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New York | Last week the Federal Reserve Board made public the annual stress test results, a financial media circus that celebrates the bank stress test popularized by former New York Fed President Timothy Geithner. The Fed essentially confirms what we already know, namely that banks have largely suspended share repurchases and at some institutions are looking at limits on dividend payouts. Banks had been conducting stress scenario analysis since the 1990s, of course, as part of the Basle process. The Geithner stress test of a decade ago was about perception, that is, confidence. It worked and the Fed tests went far to restoring confidence in banks. The subsequent iterations, however, have achieved little measured by clarity on risks taken by banks and the resulting Fed bank supervisory policy. All together share repurchases and common dividends were worth over $300 billion in 2019, but it is likely that many years will pass before investors see such cash returns on capital. To remind one and all what 2007-2015 looked line in terms of earnings, see the chart below. Source: FDIC Indeed, we’d not be surprised to see most of banking industry income in 2020 consumed by credit provisions (as opposed to actual losses). Fed Chairman Jerome Powell said back in April that he saw no need to put limits on bank dividends, but that position is evolving rapidly. Meanwhile, the cacophony of nonsensical double speak from the FOMC drones on and on. Several Fed governors have taken to referring to banks as a “source of strength” to the US economy, a uniquely Neoclassical-Keynesian synthesis. Governor Lael Brainard commented in her dissent to the stress test results : "This is a time for large banks to preserve capital, so they can be a source of strength in a robust recovery." In fact, it is the shareholders of banks that are supposed to be the source of strength to the insured depository institution. In the 19th Century, bank shareholders often had double liability and, upon call, could be required to provide new money equal to their original investment in the bank. Cutting dividends is the modern-day equivalent of double liability bank shares circa 1880, for the simple reason that the Fed dares do no more. But as we've noted before, loss absorption is about earnings more than capital. Recall that much of the loss provisions put aside in 2009 and 2010 were recovered back to income in subsequent years. Ian Katz of CapitalAlpha Parners in Washington writes that the Powell pirouette on bank dividends is not just about share repurchases. “In fact, the more common view among sell-side analysts is that at least one or two banks will cut their dividends, with Wells Fargo (NYSE:WFS) and Capital One (NYSE:COF) the most frequently cited.” Remember, though, that the folks at the Fed are making this up as we go merrily along. In today’s market, we see The Federal Open Market Committee (FOMC) brazenly manipulating market rates as though they could determine the economic outcome. By turning market prices such as federal funds into government targets for policy goals like employment, the central bank's sole effective mandate, the Fed destroyed the ability of markets to correctly price risk. The sad truth is that the Fed is completely reactive at this point, unable to fashion an exit from years of massive open market operations. The greater good, from the FOMC’s perspective, is maintaining the access of the US Treasury to the debt markets. Ludwig von Mises wrote, “Once society abandons free pricing of production goods rational production becomes impossible. Every step that leads away from private ownership of the means of production…is a step away from rational economic activity.” Of course, the Fed should provide guidance on share repurchases and dividends, but banks have already figured this out for themselves. Indeed, banks are going to be issuing new equity for a while and in large quantities. But with the Fed, OCC and FDIC busily issuing regulatory guidance to counteract the impact of the FOMC adding almost $3 trillion to the banking system’s liquidity in mere weeks, the investment situation in the banking market does seem a bit surreal. Think of the spectacle. Banks and corporate issuers are now forced to raise capital at distressed valuations, this after spending much of the past decade repurchasing shares at higher and ever more ridiculous price levels. Investment advisors and analysts must fashion some reasonable explanation of why this is good. Shareholder value will be diluted more and then some more. And who do we thank for this blessing? The FOMC. By manipulating the price of credit, the FOMC set the stage for the dilution of bank shareholders. In fact, last Monday we kicked out our remaining bank common in U.S. Bank (NYSE:USB) and moved higher up the capital structure into some preferred. As we told Melissa Lee & Co on CNBC's Fast Money , we don’t want to get our feet wet. But, of note, USB is still trading above book value as of Friday's close. Just as COVID19 is surging in the South, the credit loss picture facing US banks is also showing signs of monstrous growth. We are already at 2009-2012 levels of delinquency in commercial real estate and the proverbial flood waters are continuing to rise. Intex had delinquencies in commercial mortgage backed securities (CMBS) at 7.5% at the end of May. Try double digits in June easy? In May, the top-ten delinquent CMBS issues totaled $7 billion in loans on retail and hotel properties including Mall of America ($1.3 billion), Courtyard by Marriott Portfolio ($415 million) and Innkeepers Portfolio ($755 million). As we note in the new edition of The IRA Bank Book for Q2 2020: “The chief risk to the system, as it was in the 1990s, comes from commercial real estate and corporate exposures rather than residential mortgages. A sharp decline in rental collections in commercial office space and retail locations is hurting asset valuations. Existential changes in business usage and consumer behavior are likely to impair evaluations for many commercial buildings.” So ask not whether bank dividends are safe, especially with 2009-2012 in mind. The answer to that question is less and less likely. Better instead to think about the mid-1930s, which resulted from a decade of financial boom. A lot of very real losses in coming years will be caused by the period of easy money engineered by the FOMC and the Fed’s staff, magical people who truly think that they control the US economy. The New York Review of Books recalls in a wonderful review of “ The Marginal Revolutionaries: How Austrian Economists Fought the War of Ideas ” by Janek Wasserman: Hayek likewise rejected the idea that society could be planned. He saw the economy as a spontaneous order. In his 1937 essay “Economics and Knowledge,” Hayek argued that central planning was bound to fail because planners lacked necessary objective knowledge. Only the market, which Hayek later called a “subtle communication system,” could solve the problem of resource allocation, since it reflected “the spontaneous interaction of a number of people, each possessing only bits of knowledge.” Happy July 4th holiday. And 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 .

New York | We have released the latest edition of The IRA Bank Book for Q2 2020, which is now for sale in The Institutional Risk Analyst online store . Suffice to say that our estimates for loan loss provisions in Q1 were reasonably close, but still understated the credit tsunami that is approaching US banks and bond investors. To paraphrase the character King Willie in the 1990 Stephen Hopkins film “Predator 2,” Q2 2020 bank earnings will be "dread man, truly dread." The chart below shows asset and equity returns for all US banks through Q1 2020. Take a guess where those two lines are headed in Q2. Source: FDIC First and foremost, we have a credit loss event coming at US banks and bond investors that is of indeterminate size but likely much larger than 2009. Second, we have market risk in the form of collateralized debt obligations (CLOs) and various other structured assets that, at the moment, have rebounded. And third we have counterparty risk to a lot of nonbank funds, REITs and issuers that will be cut back in short order. But as you cut risk, you also cut revenue. While the credit losses hurtling at US banks are bad enough, the liquidity assistance from the Federal Open Market Committee is increasing bank deposits and, thus, assets so rapidly that asset and equity returns are falling. The system open market account (SOMA) is now north of $7 trillion or almost two times the portfolio expansion during QE-1-3, which ended in 2015. Under the regime of Fed Chairman Jay Powell , we no longer refer to massive open market purchases of Treasury, agency and, yes, even private corporate bonds as “quantitative easing” or QE. The Fed has not come up with a new moniker for this activity as of yet. We propose QE*, indicating an unknown quantity of intervention but also a factor closely related to Treasury debt issuance. But by forcing liquidity into the system, the Powell FOMC now also has added trillions of dollars to the banking system. And this liquidity cannot be withdrawn. For those that worry about future inflation in the age of QE*, ponder the fact that the Fed’s balance sheet is unlikely to fall much below current levels ever again -- at least so long as the Treasury is running massive fiscal deficits. The two agencies -- the Federal Reserve System and the US Treasury are inextricably tied together. The truth of QE is that you cannot go back. Hopefully we learned this lesson in December 2018 and September 2019. The addition of liquidity and its impact on banks and investors, is permanent. And this means that the FOMC must continue to buy and to thereby monetize trillions of dollars per year in US Treasury debt in order to ensure that liquidity does not run out of the market a la December 2018 and September 2019. QE forever. And future bank earnings will be depressed for years to come as a result. Source: FDIC/WGA LLC Unfortunately, financial repression may be great for the US Treasury, but it is really bad for banks and private investors. Yes, massive gushes of liquidity help to push up stock prices for a time, but how do you suppose markets will react when they discover that most or all of bank operating income in Q2 is going to be consumed by credit costs? Even the inflationary impact of QE* may not be sufficient to float money-losing bank stocks.

