposit growth rates, bank loan portfolios are running off on net, as shown in the chart below. Source: FDIC One area where lending is surging is 1-4 family mortgages, where volumes in 2020 could come close to $4 trillion in new loans, near the 2004 record. As we’ve noted in recent comments on PennyMac Financial Services (NASDAQ:PFSI) and Rocket Companies (NYSE:RKT) , lending volumes are likely to remain strong in 2021, but secondary market spreads are likely to compress further. As SitusAMC noted in their most recent presentation on trends in the market for mortgage servicing rights (MSR), coupon spreads vs the Treasury yield index have been almost cut in half since April due to the open market operations of the FOMC. While lenders are still capitalizing the on-the-run 3% Ginnie Mae MBS coupons at 3x annual cash flow, we’d argue that a more realistic valuation is closer to 1.5x given current prepayment rates. By no surprise, the banking industry is only benefitting modestly from the mortgage boom. Banks lost important market share in April due to the decision to shut-down purchases of third-party production in 1-4s. The chart below shows the US mortgage servicing sector, representing nearly $12 trillion in unpaid principal balance (UPB) of residential mortgages. Source: FDIC, MBA, FRB As the chart illustrates, the US banking sector still controls more than 75% of the servicing of residential mortgage loans, although the nonbank sector is growing quickly. The assets serviced for others (ASFO) remains just below $6 trillion or half of total outstanding UPB. Notice in particular that the decision by many banks to suspend third-party loan purchases via correspondent and wholesale channels is causing the $2.4 trillion bank retained portfolio of 1-4s to shrink. Nonbanks continue grow their share, largely in the Ginnie Mae market. In addition, sales of 1-4s and most other loan categories continue to fall, an ominous sign for future bank revenue and earnings. Assets Securitized & Sold Source: FDIC One reason that the banks are retreating from 1-4 family lending, loan aggregating and servicing is that the cash flows are negative. As one veteran nonbank CEO told us last week, “Servicing is problematic for the banks. The cost of forbearance or loss of cash flow and increased future expense plus runoff creates the accounting loss. If you sell servicing and retain the infrastructure, your fixed overhead becomes burdensome. The runoff of the MSR is the real GAAP issue. Critical mass is a big challenge. Banks will struggle with the choice of selling MSRs or staying in because the cash flow may remain positive, even in the face of losses.” Notice in the chart below that the FV of bank owned MSRs was stable Q2-Q3, but net servicing income plummeted in Q3 to -$2 billion – the worst performance since 2011 for industry. We suspect that the expense of COVID and the Cares Act is the culprit. Cash flush nonbanks may find some ready sellers of servicing among large commercial banks as year 2020 draws to a close. Source: FDIC While some of the stronger names in our bank coverage group such as JPMorgan Chase (NYSE:JPM) and U.S. Bancorp (NYSE:USB) have retraced much of the losses of Q2 2020, many names in the group remain depressed. Again, investors are not buying these names based upon current returns but in the hope of higher future returns . Notice that even the lowly Goldman Sachs (NYSE:GS) has managed to crawl out of the basement to book value thanks to the generosity of the FOMC. A summary of our bank coverage group is below: Source: Bloomberg (12/9/2020) Credit Analysis & Charts As we note above, credit costs for US banks moderated in Q3 2020 as provision expenses fell. Actual charge-offs of the $10.9 trillion in loans held by US banks fell, however, as the real cost of credit remains muted. Part of the reason that provisions expense fell in Q3 was that the Fed and other prudential regulators have allowed banks to slow-walk the process of recognizing losses on loans under forbearance due to COVID, the Cares Act, as well as state-mandated loan moratoria. We do not expect this seemingly benevolent situation to continue. Total Loans & Leases The Chart below shows past due loans and loans charged-off through Q3 2020 for all loans held by US banks. Notice that the non-current rate is rising rapidly compared with the downward trend of the past several years. At the same time, the actual rate of charge-offs fell in Q3 2020, reflecting somewhat the regulatory forbearance that has been rolled out due to the COVID pandemic. For the same reason that provisions for future loss have fallen in Q3 2020, the reported levels of charge-offs are also down for many loan categories. Source: FDIC In addition to the impact of regulatory forbearance by the Fed and Federal Deposit Insurance Corp, particularly with respect to the rapid growth of bank assets and the related decline in capital levels, the big positive impact on US banks from QE has been the inflation of asset values. Note that LGD for all US banks fell 5% in Q3 2020, an extraordinary skew. Although the level of loss given default (LGD) appears relatively normal, the price appreciation seen in real property, residential assets and