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

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

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

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

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

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

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

New York | We start this edition of The Institutional Risk Analyst by noting a couple of important developments in the world of financials. First, Western Alliance Bancorp (NYSE:WAL) Friday announced it had purchased Galton Funding , “a rare example of a depository taking title to a nonbank, non-QM originator,” Inside Mortgage Finance reports. Rare indeed, but also a red flag. WAL is a great performer and ranks in the top decile of Peer Group 1, the 127 largest US banks about $10 billion in assets. But when you see commercial banks buying non-QM loan businesses, that does kind of give us a certain feeling of déjà vu . The reason that Citigroup (NYSE:C) still has not addressed chronic internal controls issues goes back decades ago to the acquisition of several nonbank businesses. Second, we hear from the regulatory channel in Washington that the Department of Housing and Urban Development has internal estimates of seriously delinquent loans (as opposed to merely delinquent) peaking in the 13% range during this credit cycle. We noted last week in The IRA Premium Service (“ The Bear Case for Mortgage Lenders ”), that there are a number of large servicers that could capsize in the next downturn in housing. Is it not strange that certain mortgage firms were literally on death’s door in April and now are going public in October? Hmm. Yes, there is a loving and forgiving Lord. And yes, there is a reason why the smart money on Wall Street is focused today on creating new private fund strategies focused on late vintage servicing assets, non-performing loans (NPLs) and early buyouts (EBOs). Do have a look at those FOMC-induced mortgage IPOs, but then remember where those emerging issuers stood in credit terms just six months ago. Third, we see that Morgan Stanley (NYSE:MS) has agreed to acquire Eaton Vance Corp (NYSE:EV) for $7 billion, roughly 5.5x book or 15x EBITDA. This is a premium vs the closing price last Wednesday, but is about where the stock traded in 2018. This transaction increases the size of the MS asset management business above $1 trillion in AUM and further differentiates MS from competitors like Citi and Goldman Sachs (NYSE:GS) . Both of these banks are in The IRA Bank Dead Pool. “People who hang around trying to buy great companies cheaply never get anything done,” Mr. Gorman said last week when the deal was announced. Bravo. In the nuclear winter of financial repression engineered by the Federal Open Market Committee, there are no cheap earning assets. Below we take a look at the top five US depositories as Q3 2020 earnings season begins. You’ll notice a certain subtext operating for all five names, specifically revenue and earnings estimates that fall off the edge of the proverbial table in 2021. JPMorganChase (NYSE:JPM) At 1.3x book at the close on Friday, JPM is hardly cheap as a stock, especially with the dismal outlook for earnings through the rest of 2020. The equity of this $3.1 trillion total asset behemoth is still down almost 30% from the highs this year, but the debt securities for JPM and other banks have tightened considerably from the wide spreads of April 2020. Long the debt and short the equity has been a winning trade through the first half of the year. Of note, the Street has consensus JPM earnings for 2020 at almost $11 per share, but dropping to just $6 in 2021. Five-year growth estimates are showing a negative number at present compared to 15% growth rate over the last five years. As the chart below illustrates, the net income of the top five banks is running at roughly half of the pre-crisis levels. More, the top-five banks are now constrained in terms of share repurchases (none) and dividends (limited). Source: FFIEC To buy the common equity of JPM or any top-five bank is a bet on when the credit impact of COVID will subside sufficiently to allow banks to return to profitability and resume at least normal dividends. Share repurchases could be suspended for years to come for the largest banks. For JPM, the key indicator for us is whether the bank continues to build credit loss provisions through the end of the year. We expect US banks as a group to put aside $40 billion plus in additional loss provisions in Q3 2020 . The lack of visibility on future revenue and earnings is a function of a absence of clarity on forward credit losses. Unlike the 2008 financial crisis, the 2020 COVID meltdown is about recognizing credit losses on loans and bonds rather than a sudden mark-too-market on fraudulent mortgage