New York | Jay Powell made his first major misstep as Federal Reserve Board Chairman by allowing the central bank to start buying corporate debt . Using the canard of following an index of investment grade debt to guide the purchases does not make the error any less egregious. Buying the existing debt of an issuer is unlikely to change investor perceptions or the effective cost of capital, and creates risk for the Fed. While buying Treasury bonds and mortgage back securities has a broad effect on the markets and credit spreads, purchases of corporate debt is a very focused subsidy with little promise of helping the economy or the specific issuers. Whether we talk of the Fed buying ETFs or corporate bonds, what is the policy justification of this activity ? As our friend David Kotok at Cumberland Advisors reminded us last night, "fishing is not catching." Indeed, since we are likely to see record bond issuance in Q2 2020, we think it is appropriate to ask what the FOMC thinks it is achieving? Note the chart below from FRED shows corporate credit debt spreads back to the early 1990s. Looking at 2008 vs today, what's the problem Chairman Powell?? Last week our friend Frank Partnoy published a prescient piece in The Atlantic (“ The Looming Bank Collapse ”). This article caused some considerable consternation in Washington, particularly among members of the Financial Stability Oversight Counsel. A recognized expert in asset backed securities who teaches law at UC Berkley , Partnoy boldly predicted the failures of large banks due to accumulating defaults inside collateralized debt obligations or “CLOs,” the latest flavor of poison distilled by the major Wall Street firms. Partnoy argues with considerable authority that impending defaults of sub-investment grade debt (aka “crap”) that typically comprises CLOs will be so widespread that investors will lose money even on the “AAA” rated tranches of these deals. Banks hold a great deal of direct and indirect exposure to this supposedly “high investment grade” rated debt. Partnoy writes: “It is a distasteful fact that the present situation is so dire in part because the banks fell right back into bad behavior after the last crash—taking too many risks, hiding debt in complex instruments and off-balance-sheet entities, and generally exploiting loopholes in laws intended to rein in their greed. Sparing them for a second time this century will be that much harder.” Wall Street reacted to the Partnoy article by pointing out that CLOs performed quite well a decade ago and that current default rates are low. One bank research department prominently opined: “Currently, the U.S. CLO market is roughly $700 billion; U.S. bank CLO holdings are roughly $115 billion. Per public filings, roughly 80% of U.S. bank CLO exposure is held by 3 large banks, representing 1-2% of each respective bank’s total assets.” But of course, this time it’s different. We recall similar arguments made about collateralized debt obligations (CDOs) a decade ago. Then the crisis was about crap securities based upon residential mortgages. This time around, the proverbial surprise is hidden in the world of corporate debt and related commercial real estate exposures. Ralph Delguidice of Pavilion Global Markets reminds us of a little history: "One reason leveraged loans performed relatively well in the 2008 cycle was the significantly higher level of investor protection in the deals, as banks usually retained the loans on balance sheet. As demand has surged, CLOs have come to comprise more than half of the $1.7 trillion syndicated loan market through 2019. However, this demand has driven a significant erosion in loan quality, as ‘Covenant-lite’ and ‘loan-only’ structures (with no debt beneath the deal) have proliferated widely since the end of the GFC." We think the worst-case scenario painted by Portnoy is unlikely to occur, but it cannot be dismissed. When the FOMC has Black Rock (NYSE:BLK) buying corporate debt, what surprises remain?? The quality of the collateral under many CLOs is true crap, even compared to a decade ago. That's why Portnoy's complaint did indeed twist some sweat soaked nappies at the Fed and Treasury into a knot at the end of last week. Corporate bond defaults in 2020 and beyond will be far worse than 2009. The Fed thinks that they need to “do something” in response, specially since they, like The Institutional Risk Analyst , know or at least suspect that we are in the early innings of a profound credit crisis. The chart below shows actual Q1 credit loss provisions for US banks and our updated estimate for Q2 2020. Source: FDIC, WGA LLC While bank loan default rates in most asset classes actually fell at the end of Q1 2020, net charge-offs for commercial and industrial loans doubled. Note that the polynomial trend line blasted through the two actual series for income and provisions, never a good sign when the future trend is down. We expect credit costs to essentially consume all of bank operating income in Q2 and through 2020, making US bank earnings for the industry through the year likely to be a zero or less. We’ll be discussing the outlook for US banks further in the Q2 2020 edition of The IRA Bank Book , which will be released for sale to registered users of The Institutional Risk Analyst on Monday. Sadly, however, the FOMC and the Federal Reserve System are uniquely ill-equipped to deal with problems of solvency as opposed to liquidity. While the Treasury and Federal Reserve have taken on a good deal of principal risk through the Main Street lending program, we view these extensions of credit more as grants than loans. Our pal Nom de Plumber outlines the situation very nicely from his vantage point inside the risk engine of Wall Street: “In a Main Street loan, the private lender holds the IO (interest-only strip) while the Fed (taxpayers, once you pull away the velvet curtain) is the holder of the PO (principal-only strip) with all of the attendant risk. Net of origination fees, the private lender will have essentially only ~ 4% of the loan amount at stake initially. The lender is permitted to charge a 1% origination fee and also gets 25 basis points annually as a servicing fee. The Fed bears practically all the net economic exposure of the Main Street program, especially in terms of extension risk and default loss risk. Meanwhile, the lender collects fees over time, realizing that it retains little or no net principal downside upon any eventual default loss.” As the Fed slips more and more into a de facto fiscal role a la the European Central Bank or even the Bank of China , the positioning of its actions grows ever more tenuous. Appearing before the Senate Banking Committee to deliver the Fed’s perfunctory semi-annual report to Congress, Powell said the Fed is not increases purchases through its an emergency lending program that, to date, has bought only exchange-traded funds. “We’re not actually increasing the dollar volume of things we’re buying,” he happily reported on Tuesday. “We’re just shifting away from ETFs to this other form of index.” Please. But whether we are buying ETFs or corporate bonds, the question remains as to the efficacy of this policy choice by the FOMC. No amount of open market bond purchases can fix the credit problems of the underlying issuers. Indeed, if the Fed holds these positions for any length of time, the central bank is likely to take a financial loss and become a creditor in private bankruptcies. Bad optics. Not only is the Fed's bond purchase program of questionable utility, but it creates political risk for Chairman Powell and the Federal Reserve System. As we’ll discuss in our next issue, the real risk facing the financial markets and the US economy is that credit spreads are narrowing and equity market valuations measured by P/E ratios are rising, but earnings are falling and expenses are rising fast. Question from Ralph: Can the arbitrage that created CLOs in the first place survive? If not, then Wall Street has a hole in earnings that will rival the hole caused by credit losses. At the moment, the decline of net operating income is due to rapidly rising credit expenses. But by the end of 2020, however, we expect to see earnings declines caused by a lack of new business volumes on and off Wall Street. That is, a decline in revenue even as credit costs remain elevated. Buckle up kiddies.