commercial assets such as facilities of various types has greatly improved the credit exposures of US lenders. Office buildings in New York may not be particularly attractive, but other assets in superior locations are demanding premium prices. In the rare event of a loan default actually going to liquidation and sale of assets, the recovery rates are very good, sometimes more than 100% of the loan amount. The chart below shows loss given default for all US bank loans. Source: FDIC/WGA LLC Real Estate Loans In the case of real estate loans, the events of the past nine months have begun to force up default rates on real estate generally, in large part due to commercial loan defaults. The default rate on commercial and industrial (C&I) loans rose almost 40% in Q3 2020, which suggests a lot of volatility in corporate and commercial real estate credit. Since default rates on 1-4s and multifamily loans, as well as construction and development loans, are tracking near zero at present, it seems safe to assume that CRE loans are driving this increase. Notice that charge-off rates for real estate loans are still miniscule. Source: FDIC Another perspective on the changes underway in the world of commercial real estate is shown in the chart below, where LGD has spiked upward in the past several quarters. Whereas LGD on all real estate loans was actually negative at the end of 2019, today post-default loss rates on the $5.1 trillion in real estate loans are strongly positive once again at 67%, almost precisely the long-term average loss rate going back 40 years. Source: FDIC/WGA LLC 1-4 Family Loans When we next move to the $2.4 trillion in residential mortgage loans, the situation looks very similar. Non-current loans are accumulating, but charge-off rates remain very low. More important, post default loss rates are still negative, reflecting the strong market for residential homes. So long as asset prices in the residential mortgage space remain buoyant, LGDs for 1-4s are likely to remain extremely low by historical standards. As shown in the two charts below, charge-off rates for 1-4s were actually negative in Q3 2020 and LGD was -8.4% vs the 50-year average loss rate post-default of 67%. Source: FDIC Source: FDIC/WGA LLC In addition to the charts above, another significant indicator of delinquency in the 1-4 market is early buyouts (EBOs) of delinquent loans from Ginnie Mae MBS. As we noted in our recent update on PFSI (“ Nonbank Update: PennyMac Financial Services ”), buyouts of delinquent loans by Ginnie Mae issuers such as Wells Fargo & Co (NYSE:WFC) are growing rapidly, an indicator of the deterioration of underlying government-insured loans. The chart below shows Ginnie Mae EBOs by banks through Q3 2020. When a loan is repurchased out of a pool, it is considered “rebooked” and shows up on the bank’s balance sheet as an NPL. With delinquency rates on FHA and VA loans in the teens in many regions, we expect to see this indicator rising over the next few quarters. If buyers of EBOs are successful in modifying the loan, for example, they may then sell the note into a new Ginnie Mae MBS and capture the gain on sale. But EBOs also contain significant downside risk for servicers. Source: FDIC Multifamily Loans As with the single-family portfolio, the delinquency and loss rates for bank owned multifamily loans are also exhibiting considerable volatility. The $480 billion in total loans is showing virtually no net charge-offs, but the period of negative LGDs seems to be at an end, as shown in the charts below. Source: FDIC Source: FDIC/WGA LLC Commercial & Industrial Loans After real estate, the next largest loan category for US banks is the $2.5 trillion in C&I loans held in portfolio. The C&I book is less affected by the market manipulation of the FOMC, thus both the loss rates and LGD display a more normal, pre-2020 pattern. The divergence between the abnormal pattern seen in real estate exposures and the C&I book was noted in the most recent Quarterly Banking Profile from the FDIC: “The net charge-off rate declined by 5 basis points from a year ago to 0.46 percent. Net charge-offs decreased by $418.2 million (3.2 percent) year over year. The annual decrease in total net charge-offs was attributable to a $1.3 billion (15.9 percent) decline in credit card net charge-offs. This decline offset increases in charge-offs for the commercial and industrial (C&I) loan portfolio, which increased by $898.5 million (39.3 percent). The C&I net charge-off rate rose by 8 basis points from a year ago to 0.49 percent, but remains well below the post-crisis high of 2.72 percent reported in fourth quarter 2009.” Source: FDIC Notice in the chart above that the delinquency rate on C&I loans is continuing to rise, but the net charge off rate for the series actually declined like the bank loan book overall. We suspect that this decline is an anomaly and is related to regulatory forbearance from the Fed, OCC and other regulators. That said, the economic reality within bank C&I portfolios is continuing to deteriorate, as illustrated by the rising LGDs. The fact that LGD dropped from 90% loss given default in Q2 2020 to only 85% loss in Q3 does not address the more general concern. Source: