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New York | In this issue of The Institutional Risk Analyst , we ponder the latest developments in the world of secured finance. But first we thank those of you who have subscribed to our new premium service, including The IRA Bank Book Q3 2020 quarterly industry survey, which posted earlier this week. Have a market sector or financial firm you’d like to see profiled in The IRA ? Drop us a note at info@rcwhalen.com . This week we ponder the world of US-China relations. Regardless of who wins the White House in November, the US posture towards Beijing is unlikely to change – especially since the Chinese seem quite deserving of foreign criticism. From the handling of COVID to the South China Sea to military clashes with India to Hong Kong and growing repression internally, China is at odds with the world. The Trump Administration’s confrontation with China has been long overdue, but it is also a function of a lot of accumulated agendas in Washington, agendas that may not be well-informed on China’s political economy. Trade wars are yesterday’s news in the great age of decoupling and great national economic competition a la the period after WWI. “It is critical that this country not use apps that are made in China,” White House trade adviser Peter Navarro said in an interview. But the Trump White House has not yet constructed a comprehensive approach to China’s financial strategy to match the counter-attack on trade and intellectual property. Merely imposing sanctions is not a policy. Reflecting the anti-China evolution of Washington think, Clyde Prestowitz writes in The American Conservative that: “Beijing was never going to democratize because of open markets. They have merely used them to push their authoritarian designs.” He continues in a significant revision to US expectations of the China relationship: “These cautions are the remnant of the great fantasy that swept the free world in the wake of President Nixon’s 1972 “opening of China” and Chinese leader Deng Xiaoping’s 1978 decision to experiment with market economics. We imagined China on a capitalist road that would inevitably lead to liberal politics and even democracy.” Prestowitz apologizes for being part of the pro-China lobby in Washington, a legacy of western self-delusion about the nature of power in Asia. As China lurches towards another totalitarian extreme under Xi Jinping, any hopes of democratic opening must be put aside. Indeed, the modern Chinese state under Xi is tracking in the very opposite direction as that described by Mao Zedong in 1945 when he wrote about democracy in China from the perspective of the Chinese Communist Party (CCP): “A free and democratic China will be this kind of nation: all levels of government, including the central government, are created by general and equal secret balloting and are responsible to the people who elected them. It will implement Dr Sun Yat-sen’s three principles of democracy, Lincoln’s principle of ‘of the people, by the people, and for the people’, and [Franklin D.] Roosevelt’s Atlantic Charter. It will assure the independence and unity of the nation and cooperate with all democratic powers.” ( Excerpt from Takeuchi Minoru, Collected Writings of Mao Zedong, Tokyo: Hokubosha, 1970-1972 ).” Following the track of Xi Jinping’s accumulation of authoritarian control in China, it is clear that information technology and monetary mechanisms will be two crucial levers whereby the CCP will control its people, both in China and around the world in the vast diaspora of different nationalities within China. As the US and China do indeed decouple, understanding the financial dimension of the next leg of China’s economic strategy is important for Washington. First, China is already using IT to profile and discipline individual behavior by its citizens. Everything from employment to access to schools and health care to travel are now part of a political profile of every citizen maintained by the CCP and the state security apparatus. If you complain of corruption by local officials, your score can be changed instantly. With the press of a button, you cease to exist. China under Xi Jinping is becoming the embodiment of George Orwell’s “1984” nightmare fueled by 21st century technological tools. Facial recognition, for example, enabled with a lot of stolen western technology, enables the Chinese state to track the movements of its citizens and include this public surveillance in its overall profile of each citizen. The level of control enjoyed by the CCP is illustrated by the harvesting of human organs from the living bodies of political prisoners. The role of finance in China’s development and the CCP’s adoption of new authoritarian controls is a vital piece of the puzzle. By driving China towards a cashless society, the CCP and state security services can use access to electronic cash and payments as a mechanism for reward or punishment. When cash is eliminated, the state that controls the means of exchange – call it currency – controls all. As financial reform becomes the next leg of the CCP’s continuing drive to protect its political monopoly in China, the fight with Washington over allowing Chinese firms to list their shares in the US takes on significance. Many Chinese firms refused to follow US requirements regarding audit results, putting them in violation of exchange and SEC rules. But the threats by the US to shut out Chinese firms remain just threats in an election year. "Trump will get louder and louder on China before the election, but all of these things will take years to phase in after the election," notes veteran China watcher Leland Miller founder of China Beige Book . "But many Chinese companies need access to the US markets because they cannot raise significant money on a Hong Kong exchange. Dollar stability is required for their system to work." While US actions to address are correct, attracting more volumes to Chinese exchanges serves the interests of the CCP. Even as the US restricts access to US exchanges, billionaire Jack Ma’s Ant Group is poised to simultaneously list in Hong Kong and Shanghai. Bloomberg News reports Ant is gunning for a valuation of $225 billion, making it the world’s fourth-largest financial company. If you appreciate that the benefits available to CCP members for self-enrichment have been greatly reduced in recent years compared with, say, the first decade of the 2000s, then you understand the problem. Xi Jinping needs to increase the cash flow to communist party cadres in order to maintain control in the 2020s. Reforming the financial system is the perfect canvas for eliminating enemies and generating cash -- especially from the important offshore Chinese community. Following efforts in Russia to repudiate the worst aspects of Joseph Stalin’s rule of terror, in February 1956 Mao Zedong invited criticism of the Chinese Communist Party’s policies. He used a famous slogan from Chinese classical history: “Let a hundred flowers bloom, and a hundred schools of thought contend.” Xi Jinping is hoping to let 1,000 IPOs bloom in newly subjugated Hong Kong and the less sophisticated Shanghai. This, he believes, will reinforce China's growth and also strengthening authoritarian controls. Over time, Beijing hopes to create a regional currency regime bolstered by local currency stock and debt issuance that is large enough to meet the CCP’s requirements for economic growth and employment, but not big enough to threaten party rule. The all-important criteria is the continuance in power of the CCP. In order for China to even consider challenging the US for dominance as the world’s reserve currency, Beijing would need to embrace a level of openness and transparency that would also threaten CCP political control. In order for the yuan to supplant the dollar, China would need to embrace the democratic aspirations of Mao in the 1950s. Of course, after flirting with democracy as a means to power, Mao too embraced authoritarian methods of control and the Cultural Revolution. The cost of the Cultural Revolution was 20 million killed in the 1960 and 1970s and incalculable damage to Chinese society. Look for China to build a financial prison behind a firewall constructed to control the people of China and ensure the survival of the CCP. The period of collective leadership that followed Mao’s death in 1976 is properly seen as an anomaly but was never about democratic opening. Now Xi is taking China's system of personal and political control to a new level under the guise of financial modernization.

Source: FDIC Summary & Outlook In this issue of The IRA Bank Book Q3 2020 , we survey a banking market that has been disrupted by the onset of COVID and the subsequent response from the Federal Reserve, Treasury and civil authorities. The bank data from Q2 is in some cases skewed by these events, in other cases seemingly normal. Below the surface there is considerable change and opportunity. One thing to count as highly likely is that losses from the global business shock from COVID will exceed actual bank losses in 2009. Deposits held by FDIC insured banks rose by more than $1 trillion in Q2 2020 after a similar increase in Q1, but net interest margin dropped for the third quarter in a row. Overall, banking industry operating income is trending down from the peaks of 2019. “Quarterly net income for the 5,066 FDIC-insured commercial banks and savings institutions totaled $18.8 billion during second quarter 2020,” the bank insurance agency reported, “a decline of $43.7 billion (70 percent) from a year ago.” The chart below shows the deterioration of bank net interest income. Source: FDIC In Q3 2020, spreads on loan products have become tighter and volumes have fallen, part of a larger global shortage of collateral engineered by the Fed and other central banks. One of the key indicators that has emerged since September of 2019 has been a sharp reduction in loan sales by banks, which have presumably chosen to retain their production in portfolio. As the table below suggests, sales of auto loans and C&I credits have essentially gone to zero while sales of 1-4 family mortgages have likewise fallen – this even as mortgage industry production volumes have generally risen by 30-40% in 2020. Auto loan sales by banks likewise are running at 10% of 2016 levels. Of note, the brief increase in bank assets serviced for others (ASO) above $6 trillion has been reversed in the past two quarters. Source: FDIC As bank share of mortgage production has declined, the lion’s share of the increase in volume is being captured by the stronger nonbank issuers such as Rocket Mortgage (NYSE:RKT) , Mr. Cooper (NYSE:COOP) and Freedom Financial . The plat de jour is Ginne Mae or course. In the past several weeks, we have seen JPM’s Chase unit as a seller of seasoned 1-4s in a recent non-agency MBS deal, capturing a rich gain-on-sale opportunity. Even as income growth has moderated and now turned negative, credit costs rose again sharply in Q2 2020 to over $60 billion in provisions put aside for future loss. We anticipate that provisions could remain at these elevated levels for the balance of the year or longer. This implies that industry operating income is likely to go into the red in Q3 and especially Q4, when we anticipate a significant credit loss event comparable to the end of 2009. The chart below shows actual operating income vs provisions for the US banking industry though Q2 2020. Source: FDIC Of note, the FDIC reports that banks which employed the current expected credit loss (CECL) methodology saw higher provisions than did banks not yet using CECL. They report: “During the second quarter, 253 banks used the CECL accounting standard. CECL adopters reported $56.3 billion in provisions for credit losses in second quarter, up 419.2 percent from a year ago, and non-CECL adopters reported $5.6 billion, up 207.3 percent. Almost two out of every three banks (61.2 percent) reported yearly increases in provision for credit losses.” Needless to say, asset and equity returns for the industry have declined significantly, with ROA below 40bp and ROE sub-4%. Compared with the 12% equity returns averaged by the industry in 2019, the results post-COVID-19 are truly dreadful and likely to get worse in the near term. The stock market may experience a “V” shaped recovery, but the real commercial economy of people and businesses is not so fortunate. The fact of weakening earnings will not prevent managers from owning the large cap names such as JPMorgan (NYSE:JPM) , American Express (NYSE:AXP) and U.S. Bancorp (NYSE:USB) and at significant premiums to book value. Even The Goldman Sachs Group (NYSE:GS) managed in the closing days of August to crawl up to a mere 10% discount to book value, as sure a sign as could be found that asset price inflation is now a serious problem. Credit Analysis & Charts The key takeaway from the Q2 2020 bank results is that credit conditions are changing and for the worse. Street earnings estimates for top-10 banks are retreating as you might expect. The large provision expense that curtailed bank income in Q1 and Q2 is now being met with actual credit losses and rising loss rates given default (LGD) on some key loan classes in Q3 2020. The good news is that credit indicators on residential mortgage exposures remain strong from an investor perspective. Negative LGDs underline a credit market environment where collateral values below the conforming limit continue to rise, perhaps in an unsustainable fashion. But such warnings have been heard for some years now and run contrary to the stated policy of the FOMC with respect to inflation targeting. Even valuations for once moribund jumbo residential properties have been buoyed by the panic out-migration from the major cities such as New York and Los Angeles. Outside of the world of residential credit, however, the outlook is decidedly bearish in terms of the probability of higher defaults and the likely value of collateral going forward. From a big picture