New York | Last week saw news reports that Quicken Loans is considering an IPO, an exciting prospect for the mortgage sector where private ownership and Buy Side sponsorship tend to be the rules. Leslie Picker at CNBC broke the story Thursday and says Goldman Sachs (NYSE:GS) , Morgan Stanley (NYSE:MS) , Credit Suisse (NYSE:CS) and JPMorgan (NYSE:JPM) are managing the deal, according to the cable business news network. As we told Robert Armstrong at The Financial Times , there are several other players in the top ten nonbank seller/servicers that could access the public equity market – particularly now that the Federal Open Market Committee has guaranteed a bull market in residential mortgages for the next several years. Raising equity capital is always a good thing, especially when the profit margins for lenders are the best in a decade and likely to continue. But the key aspect of public ownership that can truly bring big benefits to nonbanks is the ability to build an investor base for both debt and equity. By raising term debt funding, nonbanks can diversify their capital structure and add stability to their liquidity profile, even if the yield spreads over risk-free assets are wide in comparison to depositories. You see, nonbanks like Quicken are more efficient than depositories, a lot more. This is one reason why members of the Financial Stability Oversight Council hate them so. Treasury Secretary Stephen Mnuchin is said to have a special dislike for nonbank lenders and reportedly hopes to see a small servicer fail this year. Remember, nonbanks make loans and service loans, especially gnarly distressed loans. Big banks buy loans and write loans off. Big difference. As the largest and most efficient nonbank lender in the market, Quicken is said to seek a technology valuation for its business in the tens of billions of dollars. This type of valuation is justified and reflects the huge capital investment that has made the company the biggest nonbank lender by volume and also one of the best regarded companies in terms of consumer satisfaction and overall reputation. In any consumer facing business, reputation is the key measure of “capital.” One of the better operators in the residential mortgage sector says that Quicken going public at a healthy double-digit earnings multiple will open the door to other issuers. Of course, the best valued stocks in the mortgage sector are the data and software vendors, led by Black Knight Inc (NYSE: BKI) and Core Logic (NASDAQ:CLGX) . BKI closed Friday at 5x book and on a 77 price/earnings ratio. The first mortgage lender in our comp universe is First American Financial (NYSE:FAF), the $6.1 billion revenue lender based in Santa Anna, CA. At 1.2x book and an 8.5 P/E, FAF is up 25% in the past 30 days and is a consistent performer in a highly volatile industry. Industry benchmark PennyMac Mortgage Trust (NYSE:PMT) , an externally managed REIT (aka “the balance sheet”), closed just above book value on Friday but with no current P/E, a common problem in the sector due to Q1 losses. PMT is up 77% in the past 30 days, BTW, but remains down for the last 52 weeks. PennyMac Financial Services (NASDAQ:PFSI) , which manages PMT, closed Friday at 1.2x book on a 4 P/E. PFSI is up 80% in the past 12 months and +31% in the past month. As we’ve noted previously, the owners of mortgage servicing assets such as PMT and New Residential (NYSE:NRZ) , a REIT managed by Fortress Investment Group (FIG) , took substantial losses in Q1 2020. As with PMT and PFSI, FIG declaims control of NRZ, but the economic and management links suggest otherwise. Both PMT and NRZ, in fact, puked actual and mark-to-market losses equal to 20% of managed assets in Q1. And FIG, lest we forget, is owned by none other than Softbank and Masayoshi Son , the Korean-Japanese billionaire, technology entrepreneur and investment huckster. And, as we predicted a while back, FIG and friends did come to the rescue of NRZ . As the FOMC’s massive acquisition of assets has finally calmed market volatility, mark-to-market losses should be far less in Q2 2020. What these metrics should hopefully suggest to our readers, however, is that equity valuations for nonbank mortgage stocks have snapped back far more quickly than earnings for the owners of loans and other exposures. The good news is that the mortgage sector is making money hand over fist because of the wide primary-secondary market spreads. The bad news is that owners of mortgages and servicing like NRZ are in a world of pain, an unfortunate circumstance that is likely to continue due to torrid loan prepayment rates. Unless you are really good at lending and, in particular, recapturing refinance opportunities from your owned portfolio, you are likely to see those mortgage servicing assets literally evaporate in coming months as duration of higher coupon MBS collapses. Indeed, prepayment rates are so high that we hear that the FHA and GNMA are thinking about prohibiting early buyouts of defaulted government loans. Bad idea. More on this in a future comment. Comments by Federal Reserve Board Chairman Jay Powell that the FOMC is not even thinking about thinking about raising interest rates basically tells you what you need to know about mortgage volumes for the next three years. But that's not the whole story. The fact that the big warehouse lenders have throttled back on production of low-FICO loans ensures that late vintage government servicing assets will have the potential to significantly outperform current modeled returns for last year's GNMA 3.5% and 4% coupons. The good news and the reason that Quicken and other private issuers may try to go public in the next couple of years is that the decline in interest rates is creating a huge opportunity for the industry. And the related increase in mortgage loan prepayments is essentially funding a good bit of the liquidity needed to deal with forbearance under the CARES Act. Even in the worst-case scenario presented to Urban Institute by Moody’s on June 3rd, the industry does not even break a sweat on liquidity due to prepayment float. The moral of the story is that while the commercial real estate sector is a slow-motion train wreck, the residential mortgage sector is humming along quite nicely. Indeed, one lender told The IRA last week that he’d pay 15% for incremental capital today because the prospective gain on sale opportunity is so rich and volumes are straining existing bank lines. See chart below. Since most of the larger lenders led by JP Morgan have imposed a 700 FICO floor on warehouse lines, lower income borrowers who normally would access the government market via the FHA are essentially SOL. Perhaps that’s what Federal Housing Finance Agency Director Mark Calabria meant when he told Housing Wire that it would be harder to get a loan in the future. In addition, we hear that conventional lenders are taking dry loans directly to the cash windows operated by Fannie Mae (BB:FNMA) and Freddie Mac (BB:FMCC) , this rather than take the risk of another policy curve from the FHFA while a pool is in gestation. In a world where FHFA Director Calabria can hold press conferences at any moment, time is risk. Suffice to say that if you look across the world of gestational finance among the major dealers, there is little or no conventional collateral apparent on repo facilities. Call this behavioral change on the part of investors and dealers the result of “policy risk” c/o Director Calabria. While lenders are a little constrained in terms of funding, this only means that the current bull market in both government and conventional loans is likely to continue for several years. Better loans are being selected for pooling because of tightness in bank funding for government insured loans, yet volumes continue to grow. Indeed, the strong gravitational pull of low rates – now sub-three percent for consumers – will also reflate the non-QM sector far more quickly than Director Calabria and others who pronounced the death of non-agency loans in April. Just imagine what will happen to conventional loan volumes as and when the banks start to loosen up on warehouse lending rules regarding FICO, loiter time and other credit criteria. But in the meantime, the larger, more efficient lenders such as Quicken, Amerihome (a unit of Apollo subsidiary Athene (NYSE:ATH) , Mr. Cooper (NASDAQ:COOP) , Freedom Mortgage and Caliber Home Loans are making a lot of new loans and creating some very interesting mortgage servicing assets in the process. It is no small irony to say that the low interest rate environment put in place by the Fed to deal with COVID19 is also creating a boom in residential mortgage originations on a scale comparable to the early 2000s that could see the sector significantly recapitalized in coming months. We believe that Quicken will pave the way for a series of IPOs and acquisitions. Indeed, as and when the Quicken S-1 is dropped, we fully expect to see some private acquisition offers emerge.