FDIC/WGA LLC Credit Card Loans Like most of the other loan series discussed in this report, the $979 billion in credit cards are also displaying the impact of the Cares Act and various other types of official and unofficial loan moratoria tied to COVID. Non-current rates have fallen as a result of loan forbearance, but net charge off rates have remained steady ~ 4%. We suspect that when the legal mandates regarding COVID loan forbearance have lapsed, the net-charge off rates and LGD for credit cards will begin to rise again. More than many other loan types, credit card default rates and LGD are tied closely to levels of unemployment. Source: FDIC Source: FDIC/WGA LLC Outlook for Q4 2020 As we head into year-end for 2020, the Street has earnings estimates for most of the bank group that reflect a decidedly downbeat outlook for Q4 2020 and, more important, for 2021. But that does not mean that Street analysts are unwilling to stretch -- even as a 1930s deflation threatens the US financial system. The consensus earnings estimate for JPM, for example, has the bank delivering almost $7.50 per share in earnings in 2020 and $9 in 2021, a remarkable performance given the bank’s significant commercial exposures. USB, to take another industry exemplar as an example, is believed to be headed for $3 per share in 2020 and slightly higher in 2021. Both of these optimistic estimates depend crucially on the level of loan loss provisions for US banks in Q4 2020. Given that both USB and JPM are trading near 1.5x book value and given that cash flows to investors have basically been cut by two-thirds, these valuations are quite remarkable. And since the FOMC seems intent upon keeping interest rates low for the foreseeable future and given that asset returns and sources of fee income are also under growing pressure, we have a hard time making the bull market case for US banks at this point in time. It may be several years before that Fed and other prudential regulators allow banks to resume full dividend payments let alone share repurchases. And on the horizon, investors face the probability that major banks will be required to raise capital to support the “temporary” expansion of bank balance sheets due to the effect of QE. When the Fed buys Treasury securities or MBS from banks, they credit their master account at the central bank. But these funds are fleeting and can run off quickly as the MBS and Treasury paper is redeemed. We suspect that the FOMC will maintain the current size of the Fed’s portfolio ~ $7 trillion, meaning that continued asset purchases will artificially inflate the size of bank balance sheets but will also retard lending and asset returns. In such an environment, look for earnings to come under strong downward pressure. Also, there is likely to be significant dilution for equity investors as the banks struggle to support their bloated balance sheets with new capital, this even as net interest income falls. Investors may have convinced themselves that bank earnings will rebound in the near-term, but instead we could be headed for a protracted period of low earnings and cash returns to bank investors. The IRA Bank Book (ISBN 978-0-692-09756-4) is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Book. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Book are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Book represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Book is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Book is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Book. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

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

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

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

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

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

New York | In this issue of The Institutional Risk Analyst , we look at the earnings release earlier this week by Rocket Companies (NYSE:RKT) . We also assess the market reception for independent mortgage banks (IMBs) more generally since the RKT initial public offering this past August. With returns on mortgage-backed securities (MBS) negative due to FOMC bond purchases and high mortgage prepayment rates, investors and lenders fight the Fed every day. Mortgage Group: ACGL, AGNC, AI, BKI, BXMT, CIM, CLGX, COOP, ESNT, FAF, FBC, FMCC, FNF, FNMA, IMH, LADR, MFA, GHLD, NLY, NRZ, NYMT, OCN, PFSI, PMT, RKT, RWT, STWD, TWO Because of forward liquidity and credit concerns, the window for IMBs to tap the public equity markets appears to have closed for now. As of this writing, there are only a handful of IMBs that have managed to follow RKT into the public markets, including Guild Holdings (NASDAQ:GHLD) . These deals and SPAC transactions for United Wholesale Mortgage and Finance of America were difficult stories to sell to investors and traded poorly in the secondary market, Barron's reports. Offerings for AmeriHome , a unit of Apollo Global Management (NYSE:APO) subsidiary Athene Holdings (NYSE:ATH) , Caliber Home Loans and, most recently, loanDepot , are still pending. With respect to UWM and its impending merger with a SPAC called Gores Holdings