loans and securities. Assessing the true credit impact of corporate defaults and bankruptcies on banks, REITs, and equity and bond investors, will take years to resolve. While Wall Street wants a quick answer to the COVID credit question, this hope is unlikely to be fulfilled. The basic reason for this is that commercial loan markets move at a glacial pace, especially when the market for the collateral is falling in value. As we noted in the Q3 2020 edition of The IRA Bank Book , loss given default for commercial bank exposures was already rising before COVID exploded onto the scene. Source: FDIC/WGA LLC Bank of America (NYSE:BAC) At 0.9x book as of the Friday close, the common equity of BAC is fairly valued. With a 1.55 beta and a 2.8% dividend yield, the second largest bank by assets at $2.6 trillion has above average volatility with a moderate dividend yield, for now. The Street has a consensus estimate for earnings $2.75 per share in 2020 but just $1.64 in 2021, hardly a rousing endorsement. We own BAC preferred but not the common. BAC has actually outperformed JPM by some measures, but this is to be expected given the conservative stance taken by BAC management over the past decade. Sure, the common is still down 28% since the start of the year, but BAC has actually been outperforming the bank half of JPM on earnings and losses, as shown in the chart below. Source: FFIEC It is tempting to blame the rising tide of delinquent commercial and consumer loans on the COVID pandemic, but in fact the credit cycle was already a bit ripe when 2020 began. The Fed’s manipulation of credit markets and risk preferences has kept loss given default low so far, but if we ever see asset prices weaken, then credit will deteriorate quickly and dramatically. In any event, COVID’s devastation of many sectors of the economy means big losses for lenders and institutional investors in everything from aircraft leases to small multifamily apartments. U.S. Bancorp (NYSE:USB) USB has long been the smallest and among the best performing money center banks. The strong funding base and diverse mix of business lines, but little Wall Street exposure, has always made USB one of our favorite names. We sold our USB common equity position earlier in the year, but put the proceeds into USB preferred during the March selloff. We look for periods of volatility to add to these preferred holdings. At 1.3x book value for the equity, USB is hardly cheap and, indeed, is still down 34% YTD. That said, USB’s strong credit profile has the bank trading among the tightest credits to the swaps curve at 33bp for five-year credit swaps vs 47bp for JPM. The Street has USB reporting $4.16 per share in 2020 earnings, but falling to just $1.60 in 2021. Source: FFIEC Wells Fargo (NYSE:WFC) With the bank’s common down more than 50% YTD and wallowing at 0.65x book value, WFC might seem like a bargain. Because of the steep discount to the bank's book value of equity and the other metrics, we understand why some of our readers might be attracted by WFC. At some point, the management and board of the bank are going to turn things around. This might seem like an attractive thesis -- until we recall that the bank’s problems are largely self-inflicted. Despite the sanctions imposed by the Federal Reserve Board and the continued dysfunction of the WFC board and management team, however, the bank has continued to generate relatively strong results. The Street consensus has WFC revenue down 15% for 2020 and flat in 2021. We’d not be surprised to see WFC beat those metrics, but in any event, we think the bank’s paper is money good. We purchased some of the preferred below par during the second quarter. As Pete Najarian likes to say, “Giddy up.” Source: FFIEC Citigroup (NYSE:C) In our latest risk profile on Citi this past September , we noted that the bank is largely a prisoner of history, meaning that despite the progress made by CEO Michael Corbat , the options are limited for his successor Jane Fraser going forward. At 0.54x book for the Citi common, the stock is down 44% YTD and shows little sign of improving in the near term. We wrote: "Our overall assessment of the quantitative and qualitative factors behind Citigroup is negative . The bank under-performs its peers financially, takes outsized risks compared to its large bank peers, and has no clear strategy for improving asset returns, access to funding or the bank’s overall risk profile." The Street has C delivering $8 per share in earnings in 2020, but falling to half that amount in 2021. Again, the theme here is that things will get a good bit worse before they get better. The Street consensus on revenue growth is flat in 2020 and down small in 2021, but clearly the expectation is for credit costs to consume a bigger chuck of Citi's revenue next year. Get used to it. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