In this issue of The Institutional Risk Analyst, we feature a June 9, 2020 comment by Robert Eisenbeis , Vice Chairman & Chief Monetary Economist at Cumberland Advisors in Sarasota, about the latest employment data. Bob was formerly Executive Vice-President and Director of Research at the Federal Reserve Bank of Atlanta . On Friday, the Dow bounced over 750 points, reacting to the May employment report. In truth, it seems that participants never read beyond the first sentence, which stated: “Total nonfarm payroll employment rose by 2.5 million in May (private sector employment increased 3.1 million while government employment declined by 585 thousand) and the unemployment rate declined to 13.3%....” This report was truly a surprise, especially to economists who predicted the unemployment rate to hit 20% and the economy to lose another 8.5 million jobs . That’s a big miss, to say the least. Digging deeper, there were clearly some other positives in the report besides the headline numbers, especially in the Establishment Survey, which looks at where the jobs were created. On a seasonally adjusted basis, 22% of the jobs (669K) were created in the goods-producing sector, the bulk of which were in construction. But a whopping 78% of the jobs were created in the service sector, with the leisure and hospitality segment, which had been hard hit by the pandemic, adding 1.239 million jobs. Other gains were reported in retail (367K) and in education and health services (427K), while government employment declined by 487K. Additionally, average hours worked increased slightly, as did average weekly earnings. The picture was not so optimistic when it comes to who was and was not employed. While the overall reported unemployment rate declined from 14.1% to 13.3%, the unemployment rate for black Americans increased from 16.7% to 16.8% and increased for Asian Americans from 14.5% to 15.0%, but declined for Hispanics and Latinos from 18.9% to 17.6%, a rate that exceeds that for black Americans in particular. Digging even deeper, our chairman, David Kotok , pointed out some interesting and sobering information at the very bottom of the report about the impact of COVID-19 on employment data collection and possible implications for the confidence intervals surrounding the numbers. In particular, the report notes that because of the virus, adjustments had to be made that reduced the survey response rates, which were 69% for the establishment survey, below its historical average, and 67% for the household survey, 15 percentage points below its pre-pandemic rate, implying an increase in the confidence intervals. To illustrate, the average reported monthly job creation from the establishment survey from January 2019 through February 2020 was 185.6K, with a 90% confidence interval of plus or minus 110K. In other words, a reported number of 185.6 could be as large as 295.6K or as small as 75.6K. If comparable intervals were applied to the reported 2.5 million new jobs for May, then the actual number could be as large as 4.25 million or as small as 750K. Similarly, the 95% confidence interval for the reported unemployment rate before the pandemic was plus or minus 0.2 percentage points. The report states, however, that furloughed workers were considered to be unemployed. At the same time, the large number of workers who were classified as employed but absent from work were probably misclassified. If these people had also been considered unemployed, as the furloughed workers were, then the reported unemployment rate would have been 16.3% for May and 19.3 percent for April, close to the 20% that economists had predicted. The bottom line is that digging deeper reveals that the employment situation may not be as rosy as the headline numbers suggest, due to reporting and classification errors that reduce the confidence one can have in the reported numbers. In other words, it is risky to put too much weight on a single data point when the confidence intervals are large (and likely to be even larger than history has suggested) when we are in unsettled times.

"You pass the Helmsley Palace, the shell of old New York transparently veiling the hideous erection of a real estate baron..." Jay MacInerney Bright Lights, Big City (1984) New York | So how big is the impending commercial real estate bust in the US? Bigger than the residential mortgage bust of the 2000s and also bigger than the commercial real estate wipeout of the 1990s, including the aftermath of the Texas oil boom of the late 1970s and 1980s. Commercial real estate as a mortgage asset class is half the size of the $11.5 trillion market for residential homes, but the losses this cycle could be far larger per dollar of assets. That’s big. Both markets are fundamentally affected by interest rates above all. The US has not experienced a really nasty deflation in commercial real estate prices since the 1990s and, before that, the bust in the Texas oil patch in the late-1970s. Abby Livingston told the story of Houston during the oil bust in The Texas Tribune last month (“ All of the party was over": How the last oil bust changed Texas ”): “Real estate soon emerged as the most noteworthy outlet for Texas money. With growth in commerce and in population, it seemed quite logical at the time to invest big in new housing developments, soaring skyscrapers in Dallas and Houston, shopping centers, and vacation condominiums on South Padre Island.” Last week, the Financial Times reported that Chesapeake Energy Corporation (NYSE:CHK) , the pioneer of shale oil created by Aubrey McClendon , is on the brink of bankruptcy. This not only signals the end of the US oil boom, but another surge in real estate speculation in the areas affected. From the New York border southwest along the Appalachian Mountains to Texas and as far west as California, shale exploration and production financed a period of giddy real estate investment that is now suddenly ended. Equity REITs own more than $2 trillion of physical real estate assets in the U.S. including more than 200,000 properties in all 50 states and the District of Columbia, NAREIT reports. The equity REITs, as the name suggests, are generally funded with equity rather than debt, but individual assets are routinely encumbered with mortgages to increase returns. The latest Mortgage Bankers Association survey shows that commercial banks continue to hold the largest share (39 percent) of commercial/multifamily mortgages at $1.4 trillion. Agency and GSE portfolios and MBS are the second largest holders of commercial/multifamily mortgages, at $744 billion (20 percent of the total). Life insurance companies hold $561 billion (15 percent), and CMBS, CDO and other ABS issues hold $504 billion (14 percent). The chart below shows the equity REITs and the various classes of commercial mortgage lenders and investors. Source: NAREIT, MBA, FDIC This particular bust in commercial property is very different from the 1990s, but in common with that era also includes a large energy component. The difference is that, due to COVID19 and the more recent looting in major cities, the valuation of once solid urban commercial and residential properties held by equity REITs is now very in much question. The fact of the COVID19 lockdown, the riots and looting following the killing of George Floyd by the Minneapolis Police, and the coincident rise of telecommuting, which keeps people away from the large metros, raises questions about the entire economic structure of cities. So long as social distancing is required or even the preferred option, many of the institutions and structures within the