IV (NASDAQ:GHIV) , Barron’s reported on September 23, 2020: “Gores Holdings IV (NASDAQ:GHIV) stock fell close to 2% on Wednesday after the deal was revealed, to about $10.60. Better-known mortgage player Rocket Companies (RKT) made its debut in an initial public offering last month and faced lackluster demand from investors, having to reduce its listing price. For UWM, management’s own projections have earnings falling in the next two years, and insiders are using the SPAC merger as a chance to cash out a portion of their stake. That could explain the deal’s lukewarm reception.” Various media outlets have attributed the delay in IPOs by mortgage firms as being due to “market volatility,” but in fact we think that investment managers are smarter than the investment bankers pretend. True, most equity managers are not very good at corporate finance, but it does not take a genius to realize that the boom in mortgage lending is due to 1) low interest rates and aggressive asset purchases c/o the FOMC and 2) that all good things do, eventually, end, especially when the earnings projections for 2021 are down. The fact that forward projections for 2021 and beyond show falling volume and revenue is hardly a surprise to students of monetary mechanics. The FOMC's "go big" strategy has skewed market benchmarks to absurd levels, pushing returns on MBS negative in cash terms. A mortgage servicing right (MSR), however, due to the possibility of recapturing existing clients via a loan refinance, offers positive returns for superior lenders. RKT and other IMBs in the top five are able to monetize the optionality in residential mortgages. But despite this huge positive, we also suspect that the other serious operational issues waiting in the wings have added a dose of caution to the mix with investors. Suffice to say that our friends at SitusAMC have capitalization rates for new production Ginnie Mae 3s MSRs at over 3x annual cash flow through October, but we are a seller at 2x thank you very much. The Ginnie Mae 4% coupon MSRs are marked today at 2x annual cash flow, but all of these assets will prepay thanks to the FOMC. Ask any operator in the industry that question and you'll get the same answer. And with the FOMC now targeting Ginnie and UMB 1.5s as part of QE, anybody who tells you about rising mortgage interest rates is badly mistaken. A careful reading of the S-1s filed by AmeriHome and Caliber, for example, tell the astute credit analyst all that you need to know about the risks involved in the government mortgage business. Do equity managers understand such nuances? Yes, enough not to get stuffed with a bad offering by a bunch of investment bankers who cannot spell "option adjusted duration." The table below from the Q3 2020 RKT earning report is shown below. Focus on a couple of the more remarkable points in this relatively brief earnings summary: First, the fair value of the firm’s mortgage servicing rights declined only slightly over the past year, a testament to the excellent operational efficiency of RKT as a lender and servicer. The vast investment in operations and technology is the chief reason that RKT received a good reception from equity investors. But millions of dollars in retail advertising didn't hurt either. If you figure that at least 1/3 of the mortgage servicing rights held by RKT prepaid in the past 12 months, this means that RKT was able to replace those MSRs despite the frightening rate of loan prepayments seen since April. And RKT booked a 5% gain-on-sale on every loan. Send those "thank you" notes to Jerome Powell at the Federal Reserve Board in Washington. The second point that as is related to the first is that RKT has one of the highest rates of client retention in the industry. RTK states in its earnings release: “Our recapture rate was 82% for refinance transactions for the twelve months ended September 30, 2020 and our overall recapture rate was 73% for the same time period.” This is best in class performance, yet even with the huge expansion in lending volumes, the FV of the RKT MSR still fell as shown in the table above. Third, because of the rate of prepayments and the fact that the FOMC has begun to buy 1.5% MBS coupons as part of open market operations, risk professionals and managers must haircut the MSR of firms like RKT at least by 1/3 to get to true FV. Most banks, REITs and public companies use inflated valuation multiples for MSRs, which are inevitably marked down over time. Fourth, looking at the year-over-year change in RKT’s financials, the key takeaway for risk professionals and investors is mean reversion. The volume and profitability numbers for RKT will inevitably decline, the only question is when and how much. We believe that RKT may be able to achieve its goal of 25% national market share in terms of lending ( Wells Fargo (NYSE:WFC) reached 35% in the 2000s), but the obvious question is 25% of what and at what level of profitability? Gain on sale margins for RKT, a key indicator of industry profitability, grew 44% YOY due to the actions of the FOMC. As the industry brings more and more capacity online to capture volumes these margins will decline. Indeed, the “historically strong” 4.5% gain-on-sale reported by