perspective, LGD for all bank loans trended down since 2011 and then went roughly flatline through 2017. But since 2018, loss given default has been moving higher, long before the liquidity problems of 2019 or COVID in 2020. We anticipate that this trend of rising LGD will now accelerate and driven by COVID and the collateral damage emanating from the pandemic. Total Loans & Leases In the chart below we show loss given default or LGD for the $11 trillion in total loans held in portfolio by US banks. This measure was developed a decade ago by Institutional Risk Analytics based upon the early days of Basle I. LGD reflects the loss per dollar of actual value charged off, which is a reflection of the market for the collateral underneath the asset. Source: FDIC/WGA LLC We expect to see loss given default for all loans rise toward 90% and even above in the next several quarters. Indeed, as you’ll note below, the Commercial & Industrial portfolio has already hit 90% loss as we predicted earlier and will lead other asset classes higher in coming months. The US faces a commercial credit crisis in 2020 vs a residential mortgage liquidity event in 2008. At the same time, default rates and delinquency have been trending gently higher in commercial credits since 2018. With the onset of the COVID pandemic, we now see early indications that loan delinquency is rising rapidly across the broad portfolio of FDIC-insured banks. As the chart below suggests, the amount of provision expense measured by non-current loans is far higher than the actual cash losses realized. Source: FDIC Total Real Estate Loans Despite the relative strength of the residential sector, the COVID-related problems in commercial and other areas of the bank real estate portfolio are starting to show up in the reporting. While the weight of the COVID pandemic is being felt most acutely in the commercial sector, we think residential defaults could become an issue in 2022 or thereafter. At present, from a creditor perspective, the strong collateral values in 1-4s are a big positive. Source: FDIC Note that actual credit losses in real estate loans generally remain negligible, at least for now. Indeed, the increase in non-current loan balances reflects delinquent 1-4 family Ginnie Mae (GNMA) loans, which are guaranteed by the U.S. government. These loans have been subject to early buyouts (EBOs) by the likes of JPM and Wells Fargo (NYSE:WFC) , thus inflating loan delinquency stats. Many of these EBOs will, in fact, reperform or be modified short of forclosure. Source: FDIC Given the relatively high rates of delinquency in the GNMA market and the dearth of zero-risk assets with carry available to banks, we look for EBOs to increase. For large, GNMA seller/servicers such as WFC, EBOs of FHA/VA/USDA covered loans is an attractive way to accumulate risk free assets with a significant spread. And as we've noted in National Mortgage News , WFC and other banks may actually retain these loans in portfolio to retain the servicing indefinitely. In a harbinger of things to come in commercial real estate, the observed loss given default for all $5 trillion of real estate loans actually surged in Q2 2020, as shown in the chart below. This suggests some softness ahead in collateral values in the non-residential sector. Source: FDIC/WGA LLC 1-4 Family Loans Of the $2.5 trillion in 1-4 family loans owned by banks, a larger percentage are now shown as delinquent, mostly due to the increase in GNMA EBOs as mentioned above. Non-current rates rose 40bp to 2.07% in Q2 2020 and we expect to see that series closer to 5% by year end. All that said, 1-4s are likely to remain the best credit sector overall in terms of bank owned loans. Source: FDIC Of interest, the move in LGD for 1-4 family loans owned by banks is far more muted than the move in total real estate loans. Notice that LGDs in 1-4s remain negative, reflecting a net positive outcome upon default for the portfolio. The volume of defaults and recoveries also remain low by historical standards. Source: FDIC/WGA LLC Again, the demand for existing homes below the conforming limit in most markets remains robust and thus the LGD is negative. Because of the disruption in the jumbo loan market, financing is qualified for larger, millions plus loans, yet LGD remains negative on average at the portfolio level. The average LGD for bank owned 1-4s back to 1990 is 69%, of interest. The table below shows delinquency rates for all 1-4s. H/T to Joe Garrett. 1-4 Family Loan Delinquency Source: MBA, FDIC The world of bigger loans above the conforming limit is largely a bank and hard money market today, but there are hopes of a recovery in areas such as single family rentals and jumbos loans for broader distribution. Correspondent and other channels remain largely closed for now. We see any recovery in volumes as likely a Q1 2021 conversation based upon current market flows visible today. Multifamily Loans In the world of multifamily loans, the battle in terms of realized losses swung sharply positive as LGD rose to nearly 50% after being negative about as much the previous quarter. The volatility in portfolio level loss rates for the half trillion in bank-owned multifamily assets is hard to decipher, but suffice to say we see LGD moving higher for this asset class in Q3 2020 and beyond. Source: FDIC/WGA LLC Source: FDIC Home Equity Lines of Credit In terms of home equity lines of credit or HELOCs, the asset class continues to dwindle under the relentless onslaught of lower interest rates. Between Q2 of 2019 and Q2 2020, the outstanding principal balance of bank owned HELOC’s fell by 9.5% due to amortization. At current decay rates, HELOCs will disappear as a bank asset class in a few years. Source: FDIC In terms of credit performance, the $324 billion in bank owned HELOCs come in line with the first lien 1-4 family mortgages. The small number in actual defaults generates positive results above the principal amount of the loan. Source: FDIC/WGA LLC Construction & Development Loans The $380 billion in C&D loans owned by US banks are relatively conservative compared with the loans that might have been found on the books of a bank a decade ago or in an ABS today. The loan-to-value (LTV) ratios are lower and the amount of cash the owner has in the game is so much higher. As a result, the credit profile of this asset class is relatively pristine, with charge off rates near zero and LGD deeply negative over the past several years. Source: FDIC/WGA LLC Despite the impressive credit metrics, C&D lending remains an area of concern for federal bank regulators, especially given the building tsunami of credit defaults affecting owner occupied properties and other such small balance commercial assets. Note the upward spike in LGD in Q2 2020 for C&D loans, a trend we expect will continue as defaults and delinquency accumulate. All of that said, we are still a long way from the loss rates seen on C&D loans in 2009. Source: FDIC Residential Construction Loans In the small ($80 billion) but important portfolio of residential construction loans, the credit metrics are tracking that of the larger construction loan book and with similar volatility in terms of loss rate metrics. Source: FDIC Notice that the LGD time series below has been generally negative since 2014, a clear indication of the asset price inflation achieved by the FOMC in real estate assets. The portfolio is also subject to skews, as occurred at the end of 2016 when a large recovery event occurred. Source: FDIC/WGA LLC Auto Loans In the world of auto loans, credit cards and other consumer receivables, the rules of finance change, with prompt and timely resolution of delinquency being the priority and charge-off rates exceeding non-current rates by a substantial amount. The behavior of these portfolios tend to be quite different than other types of bank loans. Source: FDIC Source: FDIC/WGA LLC Non-current auto loans have been trending steadily higher since 2019, but LGD has actually been falling, reflecting strong recovery results due to prices for used cars. That trend seems to have reversed since Q4 2019, however, perhaps reflecting the drop in bank ABS issuance and sales by banks we discussed earlier. Should unemployment continue to rise, as we expect, then credit metrics will deteriorate. Credit Card Loans The $800 billion plus in bank owned credit card receivables have behaved reasonably well over the past five years and have not yet displayed any COVID related spikes in defaults or other idiosyncrasies. Net charge off rates have been bumping up against 4% for several years as shown in the chart below. Source: FDIC Source: FDIC/WGA LLC Commercial & Industrial Loans As we noted at the top of this edition of The IRA Bank Book , the C&I portfolio is generating a lot of noise recently in terms of credit losses, including commercial real estate exposures not captured in the other categories. The numbers are still not yet alarming, but we think that will change in Q3 and beyond. The FDIC reports in the Quarterly Banking Profile : “The annual increase in total net charge-offs was attributable to the commercial and industrial (C&I) loan portfolio, in which charge-offs increased by $2.4 billion (128.5 percent). The C&I net charge-off rate rose by 31 basis points from a year ago to 0.64 percent, but remains well below the post-crisis high of 2.72 percent reported in fourth quarter 2009.” Source: FDIC As we predicted earlier this year, the LGD for bank C&I exposures is headed vertical, with a pretty good bet that loss rates could near or exceed 100%. How can you lose more than 100% of the outstanding loan amount? Because of resolution costs, taxes and other risks that come with owning a property. In many cities, for example, a lender cannot simply abandon a moribund property. Source: FDIC/WGA LLC The Final Word The net effect of the various programs and operations by the Federal Open Market Committee has been to diminish bank income per dollar of assets. The sharp decline in rates is good for mortgage lenders, but the impact on credit overall has been continued tight spreads across the fixed income complex. There is enormous buying pressure from global funds in many asset classes, adding to the competitive pressure on large banks. The yield on loans and leases by Peer Group 1 was 4.75% at the end of the second quarter of this year, but the big news was the 50% reduction in the cost of deposits. The cost of federal funds and reverse repo has come down by a point over the past year, adding some lift for the banks. The continuing challenge, however, will be finding earning assets and fighting the deflationary tendency of low interest rates. As the chart of net-interest margin at the top of this report suggests, bank operating income is likely to fall in coming quarters. Source: FDIC/WGA LLC A relatively flat yield curve and a general dearth of quality credits is making it hard for banks to earn a living. The FOMC’s decision that it would allow inflation to run above its longstanding target in order to make up for periods of “undershooting” caused the curve to steepen last week. But it is unlikely to relieve the tight spreads that prevail in many prime markets. Bottom line is that we see bank operating earnings in Q3 and Q4 2020 significantly impaired by mounting credit costs on the commercial side of the risk ledger. We do not expect to see a repeat of the market-based performance enjoyed by many banks in Q2 2020. Residential mortgage production is a bright spot on the risk horizon, but this is mostly a non-bank opportunity. While we acknowledge that considerable restructuring activity lies ahead in the commercial portfolio, banks and other advisors are unlikely to prosper greatly or for long when so many of their clients are in distress. Source: FDIC The IRA Bank Book (ISBN 978-0-692-09756-4) is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Book. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Book are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Book represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Book is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Book is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Book. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