big cities no longer function. Connor Dougherty and Peter Eavis reported in The New York Times on Friday: "Faced with plunging sales that have already led to tens of millions of layoffs, companies are trying to renegotiate their office and retail leases — and in some cases refusing to pay — in hopes of lowering their overhead and surviving the worst economic downturn since the Great Depression. This has given rise to fierce negotiations with building owners, who are trying to hold the line on rents for fear that rising vacancies and falling revenues could threaten their own survival." And the operative term is survival. Add the Shale oil bust to the already precarious state of the commercial real estate market in major metros and the image becomes truly catastrophic. In 1981, oil peaked at $31.77 per barrel, at the time an unheard-of valuation for black gold. The FDIC tells the tale in their excellent History of the Eighties : “The bottom hit in 1986. Oil was priced at $12.51, still high compared with 15 years before. But historical context was no help to oil producers who plunged deep into debt buying up rigs amid the frenzy to meet anticipated demand. The economic angel of death for oilmen came in the form of bankers calling in loans.” The 1980s were a tough time in Texas as politicians and business leaders were forced to liquidate business and their personal possessions to pay debts. Much like the shale oil industry today, the domestic oil industry was forced to adjust to changes in oil prices that made these assets uneconomic. But the wider speculative bubble in commercial real estate reached all around the nation. The FDIC continues: “When the bust did arrive in the late 1980s and continued into the early 1990s, the banking industry recorded heavy losses, many banks failed, and the bank insurance fund suffered accordingly. Compounding the magnitude of these losses was the fact that many banking organizations active in real estate lending had weakened their underwriting standards on commercial loan contracts during the 1980s.” Sound familiar? Source: FDIC The troubles in the oil patch were only part of the economic disaster of the 1980s and early 1990s. The collapse of the residential mortgage market and the S&L industry put home prices into a deep freeze for much of a decade. But the 1980s were also a very difficult time for commercial real estate and a number of major US cities, which had been abandoned by affluent households fleeing the violence and chaos of the inner cities. After a catastrophic fiscal crisis in New York during the 1970s, followed by the famous blackout and rampant acts of arson, the cities saw mass abandonment of commercial properties, leaving many inner cities derelict. The famous 1977 New York City blackout and subsequent riots destroyed parts of the city and saw public services cut to the bone. Whereas the nadir of the riots and burning of 1977 in New York marked a starting point for the rebirth of the city decades later, today New York City stands on the edge of the abyss. Changes in social behavior threaten decades of real estate investments in the highest cost market in the US. Yet the overtly left media led by The New York Times , the impending collapse of the urban economy in New York is cause for celebration . What is similar to the 1990s and before was the role of the Federal Open Market Committee in encouraging the financial excesses in commercial lending as part of a broader policy of asset reflation. In the 1970s and 1980s, banks piled into a new asset class known as real estate is a desperate effort to offset losses on loans to Third World nations. Then Fed Chairman Paul Volcker refused to allow US banks to write down bad loans to Argentina and other debtor nations until he left office in August 1987, but the workout of bad commercial loans continued for years to come. The Fed’s aggressive reflation strategy in the 1980s worked, only too well, causing the banks to inflate a vast bubble in commercial real estate that deflated through the 1990s. Since 2008, low or zero interest rates have again caused an even bigger bubble in commercial real estate assets, a gold rush that drove net loss rates negative as loan-to-value ratios plummeted. Now with asset prices in a free fall, LTVs are rising and we expect to see net loss rates on commercial exposures solidly in the red this quarter. Get used to it. Source: FDIC/WGA LLC The Scope of the Damage The state of the equity REITs casts a pall over the rest of the $5.2 trillion commercial mortgage segment. Once seen as top commercial credits, these equity REITs now face an enormous change in how businesses and consumers view urban commercial office and multifamily residential assets. As usage falls, so too do valuations and tax revenues for the localities. Projects that a year ago might have made sense as long-term bets on the future of cities like New York have no economic rationale today. And the loans and mortgage bonds that support these buildings no longer make any financial sense. Ponder all of the commercial buildings in New York and other major metros that depend upon tourism, hospitality and entertainment for their economic life. Without these features, there is no reason to be in these metro areas. The cardinal rule of landlords is that the most important thing is to be aware of your tenants, their needs and their financial situation. When your tenants just get up and leave, however, defaulting on leases and filing bankruptcy, the economic model for rental buildings and condominiums falls apart. Part of the difficulty of estimating loss rates for commercial properties is that every property is different, every loan is different, sometimes in very significant ways. Whereas you can generalize about residential assets at the portfolio level, with commercial loans the analysis is asset-by-asset, loan-by-loan. Commercial real estate brokerage CBRE says hopefully that “The real estate recovery will lag the economic recovery, with multifamily and industrial recovering first, followed by office and retail.” But the reality at the loan levels suggests otherwise. Consider an example: “WFCM 2013-LC12” or the Wells Fargo Commercial Mortgage Trust , a CMBS issued in 2013 with a combination of hotel and retail use commercial properties. Back in 2017, Fitch Ratings noted that the deal “has exhibited relatively stable performance since issuance” and reaffirmed the ratings . But things change. More recently, Kroll Bond Ratings downgraded several tranches of the CMBS because of likely losses from the foreclosure of Rimrock Mall , among other factors. KBRA writes: “As of the May 2020 remittance period, there are two REO assets (1.3%) and one loan in foreclosure (0.4%). In addition, there are 16 loans (24.9%) that appear on the master servicer's watchlist, including four loans (2.1%) that are 30 days delinquent. The REO assets, the loan in foreclosure, 10 watchlist loans (11.6%), and three other loans (13.6%) have been identified as KBRA Loans of Concern (K-LOCs). K-LOCs consist of specially serviced and REO assets as well as non-specially serviced loans in default or at heightened risk of default in the near term.” KBRA continues: “Excluding K-LOCs with losses, the transaction’s weighted average (WA) KBRA Loan-to-Value (KLTV) of 91.6% has increased from 87.7% at last review and decreased from 99.2% at securitization. The KBRA Debt Service Coverage (KDSC) of 1.67x has decreased from 1.76x at last review and 1.69x at securitization." So, the good loans, excluding the likely losses and doubtful assets, have an LTV over 90%. The equity in many of the