New York | Watching the talking heads pondering the next move in US interest rates, we are often amazed at the domestic perspective that dominates these discussions. Just as the Federal Open Market Committee never speaks about foreign anything when discussing interest rate policy, so too most observers largely ignore the offshore markets. Yen, dollar and euro LIBOR spreads are shown below. Zoltan Pozsar , the influential money-market strategist at Credit Suisse (NYSE:CS) , warns that the short-end of the US money markets are likely to be awash in cash over the end-of-year liquidity hump. U nlike the unpleasantness in 2018, for example, we may see instead a surfeit of lending as banks scramble for yield in a wasteland bereft of duration. Would that it were so. The Pozsar view does not exactly fit well with the rising rate, end of the world scenario popular in some corners of the financial media ghetto. The 10-year note is certainly rising and with it the 30-year mortgage rate. Indeed, Pozsar reminds CS clients that yen/$ swaps are now yielding well-above Treasury yields for seven years. Hmm. We believe short-term rates will remain low in the US, even as offshore demand for dollars soars. If the 10-year Treasury backs up much further, then we’d look for the FOMC to act on some calls by governors to buy longer duration securities. That is, a very direct and large scale increase in QE and particularly on the long end of the curve. We expect that Chairman Powell knows that underneath the comfortable blanket of low interest rates lie some truly appalling credit problems ahead for the global economy, the US banking sector and also for private debt and equity investors. W e expect the low interest rate environment to drive volumes in corporate debt and residential mortgages, even as other sectors like ABS languish and commercial real estate gets well and truly crushed. “The pandemic is putting unprecedented stress on CMBS markets that even the Fed is having difficulty offsetting, writes Ralph Delguidice at Pavilion Global M arkets . “Limited reserves are being exhausted even as rent collection and occupancy levels remain serious issues… Bondholders expecting cash are getting keys instead, and in our view, ratings downgrades and significant losses are now only a formality.” We noted several months ago that the resolution of the credit collapse in commercial mortgage backed securities or CMBS will be very different from when a bank owns the mortgage. As we discussed with one banker this week over breakfast in Midtown Manhattan, holding the mortgage and even some equity in a prime property allows for time to recover value. Delguidice rightly identifies that "extend and pretend" by consuming reserves is the first and, frankly, wrong strategy. The agencies have flagged this tendency since the summer, but now comes the reckoning. When the cash is exhausted, then comes the actual default and foreclosure. Meanwhile, no funds are left for maintenance of the asset. With CMBS, the “AAA” tranche is first in line, thus the seniors have no incentive to make nice with the subordinate investors. The deals will liquidate, the property will be sold and the junior bond investors will take 100% losses. But as Delguidice and others note with increasing frequency, this time around the “AAA” investors are getting hit too. More to come. Manhattan Meanwhile, over in the relative calm of the agency collateral markets, large, yield hungry money center banks led by Wells Fargo & Co (NYSE:WFC) are deploying liquidity to buy billions of dollars in delinquent government loans out of MBS pools. The bank buys the asset and gives the investor par, with a smidgen of interest. Market now has more cash, but less cash than it had before buying the mortgage bond in the first place. Why? Because it likely took a loss on the transaction. Buy at 109. Prepayment at par six months later. You get the idea. In fact, if you look at the Treasury yield curve, rates are basically lying flat along the bottom of the chart out to 48 months. Why? Because this nice fellow named Fed Chairman Jerome Powell , along with many other buyers, are gobbling up the available supply of risk free assets inside of five years. Spreads on everything from junk bonds to agency mortgage passthroughs are contracting, suggesting that the private bid for paper remains strong. When you look at the fact that implied valuations for new production MBS and mortgage servicing rights (MSR) have been rising since July, this even though prepayment rates are astronomical, certainly implies that there is a great deal of cash sitting on the sidelines. Remember that the price of an MSR is not just about cash flows and prepayments, but it’s also about default rates and the relationship with the consumer. We described in our last missive for The IRA Premium Service (“ The Bear Case for Mortgage Lenders ”), that a rising rate environment could generate catastrophic losses for residential lenders, particularly in the government loan market. We write: “For both investors and risk professionals operating in the secondary mortgage market, the next several years contain both great opportunities and considerable risks. We look for the top lenders and servicers to survive the coming winter of default resolution that must inevitably follow a period of low interest rates by the FOMC. The result of the inevitable consolidation will be fewer, larger IMBs.” Don’t get distracted by the rising rate song from the Street. We don’t look for short or medium term interest rates to rise in the near term or frankly for years. Agency 1.5% coupons “did not find a place in the latest Fed’s purchase schedule. It is possible (they) are included in the next update,” writes Nomura this week. This seems a pretty direct prediction of lower yields. But as one veteran mortgage operator cautions The IRA: “Not just yet.” We don’t think that the Fed is going to take its foot off the short end of the curve anytime soon, in part because the system simply cannot withstand a sustained period of rising rates. In fact, we note that our friends at SitusAMC are adding 1.5% MBS coupons to forward rate models this month. But that does not necessarily mean that mortgage rates will fall any time soon. Some worry about whether there will ever be liquidity in 1.5% coupon agency MBS, but fear not. We've seen this movie. If you build that Ginnie Mae or conventional mortgage bond with a 1.5% coupon, Jay will come and buy it. And he’ll remit the interest earned on that mortgage bond to the US Treasury, less the Fed’s operating expenses of course. We hear that the Fed of New York has bought a few 1.5s in recent days, but supply is sorely lacking. You see, the mortgage industry is not quite ready to print many new 1.5% MBS coupons and will not do so anytime soon. As the chart above suggests, mortgage rates are in fact rising . Why? Is not the FOMC in charge of the U.S mortgage market? No, the market rules. Today you can make more money selling a new 1-4 family residential mortgage into a 2.5% coupon from Fannie, Freddie or Ginnie Mae at 105. You book a five point gain on sale and are therefore a hero. And a year from now, after the liquidity does in fact migrate down to 1.5s c/o the beneficence of the FOMC, you can again be a hero. Specifically, you call up that same borrower and refinance the mortgage into a brand new 1.5% Fannie, Freddie or Ginnie Mae at 105. You take another five point gain on sale. Right? And who paid for this blessed optionality? The Bank of Japan, Peoples Bank of China, and PIMCO , among many other fortunate global investors. These multinational holders of US mortgage bonds may not like negative returns on risk free American assets, but that’s life in the big city. And thankfully for Chairman Powell, it's not his problem. Many years ago, a friend in the mortgage market said of loan repurchase demands from Fannie Mae: "What do you want from me?"

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

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