"History is more or less bunk. It is tradition. We don’t want tradition. We want to live in the present. The only history that is worth a tinker’s dam is the history we make today." Henry Ford Chicago Tribune May 1916 New York | Last week we noted that a lot of providers of cash to the agency repo markets are unwilling to transition term financing from LIBOR to the secured overnight funding rate or "SOFR." The notion that central bankers were mistaken in deciding to kill LIBOR without a functioning replacement at hand seems to resonate with market participants. Will Chairman Jerome Powell take note? Twin Shelby Mustangs, Greenwich 2019 A reader of The Institutional Risk Analyst asks if our new premium service “will cover the evolving payments landscape and its impact to banking.” Yep. Just about every week. Keep those cards and letters coming. There are many dimensions to the world of payments, some which are banal other that are vitally important. As with much of finance, it is the optionality represented by the participants in the network rather than a static interchange fee that holds the biggest potential returns. But somehow the Buy Side manager gets twisted into a knot over this line item. The Labor Day trip to Leen’s Lodge in Grand Lake Stream Maine is on this year. There is availability for enjoying fishing, dining and the natural beauty of Down East Maine. For details contact Scott Weeks info@leenslodge.com or (800) 995-3367. Saint Croix River Take Wells Fargo & Co (NYSE:WFC) , a top four money center bank with just shy of $2 trillion in total assets on balance sheet and trillions more in assets serviced for others and custody float. In the most recent form Y-9C for June 2020, WFC reported $1.4 billion in bank card and credit card interchange fees. The interchange fee number is reported with “other noninterest income” along with changes in the fair value of securities and the like. Important? Yes. Significant in the grand scheme of things? No, not compared with $21 billion in net interest income or $14.5 billion in total non-interest income. Our comment last week on LIBOR also generated some interesting references from readers. “Before getting into the why of the dollar’s stubbornly high exchange value in the face of so much ‘money printing,’ we need to first go back and undertake a decent enough review of the guts maybe even the central focus of the global (euro)dollar system,” writes Jeffrey Snider of Alhambra Partners . So a US bank sells Treasury bonds and Ginnie Mae MBS to the Federal Reserve, gets cash. The US bank then borrows risk-free collateral from offshore bank, gives cash in return. US bank then does collateral transformation repo, junk + cash for risk-free collateral, thereby increasing system leverage. What have we achieved? Ever wonder why the Financial Stability Oversight Council (FSOC) never looks at obvious hot spots like transformation repo? Maybe the FSOC ought ponder the transformation repo arb with CLOs? Hmm? But we digress. Speaking of what’s important in the world of payments, a lot of analysts worry about the secular decline in the rate of economic activity as measured by money turnover or velocity . Bunk (and several other things) says Lee Adler of Wall Street Examiner , who reminds us that the worries of mainstream economists regarding the “velocity” of money and other supposed measures of economic throughput are a lot of analytical nonsense. “Velocity is the ratio of GDP to M,” argues Lee with his usual passion. “ As the St. Louis Fed says : ‘The velocity of money can be calculated as the ratio of nominal gross domestic product (GDP) to the money supply (V=PQ/M).’ So V is the growth rate of the economy relative to M. If the Fed conjures and injects enough M into M to double it, by definition V is cut in half.” He continues: “There's nothing to be read into that about the economy. It is simply a fact of the equation for calculating V. In this case, total deposits increased almost dollar for dollar with the amount Likewise, the public didn't actively increase savings. It stopped spending for a month or two when it couldn't spend because of the lockdown. That didn't last long. July spending is back to trend.” Chart c/o Wall Street Examiner . “When the Fed purchased a couple trillion in Treasuries and MBS, the M showed up in the accounts of dealers and investors. Spending was and is maxed out. Only the investor class has savings. Everybody else spends everything and they get their income from their labor and government transfer payments. So GDP can never increase enough to keep up with M when the central bank surges M. Where all that excess M showed up of course was in the upward pressure on the prices of financial assets.” Ditto. Further to the getting paid category, we thank Fred Feldkamp for checking in from the Upper Peninsula to remind us about the 100th anniversary of Dodge v. Ford , when shareholder Horace Dodge sued Henry Ford over the payment of equity dividends by Ford Motor Co . The Michigan Supreme Court famously held that a business corporation is organized for the profit of its shareholders, and the directors must operate it in service to that end. “Despite the fact that Dodge v. Ford is rarely cited in judicial opinions, the case continues to spark controversy in legal scholarship,” writes Michael Vargas in Business Lawyer . “There is little justification for this scholarly attention because the factual basis is little more than a caricature of Henry Ford, and subsequent developments in corporate law have all but eviscerated the precedential value of the case. Rather, the legacy of Dodge v. Ford may simply be that it serves as a convenient talisman, standing for the one sentence anyone actually cares about and rolled out with each new battle in the war between shareholder profit maximization and corporate social responsibility.” Both Horace and John Dodge died of the Spanish flu in 1921, forever changing the history of the US auto industry and the broader economy.

New York | This week The Institutional Risk Analyst reaffirms our negative view of The Goldman Sachs Group (NYSE:GS) . The securities firm with a small bank attached had a record quarter in Q2 2020 thanks to great performance by the global markets team. But a week later, the GS investment bankers promptly puked out the profit for the first half of the year to partially settle criminal and civil claims arising from the 1MDB fraud in Malaysia. Our report is on sale now in The IRA online store . And BTW, anyone with information as to the whereabouts of the fugitive Jho Low , the Malaysian businessman and international fugitive sought by the authorities in Malaysia, Singapore, the United States, to name only three jurisdictions, do drop us a note. Not only did Low fool the folks at Goldman Sachs, including former CEO Lloyd Blankfein , but he also managed to swindle a whole lot of US financial moguls and Hollywood types, including Leonardo DiCaprio, in the process . Of course, in a purely existential sense, we could attribute the frequent financial shenanigans seen in the Asian financial markets to the vast sea of fiat paper dollars being emitted by the US Treasury. Not only does the world of offshore dollars provide big opportunities for global banks, investors and rating agencies, to name but a few, but it also produces some of the most remarkable frauds and scams seen in modern times. The arbitrage between the dollar world and the two other major currency alternatives, the Japanese yen and euro, is one of the key factors affecting US monetary policy in a global sense. As we’ve discussed frequently with our friend Ralph Delguidice of Pavilion Global Markets , the interplay of offshore spreads is a key part of understanding the global demand for dollars. Most recently, though, we have seen the US Treasury amass a vast pile of cash in the wake of the fiasco in March, when most markets essentially stopped functioning for two weeks. The Fed is supposed to be the guardian of the Treasury's market access, after all. The Fed then compounded the problem by initiating a massive open market program in April (not “QE,” you understand) that nearly caused the failure of several small banks, REITs and hedge funds. Understanding the interplay between the Treasury General Account (TGA) and the Fed’s now $7 trillion balance sheet is essential. The TGA is the proverbial dog and the federal Reserve System is the tail. In a note appropriately entitled “Carry On; Zero is Coming,” Ralph wrote last week about the monetary impact of the TGA: ”The key takeaway here now becomes clear. If a 25% contraction in system-wide reserves was insufficient to raise USD funding costs in any of the money markets used to provide leverage to buyers of US assets, what is the likely impact of a huge reversal in these liquidity flows when the Treasury spends down the account? Funds will flow back into a global USD market still saturated with cheap funding, and carry trades will become that much more attractive to foreign buyers as hedge costs fall and even go negative.” That’s right, in the not too distant future, the cost of hedging dollar assets could swing negative, something that will complete the cycle from the end of QE in 2015 and the peak of US interest rates in early 2019. Remember when the Federal Open Market Committee actually thought that they could raise interest rates even further in 2019? Three-month LIBOR never even made it to 3% in that strange period, as shown in the chart below. Students of the foreign exchange markets understand that the weight of public sector debt is acting like a 100 kg kettle bell tied around the neck of the global economy. We already had a debt problem before COVID19. But now, with much of the world economy idled or in shock, or both, and asset prices falling accordingly, the prospects for widespread global deflation are greater than ever before. And the global central banks seem powerless to prevent this long-avoided endgame. Even as interest rates in the US fall under the weight of shifts in the TGA balances, the dollar continues to strengthen, the opposite situation to that faced by most other nations. This strange circumstance allows the Fed to monetize most of the interest cost of the Treasury’s debt issuance and deficits, one big reason why people in Washington think that deficits don’t matter – at least this week. Next will come the creation of new fiat dollars to offset interest and principal expense for the Treasury. Are you horrified by this suggestion? Think this can't happen?? Tell us the last time an official of the Federal Reserve or Treasury publicly rebuked Congress for the absurd conduct of fiscal policy. The fact of global deflation makes it seem like negative interest rates and even stranger ideas like modern monetary theory or “MMT” are feasible. But in fact, the artificial environment that allows the Treasury to issue trillions in debt and the Fed to purchase most of it comes from the “special role” of the dollar dating back to WWII. The dollar monopoly on global payments and as a unit of account allows Americans to pretend that black is white or that negative interest rates are somehow the cure for deflation. What is MMT but an acknowledgement of another terrible disease, namely war? As the victor post WWII, the US became the "global reserve currency" by default. The job found us. And we'll enjoy the dubious benefits until we don't. Then the MMT illusion vanishes along with negative interest rates and the pretense of the low inflation. But for now, the rules of dollar global finance apply to all nations -- except the United States. Just as the Federal Reserve System is the accounting antithesis of the Treasury, the dollar is the global long position and the holders and issuers of debt in all other currencies are, by definition, short dollars. When economists suggest that the US should embrace negative interest rates, they betray a fundamental misunderstanding of America's position in the global markets. “The Austrian theory of interest, as elaborated in Böhm-Bawerk’s hefty three-volume Capital and Interest , holds that interest emerges from the time preference of individuals—the willingness to pay more to have something now rather than later,” writes Edward Chancellor in The New York Review of Books . “Given that people prefer instant to deferred gratification—as the saying goes, a bird in the hand is worth two in the bush—time preference, and hence interest, must always be positive.” Sadly, the widespread idiocy that suggests that expedients such as negative interest rates or MMT are a solution for global deflation, our collective woe, misses the point. It is the dead weight of burgeoning global debt and falling cash flows from assets that is the root cause of deflation. Try as they might, the Fed and other global central banks cannot avoid forever the eventual reset in asset prices to match reduced cash flows. Right on time, COVID19 has arrived almost a century since the emergence of the Spanish flu in 1918, setting the stage for the deflation of the 1920s and the economic collapse of the 1930s. We think observers should be more attentive to the historic parallels of the centennial of the Spanish flu pandemic and the deflation of the 1920s. Professors Stephen G. Cecchetti of Brandeis University and Kermit L. Schoenholtz of NYU Stern, writing in The International Economy , put the future situation in concise terms: “The value of cruise ships, airplanes, trains, retail space, office buildings, dormitories and the like has almost surely collapsed. Meanwhile, the value of other productive capital, such as high speed internet connections, has risen, but these investments appear to be far less costly to undertake. So, on average, the observed return on investment is likely to decline for some time.” The good news is that the deflation in the real value of asset prices for assets like cruise ships, airplanes andmalls has already occurred. The bad news is that the current value of these assets has yet to be adjusted. Over the next several months and years, we expect to see significant losses emerging as the inexorable process of price discovery and resolution catches up with the nonsense that passes for serious thinking in Washington. We wonder if @JoeBiden and his handlers understand that it is 1920 all over again. That we will have years more of COVID and, at the end, we'll see an end to the "special" role of the dollar. Then things like QE and MMT will fade into memory as we embrace the reality of no longer being special. How the Fed and Treasury are hurting housing National Mortgage News