remaining properties may already be gone depending upon the location and utilization levels. Bank owned CRE, by comparison, tend to have initial LTVs closer to 50, but those assets may also have seen significant erosion in the equity and thus an increase in effective LTV. And by no coincidence, the prices for WFCM 2013-LC12 have suffered since the start of 2020. The most junior D tranche of this CMBS was trading in the mid-90s after the start of the year, but then suffered several downgrades and resultant drops in price. Today the Ds trade below 70 or about 1,600bp over the curve. If you are lucky enough to hold the bonds, you get the idea. The As are flopping around below par or plus 180bp over the curve after touching 98 in mid-March. So how big will the commercial real estate bust be in 2020-21 and beyond? In 1991, the FDIC reports, “the proportion of commercial real estate loans that were nonperforming or foreclosed stood at 8.2 percent, and in the following year net charge-offs for commercial real estate loans peaked at 2.1 percent.” In 1991, the net charge off rate for all $1.6 trillion in bank owned real estate loans was less than 0.5% Multifamily mortgage loans peaked in Q4 of 1991 around 1.5% of net charge offs but remained elevated until 1996. But this time is different. Based on our informal survey of REIT valuations and individual assets, we think that the world has been turned upside down for many investors. Actual LTVs for urban commercial and luxury residential assets in many metros are well-over 100 and are likely to be restructured, albeit over a period of years. As we noted last week, it's all about buying time. We think that net charge offs on commercial loans could rise to 2-3x the peaks of the 1990s, with loss rates at 100% percent or more in some cases, and remain elevated for years to come as the workout process proceeds. Failing some miraculous economic rebound in the major metros, look for credit costs related to commercial real estate to climb for REITs, CMBS investors, the GSEs, and banks in that order of severity. Figure a 10% loss spread across $5 trillion in AUM over five years? If you have questions about a specific situation, please contact us at info@rcwhalen.com

New York | Financial markets continue to predict a better economic recovery than is widely anticipated when speaking to business leaders. With the notable exception of residential mortgage lenders, who are having a bumper year amidst the general economic carnage, most other parts of the economy remain disrupted and visibility on the financial cost of this huge dip in national wealth is limited. We note that Amazon (NASDAQ:AMZN) just raised $10 billion at crazy low rates. “The company raised $10bn in an offering that included three-year notes carrying an interest rate of just 0.4 per cent,” reports the Financial Times , quoting nameless sources. But low interest rates aside, Barry Diller got it right on CNBC this AM when he said that “tremendous economic damage” has been done. Meanwhile financials continued to move higher on hope of a quick economic rebound, but based upon little data. H/T to our Twitter pals for pointing out that the federal regulators have given banks an additional 30 days to file Q1 financials, yet public companies will be reporting earnings on time to the SEC. What gives? Most of the US banks have already filed electronically with the Fed, OCC and FDIC, so what is the justification for this delay? No matter. Stocks climb walls of worry and don’t need inconvenient details like data to distract from the great work. We note that IRA Dead Pool founding member Deutsche Bank AG (NYSE:DB) is up 21% YOY just shy of $9.50, truly a remarkable and perhaps also troubling sign of the market froth. The dearest valuation for a US bank still goes to American Express (NYSE:AXP) , at four times book value by far the segment leader. Next comes Charles Schwab (NASDAQ:SCHW) at 2.3x book and First Republic Corp (NYSE:FRC) a bit over 2x , which is also up for the year as of yesterday’s close. We bought some share of agency REIT Annaly (NYSE:NLY) and more Citigroup (NYSE:C) TRUPS over the past several days. As good as things feel at present, we are still 30 days from Q2 2020 earnings and there remain an enormous number of unknowns in the world of banking and finance. For example, we continue to learn new and interesting details about the busted, state-owned aviation company known as HNA , which for a time pretended to be the largest investor in Deutsche Bank. A unit of China’s HNA Group reportedly failed to repay $750 million owed from its buyout four years ago of a US technology distributor Ingram Micro . In an announcement to the Shanghai stock exchange last month, HNA Technology Co Ltd reportedly stated that the missed repayment was on a $4 billion loan secured from lender Agricultural Bank of China in 2016 to finance the group’s $6 billion buyout of Ingram Micro. Meanwhile U.S. Secretary of State Mike Pompeo Thursday warned American investors against fraudulent accounting practices at China-based companies, Reuters reports . Pompeo said the Nasdaq’s recent decision to tighten listing rules for such players should be “a model” for all other exchanges around the world. Ditto. Follow the rules or get out of the US market. President Donald Trump is no doubt delighted to learn that US employers added 2.5 million jobs in May, a clear sign that the demand side of the economy is still quite strong. But we continue to see signs that the credit cost of the disruption in public activities and institutions is going to be vast and bigger than the 2009 default peak. The fact that employment fell in May suggests to us that the credit picture, while still decidedly murky in commercial real estate and corporate credit, is improving on the consumer side, a nice surprise from a decade ago. That roaring noise you can hear in the distance is the residential mortgage sector having another record month of originations. Indeed, we offer as proof of the existence of a loving and merciful creator the fact that Impac Mortgage Holdings (NYSE:IMH) has returned from the near-dead and is again originating government and conventional loans, National Mortgage News reports. “Impac Mortgage Holdings has resumed originating mortgages, but at this point will not be offering the non-qualified loan products it had previously focused on,” writes Brad Finkelstein . Credit score limits imposed by lender banks led by JPMorgan Chase (NYSE:JPM) are choking off government lending to lower income households and, for now at least, pushing production back into the conventional loan market. This means that credit quality of current vintages should be even better than recent years. Meanwhile, everything else in the world of residential and small balance commercial mortgages is a cash only bid. Homes above $1 million are facing a bank-only market with little or no liquidity. We keep hearing about issuers such as FRC coming to market with single production jumbo offerings. Stay tuned. Look for banks to continue to climb higher as investors cannot help but be impressed by a steepening yield curve. But remember that this time is very different from 2009 and credit losses at some banks, REITs, BDCs and funds with CRE and leverage loan exposures could be quite a bit larger than in 2009. Look for financials to “extend and pretend” on a lot of poor credits in Q2 2020, but by Q4 we will be nicely positioned for the mother of all flushings in terms of taking bad assets to the curb. Remember, 2009 losses cost US banks over $120 billion or roughly total bank earnings for a year. Buckle up.