RKT is a 20-year record and is unlikely to be sustained, even if the FOMC continues to lower interest rates via open market purchases of MBS. Industry profits will remain strong by historical standards, but margins will compress. RKT projects that in Q4 2020, closed loan volume will be between $88 billion and $93 billion, or an increase of 73% to 83% compared to $50.8 billion in the fourth quarter of 2019. RKT projects “net rate lock volume of between $80 billion and $87 billion, which would represent an increase of 82% to 98% compared to $43.9 billion in the fourth quarter of 2019.” These results are unlikely to be repeated in 2021. “Gain on sale margins of 3.80% to 4.10%, which would be an improvement of 11% to 20% compared to 3.41% in the fourth quarter of 2019,” RKT reports, indicating that operating margins for RKT and other lenders are already under substantial downward pressure. SitusAMC, MIAC and other third-party MSR valuation houses are reporting the same trend. Bottom line: RKT is the best performer among the large IMBs operating in the residential mortgage market. Much of the increase in volumes and margins, however, are the result of actions by the FOMC and a lack of industry lending capacity coming out of the horrific year 2018, when much of the industry was unprofitable. The mortgage industry has grown headcount by roughly 50% since April of this year, thus spreads will shrink and loan quality will fall. The short-term outlook for RKT and other stronger IMBs is good, but there remain a number of challenges ahead as we noted in our last comment on the residential mortgage sector (“ The Bear Case for Mortgage Lenders ”). RKT is well positioned to take advantage of the good times and also weather the inevitable housing market correction that will come in several years. Until then, make and sell as many loans as possible. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. 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New York | In this issue of The Institutional Risk Analyst , we return to the fiscal situation facing New York and other major American cities in the wake of the apparent victory by Vice President Joe Biden in the 2020 Presidential election. The weak showing by the Democrats has stymied much of the promised Biden agenda, particularly trillions of dollars in aid to large cities in blue states that was seen as a given only weeks ago. The situation facing New York is perhaps worse than that facing other cities, both because the government of Mayor Bill DeBlasio already had a spending problem as 2020 began and because the impact of COVID on New York is more severe. The extended lockdown imposed by Mayor DeBlasio and Governor Andrew Cuomo caused roughly half a million people to leave New York City between April and the end of July, according to the New York Times . This figure has increased since July and does not include the disappearance of tourists and other visitors from the streets of New York. And most of midtown Manhattan remains boarded up due to fears of rioting and looting. The Rhino The grim reality facing New York is summarized in the most recent annual report for the fiscal year ended June 30th from New York Comptroller Scott Stringer , who was formerly the President of the Borough of Manhattan. New York City is one of the best managed US cities in terms of financial reporting, but less so when it comes to spending and fiscal sanity. Under the free spending Mayor DeBlasio, the city has seen revenues rise by high single digits each year and expenses have more than kept pace. In FY 2020, New York City had revenue of $95 billion and expenses of almost $99.5 billion. The details of the NYC budget are shown below from the FY 2020 annual report. Note that NYC has an accumulated deficit of over $200 billion and total long-term debt and other obligations of $270 billion. And these figures do not begin to capture the total debt and other obligations buried in the city’s over-extended financial statements. Keep in mind that the revenue numbers for NYC through June reflect the strong momentum of the city coming into 2020 and only begin to show the deterioration in the revenue of New York City since the start of FY 2021 on July 1st. Several sources have talked about a fiscal deficit of $8 billion in 2021, but we think the actual deficit number could be twice that or more. The chart below shows the city’s cash balance through June 30 (blue line) and then the estimate from Comptroller Stringer’s office. Notice that the estimated cash line from FY 2020 crosses through the cash line for FY 2019 in September and has trended below last year’s results since then. The estimates from Stringer’s office show cash balances falling below $2 billion around year end, then miraculously rising as the result of a Biden financial rescue plan. The FY 2020 annual report for NYC was finalized weeks before the Presidential election . But now that the election has ended with the closest race in a century and has seen the GOP pick up seats in Congress, the Democratic calculous that assumed a financial rescue by Washington needs to be reassessed. If there is no fiscal rescue plan for the states and particularly the large cities in blue states like New