Grand Lake Stream | Federal Reserve Board Vice Chairman Randal Quarles , who has a specific mandate from Congress for bank supervision and chairs the Financial Stability Board (FSB) , last month sounded the alarm regarding the role of non-bank financial institutions in the market swoon in mid-March. His yowling follows similar protestations by Federal Housing Finance Agency (FHFA) Director Mark Calabria . Leen's Lodge, West Grand Lake, Maine Simply stated, Vice Chairman Quarles and his colleagues on the Fed’s Board seems to think that the bad acts of non-banks like hedge funds and REITs caused the extreme run on liquidity in the money markets during the third week in March of this year. In fact, March was a classic systemic event characterized by a sudden onset informational asymmetry. Like Director Calabria, Governor Quarles seems to be a man looking for a dragon to slay. In fact, the massive response by the Federal Open Market Committee nearly swamped several large funds and REITs that invest in risky things like government-guaranteed mortgage backed securities (MBS). Volumes in the too-be-announced market are down 20% YOY even as the production of new agency coupons soars. Former New York Federal Reserve President E. Gerald Corrigan noted many years ago that the definition of a systemic event is when the markets are taken unawares. March 2020 certainly qualifies as a shock. Financial stocks lost a third or more of their value, thus cutting the national wealth proportionately, and private fixed income securities were likewise crushed. Unless the bonds were government guaranteed mortgage paper, there was basically no market bid and, more important, no financing available for several weeks in much of the financial world. Today, the market for non-QM prime loans remains disrupted, as we noted in National Mortgage News (“ How the Fed and Treasury are hurting housing ”), resulting in the large banks suspending third party purchases of jumbo loans. Spreads for prime jumbos are now 50bp wide of conforming loans instead of inside by the same amount, where they traded for the past several years. The Fed's lack of attention to restoring liquidity to prime private label mortgages, which are predominantly a bank market, is stunning. In response to the sudden withdrawal of private cash in mid-March, the Fed basically doubled the size of its balance sheet in a matter of weeks, this supposedly to prevent several nonbanks from failing due to the sharp drop in Treasury bond yields caused by the central bank. Bonds rallied in a way never seen before due to the "go big" strategy followed by Fed economists in Washington, who direct the bond purchases by the Federal Reserve Bank of New York. Margin calls on short Treasury bond positions nearly sank several large hedge funds and agency REITs in the last weeks of March and first two weeks in April. Indeed, the intensity and duration of the Fed’s open market purchases of Treasury securities and mortgage paper almost sank a number of funds, lenders and even some small banks. Quarles places the blame for this latest episode squarely on non-bank financial firms – aka, the private sector – and clearly places no blame for the raging contagion on either the Mnuchin Treasury, the banking system or the central bank itself. Does Governor Quarles understand, we wonder, that the problem in April 2020 was as much due to COVID-19 as to the Fed’s heavy-handed response? He wrote to the FSB in July outlining his concerns : “Reinforcing resilient non-bank financial intermediation (NBFI). The impact of the COVID Event on credit markets has highlighted vulnerabilities in the NBFI sector related to liquidity mismatches, leverage and interconnectedness, and investor behavior related to certain funds that they may treat as cash equivalents during economic calm but not during crisis. While extraordinary central bank interventions calmed capital markets, which remained open and enabled firms to raise new and longer-term financing, such measures should not be required. Understanding risk, risk transmission, and policy implications for the NBFI sector is more important than ever.” When the Fed rode to the rescue with trillions of dollars in liquidity in April and May (we thank them for doing so BTW) it did so less out of concern about the state of the US economy or employment or the solvency of private companies than it was with restoring market access to the US Treasury – the Fed’s first and most important mandate. Helping calm the Treasury market also helped the market for agency and government MBS. Why does Quarles say that "such measures should not be required?" Isn't this why we have a central bank? Otherwise we'd have to call JPMorgan CEO Jamie Dimon as was the case a century ago. Quarles, who is nominally considered a conservative on the Fed Board and relatively bank friendly, warns that: "We may be seeing significant pricing disconnects between the market and economic fundamentals, which could result in sudden and sharp repricing. The impacts of these economic strains may be amplified in emerging markets, given the risks to their currency and debt markets from capital outflows." True enough, the markets have been trading better than the economic fundamentals would suggest, in large part because the Federal Open Market Committee has decided to buy basically every Treasury security and agency mortgage bond in the market. The FOMC has purchased $1 trillion in agency and government MBS since mid-March. The US residential mortgage market is booming because of low interest rates. The rate on a 30-year fixed rate mortgage is now below 3 percent. We’ll print at least $320 billion in new Fannie/Freddie/Ginnie MBS in August, a $3.5 trillion run rate for the year. The apparent goal here is to stimulate the housing sector. It worked. Reading the Quarles letter, it is tempting to ask just what exactly in the problem? Why suggest that the Fed should not act? Would Vice Chairman Quarles merely stand by as hedge fund giant Citadel or giant agency REIT Annaly Capital Management (NYSE:NLY) collapsed? One hopes not. Since the role of the Fed is to act as the enabler of the mindless fiscal behavior of Washington, it is natural to look for scapegoats at every turn. In fact, the single biggest threat to the global financial markets is the Treasury’s profligacy and the related strength of the dollar, a trend that is self-reinforcing. Lower interest rates c/o the Federal Reserve in the US make it possible for offshore investors like the Bank of Japan or postal savings giant Norinchukin Bank to hedge their dollar risk and buy long-dated Treasury bonds and Ginnie Mae mortgage bonds. The impact of large global investors buying dollar assets tends to push interest rates down even more and, for now at least, pushes the dollar higher. The biggest threat to the United States stems from the fact that the Federal Reserve Board has essentially lost control of its balance sheet. And nobody on the Fed Board is willing to criticize Congress or the White House for their collective financial idiocy. Today banks and non-banks alike take less risk, using less leverage than ever before, one reason why the world of private finance is not a problem. The collateralized loan obligations (CLOs) that so vex Senator Elizabeth Warren (D-MA), for example, are not a problem after all. Warren is simply another politician in search of a problem to solve and thereby take the credit. In 2019 the FSB and its companion agency, the Financial Stability Oversight Council, were fretting about the potential liquidity risk posed by non-bank mortgage firms at the instigation of Director Calabria. Now the targets of regulatory scrutiny in 2020 are hedge funds and REITs that buy mortgage securities. In both cases, the attention is misplaced. We can think of some far more interesting parts of the market where risk truly does reside.

New York | We have returned from the Maine Woods refreshed and ready for the sprint to Labor Day. The fish were big and the bugs almost entirely absent. We put the nix on fried potatoes and wine at lunch, and visited some remarkable small lakes with really big bass. And we regret to report that the first large mouth bass was taken from the Fourth Machias Lake. The invading fish was eaten with great relish. Of course, a large mouth bass is considered an “invasive species” in Maine and thus may be taken and eaten in unlimited numbers. But a small mouth bass is also an immigrant from southern waters, albeit from a century ago. To borrow the moniker of our friend Dan at Zero Hedge , on a long enough timeline every creature on the planet qualifies as an invader. Ponder that when thinking about economic and social justice. A reader sends this thoughtful query: “I recently read your 2017 article on QE and FANG stocks . Looks like things have improved dramatically since then, wouldn't you say? That is, of course, a morbid joke. My heart tells me to keep hope alive, but my head says we are on the brink of the worst global economic collapse in history. Thoughts?” The fixation with Facebook (NYSE:F) , Amazon (NASDAQ:AMZN) , Netflix (NASDAQ:NFLX) , and Alphabet (NASDAQ:GOOG) tells you all that you need to know about the global, that is, consumer economy. Not a single transformational enterprise in the group. All the Fang stocks, in fact, pander to the vanity and convenience of the more affluent consumer. And it is the world's desire for access to these consumers that ultimately supports the dollar. Thus falling US consumer spending is an ominous sign. At the moment, the dollar is the global “asset” and other currencies are liabilities. Dollar stocks are an inflation hedge of sorts, while bonds are taxed by the FOMC’s targeting of federal funds as a policy instrument. As and when America’s incompetent political class convinces the world that we are unworthy of the privilege of being the world's reserve currency, then the dollar will become a liability and another medium will be the global asset and means of exchange. Note, for example, that after the dollar spiked 10% higher in March, the broad index has given up these gains and more. Seeing Americans rioting and burning buildings in major cities does not help the value of the dollar. And as the dollar has weakened, the spreads between short-term rates in yen and euro have narrowed. Improvement is a relative concept in a world where American elected officials have lost the ability to govern and maintain civil order. Chicago’s Democrat Mayor Lori Lightfoot , in the latest example, allowed citizens to riot and loot stores on the Miracle Mile. “ All bridges are being raised along the river throughout The Loop ,” reports  CBS News . “Chicago’s Office of Emergency Management announced street closures throughout areas in the Magnificent Mile, Gold Coast and South Loop.” Meanwhile, President Donald Trump urges officials in Oregon to bring in National Guard amid unrest in Portland, and warns officials they will be 'held responsible' for destruction. See our comment in The American Conservative , " A Socialist New York Staggers Toward Default ." In the face of the misgovernance evident in many parts of American life, our dutiful central bank continues to do too much in response. And, of course, the Federal Reserve refuses to ever say no to the debauched politicians who mismanage things in Washington and elsewhere. Thus, there is copious and ever flowing liquidity in the financial markets. That is a clue. Our friend Rob Chrisman provides this update on Treasury issuance for the rest of the year: “The US federal government will need to maintain borrowing at elevated levels as the coronavirus crisis continues, although it should decline marginally this quarter, the Treasury said. Offerings of all Treasury securities will be increased but the emphasis will be on 7-year and 10-year notes, and bonds with 20-year and 30-year maturities, as the government aims to shift to longer-dated debt.” Of course, the Federal Open Market Committee will be purchasing a great deal of the Treasury’s debt issuance in the next several years, raising questions as to how and when the central bank will ever reduce its balance sheet. As we like to remind one and all, the problem with quantitative easing or QE is that it represents a permanent add to the Fed’s balance sheet so long as Treasury remains in deficit. The chart below shows the system open market account (SOMA) vs the CBOE VIX Index. Notice that the VIX has still not returned to levels of Q1 2020. The FOMC must continue to purchase Treasury and agency mortgage backed securities sufficient to maintain the size of the balance sheet and thereby market liquidity and bank deposits. Otherwise, we risk a repeat of the market volatility seen in 2019. Again, the bias in interest rates is lower for longer. Last week, Rocket Companies (NYSE:RKT) priced at $18 per share or a $36 billion enterprise value, adding yet another name to the world of listed non-bank financial firms. The strong financials of RKT (1x leverage) and the ability of Quicken Loans to create new assets, we suspect, will make the leading mortgage lender and servicer a benchmarks in the mortgage group. We’ll be publishing a profile on RKT once some of the data settles down. It is interesting to note that Mortgage Originators & Servicers have outperformed the S&P and other broad indices over the past month, perhaps due to the RKT IPO. But we also think that a number of investors have noticed that interest rates are low and are likely to remain low for some time. The FOMC intends to use housing as the engine of an eventual recovery in the broader economy, but that indirect method will take years to achieve success. Thus we expect primary-secondary market spreads for residential mortgages to remain very attractive for issuers like RKT. As one leading industry MSR owner opined last week, the rich primary secondary spread (consumer loan coupon minus the MBS debenture rate) ensures that most of pre-2020 vintages will prepay. "We'll see 2.5% loan coupons," he muses. “It's going to take years for the US economy to fully heal from the economic disaster brought about by COVID-19 and the government-mandated shutdowns which continue to limit economic activity across the country,” write FT Advisors. “When we talk about a full recovery, we don't simply mean getting real GDP back where it was in late 2019; a full recovery comes when the unemployment rate gets back below 4.0%, and we don't see that happening until at least late 2023.” The IRA Adds Premium Service Editor's note: For some time, readers of The Institutional Risk Analyst have been asking for a subscription offering for our company analysis service. In response, we shall be creating a paid addition to The IRA blog that will showcase company risk profiles, videos and other premium content. In addition, the online store for bank risk profiles will be going away. Look for these and other changes to go live between now and Labor Day. The very popular Labor Day trip to Leen’s Lodge in Grand Lake Stream Maine is still on this year. There are a couple of spots available for fine end of season fishing, dining and natural beauty. For details, please contact Scott Weeks info@leenslodge.com or (800) 995-3367.