New York | This week The Institutional Risk Analyst takes a step back to look at the world of credit and banking 30 days before the end of Q2 2020. Suffice to say that there are reasons for optimism as well as dread, depending of course on where you turn your gaze. Stick with dread for now. We see a second credit tsunami approaching on the horizon. Those risk professionals who keep their heads and stay focused on value (or a lack thereof) in the next few months are likely to prevail in our view. Indeed, this dynamic process in the credit markets is one of the reasons that the private markets in the US continue to reject negative interest rates despite the obvious threat of deflation. A reader asks why money market funds are bottoming out at about 0.1% yields, but banks are still paying 1.6% for one-year money in federally insured deposits. Of note, dealers are also offering attractive, zero risk weight returns providing financing for dry agency loans. Treasury yields at 1 year are sub 0.2% vs 0.65% at ten years, but with an increasingly steep yield curve. Meanwhile, Ginnie Mae 2% coupons closed Friday at 103 & 19/32s for June delivery, just above 1.1% yield. The simple answer is that commercial banks and broker dealers have private financing opportunities that remain superior to the heavily manipulated rate for federal funds and US government bonds. This is part of the reason that mortgage rates have not followed Treasury yields lower, even with the Fed standing on the end of the Treasury curve. And of course, not all money market funds are created equal. Looking at the System Open Market Account (SOMA), it seems that Fed Chairman Jay Powell and the Federal Open Market Committee started to accommodate back in September of 2019 and just kept on going. Readers will recall that last September saw the most serious liquidity crisis in the US markets since the December 2018. The FOMC has been buying bonds ever since. Notice that the dreaded VIX volatility measure has been muy tranquilo in recent weeks as a result of the launch of the latest Fed bond buying surge. Shall we call it QE5? Sounds like a so-so rock band from Lincoln Park, MI . Street pharisees talk about the Fed easily growing its balance sheet in magical fashion, but in fact the reality is more subtle -- especially when the Fed is trying not to inflict collateral damage on private market players. Kudos to Chair Powell and Godspeed. Fact is, the Fed’s reaction to the March market fade is about right. If you look at global credit spreads in the chart below, the impact of March Madness on corporate bond yields was subdued to say the least. Indeed, many investors never fully had an opportunity to become uncomfortable because they already started getting comfortable with the new normal post-COVID19. But while the credit markets are subdued and the equity markets are, well, silly as usual, the real world prepares for the reckoning of 40 million Americans unemployed. We suspect that bond spreads will adjust accordingly as and when the pound of flesh is cut away to fulfill the creditor's bond. Vultures continue to gather on Park Avenue, mostly in a virtual sense, but the money is real enough. PitchBook reports that KKR & Co (NYSE:KKR) raised roughly $4 billion to invest in the corporate debt of companies struggling due to the coronavirus pandemic, including a 10% GP commitment. The KKR Dislocation Opportunities Fund reportedly brought in $2.8 billion alongside an additional $1.1 billion-plus in SMAs. We are struck by the number of funds and strategies surfacing to exploit “distressed” opportunities, but we suspect that few of the investors we’ve seen in the mix are looking to take a risk position in the debt of a bankrupt restaurant operator, for example. Yet the appetite for risk on the part of global investors is certainly growing as the Fed and other central banks drain marginal duration from the markets. For the more adventurous, how about lending to private equity startups in China? Nikkei Asia Review reports that “fund houses, distressed debt investors, hedge funds and pension funds” have billions in new money ready to lend to companies in China. And the Vig? No more that you pay on a bad credit card. “Burgeoning demand has boosted yields on such loans to as much as 18% from about 12% at the end of last year,” Nikkei reports. Distressed real estate funds are raising funds at breakneck speed, in some cases turning away investors, the Wall Street Journal reports. The investment thesis: Buy bad loans from banks, that want to jettison the detritus as fast as possible. Determining value amongst the proliferation of “opportunities” in the world of credit defaults is another matter entirely. Perhaps one of the more reasoned views we’ve encountered in the past week comes from the world of European commercial real estate. SitusAMC advises that there may not be easy pickings for vultures look to feast on busted real estate in the EU. “Investors and lenders will take write-downs on their assets, but this will be sector-specific and could be limited if some parts of the market recover swiftly. One thing is clear, there is significant weight of capital out there and banks are willing to lend," SitusAMC opines. Of course, we’ve never been particularly disposed to invest in European real estate, in large part because creditors in Europe don’t have any effective legal rights. Distressed debtors can take years or even decades to resolve, ensuring that any distressed opportunity may well turn into a multi-generational affair. In Europe as in the US, the debt grows and grows, but is rarely repaid. Back in the US, banks have rebounded nicely, but are still trading below the 52-week highs. Part of the reason for this striking underperformance stems from the fact of known unknowns. We know that banks are facing very large credit losses in coming weeks, but we still don’t know the particulars. We increasingly suspect that the most pain will be felt on the commercial side of the ledger as small and not so small businesses fail. While the pool of ready buyers for distressed commercial properties has shrunk in recent days, the wall of money in the hands of modestly competent investment managers has already started to support property prices. Sadly, we suspect that this is a false bottom to the commercial property market. At present, it still is not possible to assess the viability of many commercial properties. Loss given default is a metric we really won’t fully understand until later in the year or in 2021. Beware the double dip as or after the full horror of Q2 2020 earnings becomes apparent to the raging bulls.

New York | This week The Institutional Risk analyst released our latest credit profile on the housing GSEs, Fannie Mae and Freddie Mac, which is now available in our online store . Registered readers received a special coupon code to save 50% through COB this Friday. (Hint: "Calabria") Suffice to say that our outlook on the credit profiles of the GSEs is negative. The posture of the world class regulator, the Federal Housing Finance Agency , is confusing to both lenders and investors in conventional mortgage backed securities. The lack of support shown to conventional lenders is particularly of concern since it undermines the value of the entire asset class. On the one hand, the FHFA is reducing the footprint of the GSEs and ignoring the liquidity needs of the conventional market. On the other hand, the two GSEs are preparing to raise money from investors, this despite the lack of clarity on the future business model. Can you do both? No. But wait, if all this were not enough, FHFA is also imposing impossible and really silly Basle III style bank capital requirements on the GSEs. We write: “The FHFA capital proposal attempts to benchmark the capital of the GSEs with that of the largest bank SIFIs. In the narrative to the rule, the FHFA makes clear that they seek to not only ensure sufficient capital to remediate losses on insured loans, but to also provide sufficient mass financially to keep the enterprises liquid in a stressed economic scenario. Ensuring 100% safety against credit loss and market stress is not possible in an economic sense, raising basic questions about the FHFA capital framework.” And in the back of the minds of lenders, there is worry that the GSEs will seek to reject conventional loans that fall into default once the borrowers exit the CARES Act forbearance. It has happened before, after all. Indeed, senior officials at FHFA have made clear that any perceived defect in credit underwriting after March will result in the GSEs cranking up the good old loan repurchase engine as in the 2009-2015 period. But truth to tell, while we remain concerned about the lack of clarity coming from the FHFA on COVID19 forbearance and conventional loans, we are far more concerned about the state of commercial real estate and how this catastrophe will impact state and local finances. How things change and so quickly. A year ago, equity REITs that owned prime commercial real estate in New York and other major metros were the top of the heap in the world of real estate investing. Today these same investors face the prospect of foreclosures and protracted litigation over busted commercial properties. And the impact of this economic collapse on the revenues of major cities is enormous. Matthew Haag writing in The New York Times describes how the decline in rent payments to landlords means an inevitable drop in tax payments to New York City. “The drop in commercial rent payments could imperil property tax collections that pay for city services,” notes Haag concisely in what may be the most important article published by the Times this year. He illustrates the disaster: “The cascading impact of the coronavirus pandemic and stay-at-home orders on New York City have reached a breaking point, property owners and developers say. Two months into the crisis, the steep drop