York, then it seems safe to predict that several large American cities may be forced into default before Joe Biden takes the oath of office in January. “ Big city mayors and Democratic state governors had been counting on a ‘blue sweep’ of national offices to help get them out of some very deep budget and pension funding holes. They also dreamt of green transport, more help with healthcare . . . the list was long,” writes John Dizard in the Financial Times . “Now there is the grim winter reality of a surviving Senate Republican majority, led by Democratic bugaboo Mitch McConnell , which keeps its veto on all that progressive spending and redistributive taxation.” Of course, Republicans in Congress have no intention of riding to the rescue of the blue states. Changing the state and local property tax (SALT) deduction was the first assault on the economic base of the Democratic Party. Step two is to push major cities like New York into bankruptcy, which would force a violent confrontation with the public sector unions. Such an apocalypse would see elected Democrats voiding union contracts and also see the end of New York’s New Deal era state constitution. Red-state Democrats in Congress are unlikely to be very enthusiastic for spending trillions of dollars to help New York City, thus Congressional Democrats have a serious problem brewing in New York and cities like Chicago. The Stringer report is quite a sobering read, particularly as it details the impact of COVID on the New York economy. For example: In New York City, employment plunged by almost 20% from February to April and grew by a smaller 3.2% from April to June. This nearly 20% decline in New York City employment was equivalent to the loss of an unprecedented 910,050 jobs between February and April. Small business revenues declined dramatically in March. Manhattan small business revenue was already declining in early March, and had declined by 70% by month’s end, as businesses shuttered and commuters stayed home. Despite some recovery, Manhattan small business revenue in early July was still down over 40% from the beginning of January. Most immediately, a failure by the Federal government to provide adequate fiscal relief to state and local governments could upend the New York State budget—and by extension, the City’s resources. New York State has threatened to reduce local aid by as much as 20% if Congress does not appropriate additional unrestricted aid to state and local governments, using executive powers included in the enacted State budget. The big problem for New York and other major cities like Chicago and Los Angeles is that the dollar of municipal revenue comes from many different sources. When the local economy is disrupted massively as in the case of New York and other blue state cities with restive populations, the impact on the different components of city revenue is magnified. The breakdown of NYC revenue for the last fiscal year is shown below. The real question facing NYC is how much will the impact of COVID and the exodus from the city due to fears of rioting and looting impact each of these revenue lines. Sales and use taxes are clearly down, and real estate taxes are also falling as more tenants and landlords default. Surviving landlords will press the city for reductions in appraisals and taxes. Last month, New York City and state both had their credit ratings lowered by Moody’s Investors Service , which said the impact from the coronavirus on the most populous U.S. city -- the core of the state’s economic engine -- is among the most severe in the nation. “In a pair of downgrades announced within an hour of each other, Moody’s dropped both the city and state by one notch to Aa2, the third-highest investment grade rating,” Bloomberg reports. But frankly neither issuer deserves an investment grade rating at this stage. With Mayor DeBlasio refusing to take action to cut city expenses to size with the new population of Gotham, and Govenor Cuomo suddenly sounding like a Republican deficit hawk from the 1990s, a default seems inevitable. The FY Q1 2021 numbers ending September 30th won’t be released until December, but suffice to say that the picture is likely to be a good bit more dire by that time. Comptroller Stringer proudly notes in the FY 2020 annual report that the city has not had to issue short-term cash notes for 16 consecutive years. When you see New York City issuing cash notes, that’s your hint that a debt default by America’s largest city is imminent. Truth is, it's already too late. Mayor DeBlasio cannot cut spending fast enough now to avoid running out of cash. Will Senator Mitch McConnell (R-KY) and Senate Republicans really push New York into default? Yeah, they probably will and more. Students of history will note the mirrored parallel between Biden and President Herbert Hoover , who FDR declined to help in 1932 as the nation's banks were collapsing. President Donald Trump will be cheering on Senate Republicans as he heads home not to New York City but to Palm Beach. For investors in municipal credit, the next couple of months will be quite an experience.

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

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