" In the darkest hole, you'd be well advised Not to plan my funeral 'fore the body dies, yeah Come the morning light, it's a see through show What you may have heard and what you think you know, yeah" "Grind" | Alice in Chains (1995) New York | On Monday we launched the premium edition of The Institutional Risk Analyst , which contains our views of specific companies and markets. We have ended our sales of individual reports, and will include risk profiles and The IRA Bank Book quarterly survey of the banking industry as part of premium service. Send questions and comments to info@rcwhalen.com . London (1977) We thought it might be worth remembering that things in the credit markets were not so great a year ago, when the Federal Open Market Committee started to retreat from its pretense about raising interest rates. In August of last year, dollar LIBOR blew through 2.5% and proceeded to decline until February 2020, when US interest rates fell off the edge of the proverbial table. And thus comes into the focus the great idea of the Fed and other regulators of several years before: Let’s replace LIBOR. Today dollar rates are starting to edge higher, disappointing those analysts who expected the 10-year Treasury note to test the zero bound prior to the next Treasury refunding. Instead, dollar interest rates seem to be firming ahead of this November’s abortive election scenario. None of the above? Japan is flat lining as usual and rates in Europe are sinking deeper into negative territory. Many advisors and counsel worry about what happens if the US follows the EU into negative territory. The short answer is that bonds may trade negative yield, but commercial banks and, yes, Federal Reserve Banks and the DTCC can't and won't price negative assets and liabilities. This is Y2K two decades later. The tightening of Treasury yields is a bit of a surprise given the drop-off in bank lending activity -- at least outside of the overheated residential mortgage sector. In August, the industry will again create well more that $330 billion in new mortgage backed securities (MBS), but markets for non-agency paper remain quiet, that is to say, dead as a doorknob. Polly parrot kinda dead . The carnage caused by the Fed's "go big" strategy in April and May continues to be reckoned in dollars and professional lives destroyed. Of note, volumes in trading too-be-announced (TBA) and cash MBS coupons continue below the trailing averages. Despite the big issuance numbers, continued Fed purchases of agency MBS is depressing market liquidity. Thus comes the question: What happens when the Treasury starts its next cash raising exercise in a month? How will the market benchmarks react? And are there any benchmarks worthy of the name? Now conventional market theory holds that when a nation issues more debt into the capital markets, yields should rise in response to the added supply. But in this case we may see the dollar strengthen as foreign demand drives yields down , particularly demand from Japan and the rest of Asia. The economic context for future market moves will be deflationary, needless to say, owing to the negative impact of COVID19 on spending and credit creation. Robert Eisenbeis of Cumberland Advisors notes in a comment about future inflation that ”the decline in velocity in the short run has offset the money supply increase, due in part to a large increase in precautionary saving and a drastic cut in aggregate demand for many goods and services.” Perhaps the Fed is finally about to find the inflation long sought? Hold that thought. It is interesting to note, so long as we are focused on market dysfunction, that while many parts of the market are starting the transition from LIBOR to the secured overnight funding rate (SOFR), the bank funded markets for 30-day securities repo and collateral financial markets are not changing. Not even close. And why is SOFR being shunned by the most important, most conservative MBS market after US Treasuries? Because the banks don't see an alternative to LIBOR for pricing both sides of a 30-day repo trade for MBS and dry FHA guaranteed loans. And for those of us who appreciate that forward TBA contracts for GNMAs are the foundation of the hedging market for Treasury securities, nothing more need be said. You see, 1 month LIBOR is presently trading around 17bp but there is no comparable 30-day rate in the magical land of SOFR, which is about 9bp for overnight. The lesson? It was easy for the Washington economists who staff the FOMC to several decades ago confiscate a market benchmark like federal funds. Today, however, its is less easy to create a functioning market rate out of an economic fantasy like SOFR. Since SOFR is an artificial overnight rate and does not yet have a true market following (aka "markets, people"), including a term structure out even 30 days, warehouse lenders and other providers of cash to the markets are not moving as yet. Memo to Chair Powell: How can a federally insured depository use a nonexistent benchmark like SOFR to price assets and liabilities? Anyone out there with a term rate structure they don’t need please call Chair Powell at the Federal Reserve Board in Washington. We understand he’s in the market for a slightly used benchmark with an intact secondary market. No questions asked. It is worth noting that the administration of LIBOR was shifted to the Intercontinental Exchange (ICE) in 2014. In the event that the Federal Reserve is unsuccessful in breathing life into SOFR, as close to a monetary Frankenstein’s Monster as you’ll ever see, we suspect that the Fed may be forced to either (1) fix LIBOR under ICE’s administration or (2) fashion a new indicator based upon the TBA market. Haven't heard that one? Wait for it. Why not simply fix the existing LIBOR? Well, that would require the folks at the Fed and other central banks to admit that they were wrong to kill the benchmark in the first place. Probably not a good idea. But fashioning a new, functioning market benchmark is not easy. For one thing, it probably never occurred to the economists at the Fed to base the replacement for LIBOR on a functioning, secured marketplace like TBA. That would require imagination. Stay tuned.

New York | As we head into the bottom of Q3 2020, risk managers and investors face a tough puzzle. Financial markets have rebounded to the point where all-time highs are within reach for some equity market benchmarks, but fundamentals like earnings and lending volumes are weakening in most of the financial sector. And even with the record volumes of mortgage loans sold in June and July, risk remains a large factor for bond investors due to torrential flows of loan prepayments. Mortgage Sector We’ve noted that the sector known as Mortgage Originators and Servicers outperformed most major indices in July, this according to a note by KBW. This was in part due to the successful IPO by Rocket Companies (NYSE:RKT) . But more to the point, interest rates are low and likely to stay that way for years to come, at least listening to the statements coming from the FOMC. We look for continued strong volumes and earnings from nonbank mortgage issuers. Lending has started to decelerate slightly from the torrid levels of June and July, when total issuance of mortgage-backed securities exceeded $350 billion, a record going back more than a decade to the mid-2000s. The chart below shows the latest data from the Federal Reserve on bank lending. Notice that nonbanks, which are driving much of the growth in mortgage lending, are not included. Source: Federal Reserve Mortgage lending by commercial banks actually fell in June overall, but nonbank production surged. Bulging new issue pipelines of nonbanks kept the issuance side of the equation humming along even as commercial banks have stepped back from correspondent channels. The chart below shows total debt issuance by SIFMA, which includes non-bank production in the total mortgage issuance ( green line ). Yes, in July 2020 the US mortgage industry printed $350 billion in new MBS. The only negative in the first half of August 2020 was the bad decision by Federal Housing Finance Agency Director Mark Calabria to impose a 50bp fee on loans purchased by Fannie Mae and Freddie Mac, this to offset the supposed risk posed by mortgage refinance loans. The Trump White House immediately criticized the action as being "bad for consumers." “The mortgage industry exploded with outrage late Thursday night after being greeted with the news that Fannie Mae and Freddie Mac, come Sept. 1, would begin charging their seller/servicers a 50 basis point 'market condition credit fee' on most refi products,” reported Inside Mortgage Finance . Think of the change that takes effect September 1st as a tax. FHFA chief Mark Calabria is effectively confiscating 1/3 of the 150bp or so in net profit on retail mortgage business, but most of the 70bps or so on correspondent. Indeed, some smaller conventional lenders will lose money on every correspondent loan. As market participants know very well, refinanced loans tend to perform better, especially when LTVs are falling due to strong home price appreciation. Indeed, we suspect that strong home prices are one reason that default rates are running below our worst-case scenario. When borrowers get into trouble, they simply sell the house and take the net equity off the table. The FHA change will severely impact the correspondent business needless to say, because a 50bp tax pushes many correspondent lenders out of the market entirely. One wonders if the FHFA considered the economic impact of their actions. We suspect that Calabria's hasty action was driven by a need for cash. “Housing… may be the most government owned and controlled of any industry in the country or even the world,” notes Dick Bove at Odeon. “This system is now running into difficulty. The recent increase in a GSE refi fee indicates this. It is my belief that this fee is being levied to cover loan losses and, therefore, it will not go away. It is unlikely to result in big profit gains that are not offset by other costs.” We concur with Bove’s analysis and believe that the government-controlled GSEs, Fannie Mae and Freddie Mac, face a capital squeeze in 2021 as they are forced to finance COVID-19 related forbearance and also actual default activity. You won't find any conventional collateral in most commercial bank warehouse lines or repo programs, and for a reason. But in the event that Joe Biden wins in November, the privatization of the GSEs will be off the table. The fact remains that interest rates will continue to drive strong mortgage lending volumes, helping banks, independent mortgage banks and the GSEs offset pandemic related operating costs. If you look at the mortgage sector, the exemplars such as Mr. Cooper (NASDAQ:COOP) and Penny Mac Financial (NASDAQ:PFSI) are up 100% over the past year and mid-double digits over the past month. Add RKT to the leadership group in mortgage finance in terms of lending and also operational efficiency. RKT Friday released an estimate of the firm’s second quarter earnings number at $3.46 billion. The largest non-bank issuer of residential mortgages in the US disclosed an extraordinary gain-on-sale margin of 519 basis points for Q2 2020. Private issuers such as Amerihome , a unit of Athene (NYSE:ATH) , Caliber , and Freedom will also benefit from continued low MBS yields and wide primary/secondary spreads. After these hyper-efficient issuers in the mortgage space come data providers CoreLogic (NASDAQ:CLGX) and BlackKnight (NYSE:BKI) . Both of these quasi-monopoly providers of mortgage data and servicing tools give investors exposure to the mortgage sector, but with less cyclicality in terms of credit. Looking at the rest of the group, REITs such as New Residential (NYSE:NRZ) and Two Harbors (NYSE:TWO) have rebounded, but still trade at significant discounts to book value – and for a very good reason. We continue to be concerned about the effect of strong MBS prepayments on investors such as NRZ, who have abysmal rates of retention on their servicing portfolios. The FHFA change regarding refinancing will hurt NRZ and conventional correspondent issuers like Penny Mac and Amerihome. As we’ve noted previously, we expect primary-secondary market spreads for residential mortgages to remain very attractive for issuers like RKT, COOP and PFSI. As one leading industry MSR manager told us last week, the rich primary secondary spread (consumer loan coupon minus the MBS debenture rate) ensures that most of pre-2020 MBS vintages will prepay. "We'll see 2.5% loan coupons," the manager continues with considerable amusement. He reckons that 2.5x multiples are reasonable for new MSRs, but worries that holders of legacy product will take losses on soaring prepayments. This view suggests to us that holders of MSRs that lack the ability to generate new assets vs retention are in big trouble. We expect to see lending volumes slow somewhat for the balance of 2020, but we note that the MBS volumes through July put the US mortgage market on a run rate to exceed $3 trillion in production in 2020. 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 Please email info@rcwhalen.com if you have questions. Banking Sector The US banking sector has rebounded since the end of May, but has recently given back some ground as analysts reluctantly start to focus on the fundamentals. Many banks are raising overhead and headcount even as lending volumes and liquidity falls. We look for a general increase in efficiency ratios, meaning less operating leverage, in coming quarters. In June, the Federal Reserve reported that bank lending overall fell by double digits compared with May. Bank liquidity also fell sharply as the deposits created by the open market intervention by the Federal Reserve Board have begun to run off. The cost of funding has fallen sharply since the start of Q2 2020, but we worry that the decrease in asset returns and increase in credit expenses will start to take its toll on investor perceptions. Source: FFIEC The bank group tracked by The IRA is up for the past month, but mostly down double digits for the year so far. Some of the exemplars in the group are shown below with price to book value (P/B) and % change year-to-date (YTD): Source: Bloomberg At present, the financials group is being supported by investor appetite for assets and the fact that the FOMC is purchasing all of the Treasury’s net issuance and a large portion of the agency MBS issuance. We note that bank valuations were significantly higher at the end of 2019. Once worries about earnings and dividends subside, look for bank valuations to rise. The resulting dearth of quality assets is driving liquidity into stocks, even stocks that have weak or no outlooks for earnings. The proliferation of story-company, zero revenue SPACs is a cautionary sign. There seems to be little connection between earnings estimates, which are pretty dreadful for the entire group, and current market valuations and credit spreads. The situation facing many large banks, for example, is rising operating expenses and falling revenue. As a result, we have sold all of our common equity exposure in banks and have increased our preferred holdings . The good news is that the outlook for defaults in areas such as residential mortgages is improving, but there is still precious little visibility on credit expenses for the rest of the banking industry balance sheet. Commercial foreclosures in hospitality and retail assets will be accelerating as the year progresses. As the year moves forward to a close, we expect that institutional investors will continue to hold bank stocks in the hope that they will be positioned to enjoy the inevitable return to pre-2020 valuations. There will be little comfort for investors coming from actual earnings, however. We expect bank earnings to significantly under-perform the Street’s admittedly rosy assessment. JPMorgan (NYSE:JPM) , for example, is estimated to see revenue down single digits in 2020, but the Street still has earnings up in 2021. Bank stock valuations may move higher in the near-term. But common stock dividends are in increasing danger in several cases due to rising credit costs as the industry heads for a significant credit loss event in the fourth quarter of 2020. Then comes 2021, which could actually be worse in terms of absolute dollar loss and also loss given default (LGD). We expect LGD for total loans to turn sharply higher as the year grinds to a finish. Source: FDIC/WGA LLC Bank Group: AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC Please email info@rcwhalen.com if you have questions.

New York | At the end of last week, we featured an update from Michael Whalen about the latest developments in the world of new/old media, specifically television and streaming content. After a week of bank earnings, it seemed like a everybody might need a laugh, at least in relative terms. Like many other industries, in media fragmentation is the order of the day. As we predicted in the Q2 2020 IRA Bank Book , loss provisions for all US banks will be higher this quarter than last. The total level of loan-loss reserves for all US banks is now just shy of $200 billion, still well-short of the peak of $250 billion in 2009-2010. Our guess is that loan loss reserves could reach half a trillion dollars before we are close to the peak for COVID-19, but some in the banking industry are more constructive. Source: FDIC This week in The Institutional Risk Analyst , we are doing a little teach-in on bank loss accounting and earnings. As many of our readers know, when a bank puts aside provisions for future loss, this income is shifted to an off-balance sheet account where reserves, loan losses in the form of charge offs, and credits recognized in terms of recoveries, are reconciled. Let’s use Goldman Sachs (NYSE:GS) as an example. Loan loss reserves were $2.86 billion at the end of March, but jumped to $4.39 billion in Q2 2020, this after the addition of $1.59 billion in provisions in the second quarter. Goldman’s loss rate was 55bp vs an average of 26bp for the 123 banks in Peer Group 1 , which is all depositories above $10 billion in assets. In cash terms, GS had net charge-offs of $225 million in Q1 2020 and $260 million in Q2 2020. By comparison, GS had a $688 million accounting restatement in Q1 2020 that was disclosed to federal regulators. At GS, you see, nothing is extraordinary. Provisions for future losses at Goldman are up sharply, but actual realized losses net of recoveries are not yet elevated. Following the industry trend and guided by internal credit metrics, GS and other banks are likely to continue to build loan loss reserves for the next several quarters, a fact that will depress earnings and also the hopes of a lot of Buy Side managers for a rebound in financials. But it this right? Will the bank credit reserve build continue? The answer to that question will move a lot of money into or out of bank stocks in coming weeks. The calculus depends fundamentally on your view of the economy and in particular corporate credit. In the 2009-2010 period, loan loss reserves for all US banks rose to $250 billion, but actual losses net of recoveries tracked at 20% of that then astounding number. This is why we use the early version of Basle I to measure loss given default or “LGD” for bank loan analysis. It informs your perspective of net loss rates and thus the trajectory of future provisions and thus earnings. Source: FDIC/WGA LLC What does all of this mean? So far, the pace of bank credit loss reserve build in 2020 is larger than in 2009, twice as big to be precise. At the current loss rate, we expect to see the industry consume total operating earnings with credit expense in 2020 and some of 2021 as well. We also expect to see realized losses net of recovery jump sharply higher in Q3 and several quarters thereafter. Banks such as GS, Citigroup (NYSE:C) and JPMorgan (NYSE:JPM) that managed to ride the wave of volatility in Q2 2020 are unlikely to see that extraordinary gain repeated in Q3 2020. The record increase in revenue for Investment Banking and Global Markets at GS, for example, is extraordinary and again illustrates the volatility of the firm’s financial results. Also, the growth in deposits seen at GS depends greatly on whether the Federal Open Market Committee continues to monetize the national debt at the current pace. The Q2 2020 results for GS are shown below. Source: Goldman Sachs Estimating the actual source of the losses coming at banks is more difficult because of the breadth of the COVID-19 disruption and the efforts being used to obscure the actual credit situation facing many debtors. Many issuers, for example, are using financials adjusted for COVID19 losses on the theory that these losses are “extraordinary,” “unusual,” “infrequently occurring” or “non-recurring.” In the age of COVID19, nothing is extraordinary. Bank do not consistently break out provisions by loan category or sector. JPM, to its credit, does provide detail on business line provisions expense. The chart below shows the provisions by business line and particularly shows the big surge in loss provisions for consumer exposures. Source: JPMorgan When people ask us: How bad will it be for the banks? Our short answer is dreadful, yet the scope of the task still remains uncertain. Will loss provision builds be sufficient in Q2 2020? JPM held out the possibility that "worst case" reserve builds may have peaked in Q2 2020. JPM's Chief Financial Officer, Jennifer Piepszak, summed it up nicely: “In addition to the obvious impact on consumer, its protracted downturn is expected to have a much more broad-based impact across wholesale sectors that we’ve seen in the first quarter. Given the increased uncertainty of the macroeconomic outlook, how customer payment behavior will play out and the future of government stimulus and its ultimate effectiveness as it relates to both, consumers and wholesale clients, we've put more meaningful weight on the downside scenario this quarter. And so therefore, we're prepared and have reserved for something worse than the base case. And given CECL covers life of loan, if our assumptions are realized, we wouldn't expect meaningful additional reserve builds going forward.” We are heartened to hear Piepszak’s optimism about the “base case” for credit losses at JPM. JPM CEO Jamie Dimon went further and suggested that an additional $20 billion in reserve build would leave him over-reserved for the base case scenario in the Fed’s latest stress test exercise. But the reality is that nobody in the industry yet knows what will happen with corporate exposures as the year grinds to a conclusion. We suspect strongly that provisions for commercial exposures at JPM and other major banks will be higher than reserves for consumer losses by year end. Piepszak notes in response to a question from John McDonald at Autonomous , the most heavily impacted COVID sectors are “Consumer and retail, oil and gas, real estate, retail and lodging, and sub-sectors, as you think about real estate.” That takes in a lot of the US and global economies. Summer Reading List The Need for a Federal Liquidity Facility for Government Loan Servicing Karan Kaul & Ted Tozer, Urban Institute Prepayments: Ginnie Mae vs. the big banks National Mortgage News Yes, the annual fishing trip to Leen’s Lodge in Grand Lake Stream Maine is on this year for the first week in August. For details, please contact Scott Weeks info@leenslodge.com or (800) 995-3367. David Kotok West Grand Lake (2019)

This week in The Institutional Risk Analyst, Emmy award winning composer and music executive Michael Whalen gives us the update on the slow and steady fragmentation of what we used to call television. Michael called this trend years ago and takes particular relish in describing the latest changes in the industry. By Michael Whalen Making predictions is dangerous and arrogant. Making predictions almost ensures that the future you see will never actually happen, right? I know. Maybe I have had one too many nights in “self-isolation” during this year’s pandemic staring at a huge screen in my living room… But, for those of you who are interested in the future of media here in America and you’re not afraid of outrageous statements — even after three and half years of President Donald Trump  — here comes one more outrageous statement. Prediction: The three “traditional” US television networks ( CBS, ABC, NBC ) will merge their enormous oceans of content to survive in a brutally tough video streaming environment. And, the merger will happen much sooner than you think: my prediction: 3–5 years. Let me be clear: I am not saying CBS, ABC and NBC will merge their companies, but I do believe that they will merge their content to compete in today’s vicious online streaming environment. Let that sink in for a minute… Given the recent launches of “Peacock” (NBC), HBO MAX , Disney+ and yes, YouTube Live into a crowded field of video streamers that include Netflix, Amazon Prime , Apple TV+ , Hulu , Crackle , Sling TV , Crunchy Roll and many others. You might have noticed that we here in the United States have a plethora of “choices” for our video content. Or… do we? Even though it’s (almost) 2021, we as a media culture are still dealing with a huge number of legacy video carriage agreements and licenses left over from the TV and cable days. Because of the bizarre eccentricities of these contracts, we TV streamers must manage and sidestep these prehistoric contracts even though we are “cord cutters”. You’re someone who has “cut the cord” with your cable company, right? No..? “Cord cutting” ( watching television via Internet only ) now accounts for 19.9% of US households in 2020, raising their numbers to a staggering total of 25.3 million. In 2018, there were 90.3 million US households subscribed to (Cable/Satellite) TV, with that number dropping by almost 4 million this year to 86.5 million. Here’s the basic problem: in the cable television era we had ONE place that provided hundreds of channels of content where the copyright issues and residuals were transparent to the masses who surfed channels the offerings of the moment. As of the end of 2019, seventy percent of U.S. households have at least one subscription to a streaming video platform, compared with just 40 percent of U.K. homes. The average American video subscriber watches 3.4 services. For each one, they pay an average $8.53 per month. If you annualize this average, it’s $102.36 a year. This total is less than the cost of most premium cable packages across the United States. The average cable bill in the United States is: $217.42. Now with these new streaming services coming on-line, Americans will be evaluating whether they are getting value for their streaming dollar. These first few years of video streaming demanded much of us early cord cutters. But now, streaming is all the “rage.” Now old fashioned TV networks scramble to be relevant in an environment that feels more like the Wild West of the 1800s rather than the streamlined technology-driven future utopias detailed on TV shows like “Star Trek”. Are Americans getting “value” from their streaming dollars? The answer so far is….. no. Like, really no This “no” response will force copyright holders to make some strange (read: desperate) decisions. Said another way, I won’t pay $9.99/month for the non-ad version of Peacock (NBC) so I can watch episodes of “Saturday Night Live” from 45 years ago. The data is only now starting to dribble in, but Americans have reached their limit with content subscriptions and feeling ripped-off because the video platform they signed up for has very finite amounts of content. Also, the COVID-19 pandemic has Americas very scared as for the first time since the 1980s consumer savings is going up and personal debt is going down. People are very wary of being “nibbled to death” by 10 or more small automatic subscriptions a month for music and video content. If you go to business school, day one they define “value” as: “in the absence of value; price matters.” In this very bizarre and unsettled environment, price matters. This is the impetus that will drive the “big three” to consider merging their catalogs, creating a pool of co-produced content and to do battle with: Apple, YouTube, Netflix and Amazon Prime. Let’s pause for a second and talk about the genius of Amazon Prime: tying a video streaming subscription with free shipping (and other stuff) from the biggest on-line market in the world is very, very smart. Bundling these services masks the sting that would occur if consumers were asked to pay for these items separately. Look to see bundling of services coming very soon from Apple, Google and others. Amazon also only produces a tiny percentage of original content versus the licensed content that they have online. Again, they’ve made a smart decision not to do battle with Netflix in the content wars. They pick their shows and they produce a surprising number of “hits” on their own ecosystem. Creating your own audience ecosystem versus trying to fight the fight of video streaming apps on consumer’s home systems will be THE reason that the TV networks will merge into one streaming platform. Netflix knew early on that if you had compelling content you could keep your audience in your ecosystem, market to them and you were more or less “protected” from the brutal winds of companies trying to create an audience of their own. Sadly, the analysts at UBS just downgraded Netflix stock because of fears of “tough subscriber comparisons”. In English, this means there is a ton of competition and Netflix is losing its grip on its once bulletproof subscriber ecosystem. Again, let me be clear: I am not saying CBS, ABC and NBC will merge their companies. Combining those three cultures, real estate, facilities, union agreements and complex infrastructures would be an Olympian effort. I believe that these three traditional broadcast media companies will merge their content, market it and even co-produce new content to help offset the spiraling cost of high end-television production (read: “Game of Thrones”). Remember that these networks own cable divisions that could contribute even more content. When CBS launched their “All-access” streaming service with every episode of every show they’ve produced they were sure that consumers would be amazed at their choices. It took about a weekend for America to look at their offerings and respond with a shrug and “so what?” For those of you reading carefully, you might ask: “ABC is owned by Disney and why wouldn’t Disney simply put ABC content on their own successfully launched streaming platform?” Consider that ABC is an outdated albatross in the Disney content world which also includes the Marvel franchise, Star Wars, Pixar and others. We are talking about the survival of ABC and Disney isn’t willing to be taken down with that ship. Placing ABC inside the Disney platform would be Disney and ABC surrendering to a not-so-obvious truth of television in 2020: network television content doesn’t age well on streaming platforms and it is very tough to market “older shows” (especially to a younger audience). This is to say nothing of the hidden costs associated with network shows that any producer working on a Netflix show would laugh at: mostly the reliance on only using union talent and production people. There were decades when the intellectual property of the “big three” television networks were some of the most valuable assets in all of entertainment. Those days are long gone. There are some network shows: “Friends”, “Seinfeld” “The Gilmore Girls” and about a dozen others that have aged better than most on streaming platforms. However, all of this is just furthering my argument that “birds of a feather flock together” and these three networks know each other and by and large have similar older audiences. Therefore, having them huddle together to survive a relentless race for audience share and relevance makes sense, right? Maybe my prediction isn’t so “outrageous”? Time will tell if I am right or even partially right. However, the streaming wars are far from over. We are just getting to the really brutal and bloody part of the streaming wars. Stay tuned…

New York | We go into Q2 2020 earnings season with a combination of expectation and dread. On the one hand, we are getting more data on the state of credit inside banks and nonbanks alike, a process of revelation that will make a lot of investors and risk professionals queasy. The discovery process must continue even as many cities remain effectively closed, with plywood covering the windows of businesses. Spray Paint on Plywood, Broadway & Houston Street | 07/12/20 For now, the reversal of progress on COVID19 in many states throws any calculus of two weeks ago regarding future credit losses into the waste bin. The longer the US economy remains in lock-down, the more horrific will be the financial and economic cost. This cost will soar into the tens and hundreds of billions, and will be spread across banks and institutional investors. Tom Michaud , KBW CEO, told CNBC’s “Squawk on the Street” last week he expected to see higher credit loss provisions in Q2 2020 earnings, something we have flagged as an indicator of the degree of comfort inside banks as to the credit outlook for 2020. Michaud also bravely predicted that Q2 would be the worst quarter in terms of big provision numbers, but that actual losses would remain muted in Q2, a point with which The Institutional Risk Analyst concurs. Note that loss rates were already starting to lift in Q1 2020, an unfortunate trend that we can see going hockey stick in the current quarter due to commercial losses. Source: FFIEC In the past couple of weeks, US bank stocks have given up most of the “rebound” from April and May, and are now again in the red for the year – with the notable and ironic example of Deutsche Bank AG (NYSE:DB) , the quintessential example of the too big to fail bank. Despite its latest faux pas regarding transactions for deceased sexual predator Jeffrey Epstein, DB is up 29% this year as of the close on Friday. Morgan Stanley (NYSE:MS), which looked left for dead two months ago, is also up double digits in the past month. The YTD results are less promising for the large bank group. On CNBC's “Fast Money” last week, we opined that there is still a lack of visibility on credit and earnings for financials, except in residential mortgages, where a record year for volumes and profit per loan is in prospect. A heavy calendar of corporate bond issuance, surging residential loan volumes and fees from risk free government loans may be the bright spots for US banks this quarter. Also, kudos to the folks on the Federal Open Market Committee for moderating intervention in the REPO and the mortgage backed securities (MBS) markets last week. GNMA 2.5s for August are off from the June highs, this even as the Treasury benchmarks fell in yield last week due to COVID concerns. We note, however, that the VIX has not been much below 30 for long since March. The flip side of bull markets in residential mortgages is prepayments. The asset shrinkage due to consumer mortgage refinance activity on higher coupon MBS is pronounced and accelerating, which will force the Fed to continue MBS purchases merely to keep the portfolio size stable. But the macro picture of stability remains dependent upon near total monetization of Treasury emissions by the independent central bank. “The biggest question is whether the Fed will continue to buy enough Treasury and MBS paper to fully fund the issuance of US Treasury debt," writes Lee Adler of The Liquidity Trader . “In other words, will the Fed continue to do enough to monetize the entire Federal Debt? So far, the answer is yes. That could change, but it hasn’t yet.” The constant prepayment rate (CPR) for the $1.2 trillion in FNMA 4s were running around 40% in June and speeds on GNMA 3.5% MBS were equally high, accordingly to MIAC . With coupon spreads at 2% and the current MBS coupons headed for 2%, this means consumers can get a 3% mortgage or better. At the present rate of prepayments, on-the-run MBS (which are, in theory, comprised of 30-year mortgages) will basically disappear within a year or so. Properly understood, we think that 30-year mortgages are really 30-day instruments that renew if the home owner/debtor does nothing. The owner of the mortgage note is short a put option, which is given to the debtor at no cost. Is this a great country or what? The wave of prepayments in June and beyond will likely come as bad news for owners of mortgage assets such as REITs and MBS funds that are not able to lend and create new assets at reasonable cost. The June prepayment numbers on MBS were so high, in fact, that the FOMC can expect the system open market account (SOMA) to take some pretty hefty losses on redemption on its MBS holdings, but that is the point is it not? Through its various emergency lending activities, the Federal Reserve is taking direct credit risk in ways never anticipated by Congress but mandated, if you’ll forgive the pun, by circumstances. And as we have said before, the circumstances in terms of credit are quite dreadful. Just as the Fed takes a cash loss on a loan prepayment at par in an MBS, a default on a loan made via any of these emergency credit programs may eventually cause a loss to the central bank. This loss is subtracted from the earnings on the Fed’s portfolio, including the interest earned on MBS and private securities. The Fed is, in fact, operating as a fiscal agency of the US government. Nobody in Congress seems to know or care. Meanwhile across the world in China, the Chinese Communist Party led by dictator Xi Jinping has apparently mandated an economic reflation of huge proportions. This includes a bubble in stocks fueled by higher margin lending, the Financial Times reports. The mandate from on high is that China is recovering, thus all of the proverbial levers of stimulus are being pulled. The renminbi has rebounded to a three-month high, reflecting the strong government intervention that began around the end of June. The iShares China Index (FXI) is ahead of the S&P 500 over the past 30 days and for the year. But the recovery of the real Chinese economy lags far behind the manufactured reality visible in the financial markets. The stampeded of Chinese investors into shares, in many cases using illegal margin loans, is the latest evolution of economic thinking by Beijing, a development that does not exactly instill great confidence about the future. Recall 2015. Securities margin lending is the exclusive business of licensed brokerages, Caixin reminds us. Margin lending is illegal for other institutions or individuals, yet the activity is grows rapidly as available liquidity overwhelms the regulatory constraints. While there are many examples of resurgent financial markets, we remain concerned that the predominant global tendency is and will be deflation, one reason why a number of policy makers believe that additional credit support for the economy will be required in coming months. We agree. Look for a surge of equity issuance in coming months as financials look to maximize liquidity and capital. For Q2 2020 earnings of banks and financials, we can say that the process of data gathering and disclosure will be ongoing and intensive. We are still trying to understand the scope of a problem that is outside of recent experience and the silly media narrative of a “V” shaped recovery. Our friend Professor Edward Kane at Boston College sums up the approaching loss horizon for commercial real estate and related corporate risk exposures: “When payments are not made as due, delinquencies are not immediately registered. Often, the grace period is 60 days. But when grace periods expire, lenders and landlords have only two options: taking possession of the property (or collateral) or easing contract terms. Exercising these options generates uncertainty, takes additional time, and reduces the cash flows that existing contracts and properties can generate going forward.” “In the wake of the indelible economic damage the pandemic is causing, a lasting contracting equilibrium in the real-estate sector requires the rents and mortgage payments implied by pre-existing contracts to be renegotiated sharply downward. The long-lasting effects of the virus on opportunities to travel and work from home will eventually make it clear that the equilibrium value and size of various commercial real-estate holdings have been permanently reduced. The glut of commercial properties (especially hotels and shopping centers) will reduce land values all around. Agreeing to tear down commercial buildings and repurposing the land on which they sit is a time-consuming business. Far from undergoing a V-shaped recovery, travel, real estate and real-estate finance will remain depressed sectors for whatever time the recontracting and loss-allocation processes take.” “Sooner or later, direct and indirect mortgage lenders and tax collectors at every level of government must face the pain of these adjustments. State and local governments are deeply vulnerable. Targeting an increased flow of liquidity from the taxpayer-owned Federal Reserve System to benefit selected firms and investors in the travel, real-estate and state-and-local sector can delay and redistribute some of this pain across the population. But the pain can be postponed for only so long. We should not kid ourselves. It is going to take a good deal of time for the pain to go away.” To Melissa Lee's question last week on CNBC , bank stocks are a value trap for now. Look for markets to sell into the news on earnings for financials as a combination of frightful credit provisions and commensurately low earnings will kill the party that has kept even some blue-chip names well above book value since March end. And remember Lee Adler’s point, namely that we got effective MMT right now through FOMC monetization of the US fiscal deficit. The bank group we track actually closed up mid-single digits on Friday because, stated frankly, the Street wants to own these stocks, plain and simple. JPMorgan (NYSE:JPM) and U.S. Bancorp (NYSE:USB) led the way, but neither of these stocks is especially cheap at 1.3x book or so and given the magnitude of credit losses in prospect. Even as the banks take a licking on their CRE and commercial exposures in coming quarters, look for the nonbank residential mortgage sector to remain buoyant as swelling volumes and earnings contrast with the carnage elsewhere. The impending IPO by Rocket Companies , owner of Quicken Loans, will be cause for joyful fascination by long suffering mortgage folk even if the big media barely cares. The first version of the Rocket Companies S-1 was filed last week. The Street is hoping for a multiple on earnings in the teens or better for the IPO, which is led by Goldman Sachs (NYSE:GS) . In the event Quicken founder Dan Gilbert gets such a rousing reception from investors, the members of the mortgage finance ghetto all will be very pleased indeed. The annual fishing trip to Leen’s Lodge in Grand Lake Stream, Maine, is on this year for the first week in August. For details, please contact Scott Weeks info@leenslodge.com or (800) 995-3367.

New York | The summer of 2020 is all about picking winners and losers in the COVID19 lottery. This is especially of concern since government agencies such as the Federal Open Market Committee and US Treasury get to do the picking, a classic example of crony capitalism in practice. Counting and sizing the winners and losers will inform the macro perspective in the weeks and months ahead. The Treasury just released a list of the largest participants in the PPP program, but the market is no longer the biggest factor in selecting winners and losers. We can recall a decade ago going to see one of the bigger lawyers in the New York commercial real estate community. A young graduate who had worked for a small developer fixing and flipping homes in the Hamptons wanted to get into big time commercial real estate development. He sought guidance. The lawyer viewed his resume and advised the young man to stop seeking a position in development, but rather look for work in restructuring. "We're not doing development any more kid," he advised. "It's about restructuring now." Then as now. Many observers are predicting a November victory for Presidential candidate Joe Biden (D-DE) , a phenomenon strangely similar to the predictions made about Hillary Clinton four years ago. Recall that both democrat candidates were largely invisible, then and now. Meanwhile, the frequently overexposed President Donald Trump is doing the sort of things that incumbent presidents do to win re-election, namely being nice to Teamsters. “The US Treasury department has reached a deal to bail out YRC, a struggling US trucking company, with a $700m loan using funds from the $2.2tn stimulus legislation passed in March,” reports The Financial Times . The loan gives the Treasury a 29% equity stake in YRC, which Treasury Secretary Stephen Mnuchin describes as a key Pentagon vendor. Now YRC is a key vendor for just about everybody, right? And did we mention the loan saves 30,000 jobs including the jobs of 24,000 Teamsters? Moving from the sublime to the tragic, appraiser Miller Samuel says that purchases of co-ops and condos in Manhattan tumbled 54% from a year earlier to 1,357. In a report published last week with brokerage Douglas Elliman Real Estate , Miller Samuel says this was the biggest annual decline since the two firms started keeping the data three decades ago. While the world of high-end Manhattan residential real estate is certainly not looking very promising, the outlook for employment continues to be a big bone of contention. Recent strong gains in jobs have caused some analysts to claim that the headline unemployment rate is at best distorted to show an overly optimistic picture of the labor market, and at worst a downright lie perpetrated by President Trump to manipulate public perceptions. Bryce Gil of First Trust Advisors retorts: “It’s crucial to point out that even though the level of the unemployment rate would have been higher in June, its decline would have been larger. The official rate fell 2.2% in June, from 13.3% to 11.1%. With reclassification, the decline would have been nearly twice as large, falling 4.2% in June, from 16.3% to 12.1%. Given that it's the change in the unemployment rate that matters for financial markets when gauging the strength of the economic recovery, reclassification reinforces the optimistic outlook.” Good news on employment would be really great right about now, but we continue to worry about anecdotal reports that suggest a second wave of job losses impends in 2H 2020 and that this wave could be a significant obstacle to economic recovery. Those parts of the economy that are reopening are not nearly sufficient to provide jobs and livelihood to millions of people who worked in the services sector. And many employers who did protect workers for the past few months are running out of cash. We won't mention the names out of compassion for the losers. Another positive is that corporate bond issuance is likely to hit records in Q2 2020, however, the leverage loan market is headed in the opposite direction. Issuance across the U.S. syndicated loan market plummeted in the second quarter, Thompson Reuters reports, this “as the asset class navigated a slow recovery from the novel coronavirus that left borrowers scrambling for cash to keep their businesses alive while economies around the world gradually reopen.” The chart below shows SIFMA issuance data through May, seemingly affirming the concerns we’ve discussed in past weeks with Ralph Delguidice and others about the damage done to asset-backed securities (ABS) markets. While straight corporate bond issuance is up and mortgage related offerings are also surging to over $300 billion per month, ABS and other issuance is down. Th purple series showing ABS issuance is essentially a zero. Anecdotal reports suggest that corporate bond issuance in June was above May levels. Residential mortgage issuance also hit new volume records, suggesting a record $3 trillion annual run rate for new residential mortgage production in 2020 . Of note, the residential mortgage sector will be a big bright spot in Q2 earnings for some banks and financials, but players such as JPMorgan Chase (NYSE:JPM) may benefit less because the larger banks have stepped back from retail home lending. The latest changes made by Ginnie Mae with respect to loan eligibility (“ The problem with Ginnie Mae's new restrictions ”) may further hurt the appetite of larger banks to finance distressed government-insured loans. Follow-on equity offerings and even convertibles were strong in June, again suggesting that the flow of secondary equity and debt offerings from banks and corporate issuers will continue. A proliferation of IPOs and even special purpose acquisition corps (SPACs) suggests a “V” shaped equity market is forming, but will the economy follow suit? We are a seller of Vs, Us or anything normal in the way of economic bounce, a large seller. Torsten Slok at Deutsche Bank (NYSE:DB) argues that COVID19 peaked two months ago and that the number of news cases continues to fall along with the VIX. He notes, however, that “the speed of progress is slowing.” Slok also observes that despite record corporate bond issuance, dealer inventories of corporate debt remain low. And high yield credit spreads are stable, as shown in the chart below. As we suggest in the National Mortgage News comment above, maybe the Fed can stop buying MBS now? Indeed, while we continue to worry about an increase in unemployment as the credit default process ripples through the corporate world, market indicators are relatively strong – even if earnings are unlikely to meet the challenge. Thus, there is multiple expansion for stocks, but no earnings growth -- or earnings at all. The good news is that the credit markets continue to function. The bad news is that the cost of credit is rising dramatically and is already at highs seen a decade ago. We expect the June data to be horrendous in commercial real estate and corporate credit, but we also note again that credit spreads remain tight and markets are functioning for deals that make sense. Yet the tenor of things is decidedly deflationary. “Is the corporate money now sitting on the sidelines available to stimulate the economy; grow the value of financial assets; or to eliminate debt?” ask Dick Bove of Odeon Capital Group . “If the answer is the last option of the three, this would not be good for either the economy or the financial markets.” We kind of agree with Dick when it comes to the credit situation. We stand at an Irving Fisher moment, when our leaders either take collective action to fight deflation, as we did in the 1930s, or we stand back and watch as “market forces” led by the private equity industry do the work. The candidate that wants to win in November needs to start talking about restructuring and renewal, the twin national priorities that will assert themselves in coming months to the exclusion of aught else. It’s fine to buy time with PPP and other measures, but much of America’s economy needs to be restructured and made productive again. Reauthorizing the Hoover-era Reconstruction Finance Corp with receivership powers and a mandate to work with the Federal Courts and the Federal Deposit Insurance Corp to resolve insolvencies and fund new, restructured companies and banks is the obvious first step. Which of the two candidates, Trump or Biden, will first figure out this looming economic and political reality? Yes, the annual fishing trip to Leen’s Lodge in Grand Lake Stream Maine is on this year for the first week in August. For details, please contact Scott Weeks info@leenslodge.com or (800) 995-3367.