in rental income now threatens their ability to pay bills, taxes and vendors — a looming catastrophe for the city, they warn.” The impact of the disruption in commercial real estate will be felt by REITs, banks and bond investors widely. We hear tell that a favorite trade chosen by some managers was to pair commercial mortgage backed securities (CMBS) with credit risk transfer (CRT) bonds issued by the GSEs, both leveraged of course. Both exposures went sideways at the same time! Wonderful. But now the CMBS paper and the derivative indices that some managers found so fascinating have both crapped out, leaving investors with another example of the fickle nature of markets. Where is Joanie McCullough when we need her? Indeed, there are distressed investors already buying up CRT paper at triple digit spreads, a testament to the ability of the speculative classes to become comfortable after any market event. The CMBS delinquency rate, which measures payments that are late for more than 30 days, climbed 22 basis points to 2.29% in April, the biggest jump since June 2017, according to Trepp . No surprisingly, lodging and retail loans were among the hardest hit. May data should show CMBS delinquency well into double digits. JPMorgan (NYSE:JPM) estimates that new issue CMBS volumes will be cut in half this year as retail and hotel deals were sidelined. The spreading disruption in CMBS is already forcing investors to take a “different” approach to loan delinquency for loans in a given deal, namely ignore it. Extend and pretend as we say in the world of risk. Kroll Bond Ratings wrote in a surveillance report on COVID19 at the end of April: “[M]any deal participants are considering whether it may be in the best interest of the trust to allow certain relief requests, including temporary debt service forbearance, to be accomplished without a transfer to special servicer. Given the immediacy and severity of the cash flow disruptions to many properties (in particular, lodging and retail) and great uncertainty as to how long the economic disruption will last, some believe that short-term relief may be warranted, particularly for properties that were performing well prior to the pandemic.” It is important to state that there are deals getting done in the world of CMBS. Blackstone Group (NYSE:BX) just brought a $608 million deal for its REIT comprised of loan participations on commercial properties, including a portfolio of 68 warehouse and logistics facilities, but no hotels or retail properties please. There is a great separation underway between viable CRE assets and commercial properties with retail and office tenants. While stocks have rallied in recent weeks on the elation arising from the economic opening after 90 days of lockdown, the joy is not being felt by many subsectors of the financial ghetto. Bank for example have rallied double digits in the past 30 days, but are still well off the highs of 2019. Names such as JPM are currently trading near 1.3x book, but are still down for the past 52 weeks. And Q2 2020 earnings loom ahead in just six weeks. Banks, lest we forget, have lots of exposure to commercial real estate. Meanwhile, equity REITs such as Equity Residential (NYSE:EQR) and Starwood Properties (NYSE”STWD) are deeply depressed, reflecting the negative expectations for the group as a whole. Meanwhile in the world of CMBS, the “AAA” CMBX index still trades well off the highs of the past year, reflecting the fact that some investors still don’t quite know how bad the crash will be in commercial real estate. We certainly do know that the world of commercial real estate will be really, really dreadful in the next several years. Default rates could exceed peak losses of the 1990s by a wide margin. Act accordingly. And as you read about the trials and tribulations affecting the commercial real estate sector, remember that the big northern cities like New York and Chicago are right behind the busted property deals. Social distancing means financial Armageddon for commercial real estate and municipalities in coming months. Get used to it.

New York | This week, The Institutional Risk Analyst releases our Q1 2020 bank earnings report, which is for sale in our online store . In our latest credit comment, we feature net loss rate and earnings estimates for JPMorgan (NYSE:JPM) , U.S. Bancorp (NYSE:USB) , Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS) through Q2 2020. Suffice to say that our view of Q1 2020 bank earnings is pretty grim, but the real fun won’t start until the Q2 2020 earnings are released in about 90 days. The key variable in the credit analysis for both banks and bond investors: unemployment. In March, unemployment reached 4.5% nationally. Estimates for April vary but are all in double digits. We write: “We expect that commercial banks too will take losses on default events involving commercial real estate. Imagine, for example, the wreckage that will result from the impending default of WeWork and other leveraged investors in commercial and high end residential real estate in major cities like New York, Los Angeles and Miami." Distressed credit investors are already assembling funds to take advantage of what may be the largest liquidation of commercial properties in a century. Rather than 2008, however, the operative model for the COVID19 crisis may be closer to the deflationary years of the mid-1930s. The chart below shows unemployment through March from the Bureau of Labor Statistics and the consensus estimate for April unemployment. Source: BLS, Survey Despite the grim unemployment numbers and related loan loss estimates for US banks, it is important to remember that the US banking industry is quite liquid and well-capitalized. While there are a lot of dire predictions about the economy and employment, remember that in Q4 2019, US banks had almost $150 billion in net income, dividends and cash used for share repurchases available potentially to absorb losses. This substantial cash flow is now about to absorb the full weight of the COVID19 virus disruption. In our latest IRA Bank Earnings analysis , we assume that US bank loan loss provisions double in Q1 and then double again in Q2 2020, taking American banks back to 2009 levels of loss reserve build. Yes, the numbers for credit losses due to COVID19 are large and earnings will be ugly for the rest of the year, but in our judgement, the task is more than manageable by the US banking system. Because US banks are stable and healthy, these institutions will be more than able to weather the huge storm of credit losses to come. In addition to $45 billion per quarter in cash earnings, the industry has $35-40 billion in share repurchases and $50 billion or so in dividends each quarter. Just by suspending share repurchases, the largest banks will retain over $100 billion annually in additional equity capital, as shown in the table below. Source: Federal Reserve Form Y-9C While the banks may be islands of liquidity, though, the bond market and particularly “fringe” products such as non-QM residential mortgages and non-bank business loans and the like are going through the meat grinder. The Fed has agreed to buy limited amounts of AAA and recently investment grade paper, but there are piles of leverage loans and real estate paper that is currently looking for a bid. If we get to 5% loss rates on 1-4 family loans owned by US banks – roughly 2x the levels of 2008 – we should count ourselves lucky. Anything close to double digit loss on $2.5 trillion in residential mortgage loans owned by banks is a problem for everyone. Why? Because if bank default rates on 1-4s go to 5%, then loss rates on the other $8 trillion in agency and government loans will be higher. The GSEs, Fannie Mae and Freddie Mac , will be swamped by loan repurchase demands and will require additional capital funds from the US Treasury. And, meanwhile, the carnage in commercial loans, CLOs and all other manner of ineligible securities will be equally bad but also will provide a sizable opportunity for the vultures. All that said, between Fed Chairman Jerome Powell’s commitment to do “whatever it takes" to liquefy the system and Dr. Fauci’s determination that the rate of infection from COVID19 may have crested, the index of FRED Spreads created by our friend Fred Feldkamp dropped 280 bps last week (a little more than 10% of its total rise during the crisis). As we all know, falling credit spreads are good. Some people are even talking about getting “AAA” CLOs restarted by June. We’ll see. Until you see HY spreads inside of 500 bps over the curve, not much is likely to happen in sub-investment grade debt. Be well.

New York | In this issue of The Institutional Risk Analyst , we review some of the credit developments that have occurred since the explosion of the COVID19 pandemic and related hysteria. But first a few comments about the American political economy seem to be warranted. With the panic-stricken response to COVID19, any semblance of fiscal probity in the major industrial nations has long since been tossed into the dumper. In Washington, the national Congress passed the largest unfunded mandate in American history with the CARES Act and promptly left town for safer climes. Would that Mark Twain were alive today. Full nationalization of the US credit markets has been achieved. The US Treasury bond market and the government-covered mortgage related markets are the only liquid markets remaining outside of the crap shoot/inflation hedge we call global equities. The markets for Treasury and agency securities have now been turned into a terrarium project for the fun and amusement of the Federal Open Market Committee . Of course, this development was inevitable following the equally great social sacrifice of two World Wars a century ago. We are living in the aftermath of the Somme and Verdun, Guadalcanal and D-Day. As we noted in the inside page of the 2010 book, “ Inflated: How Money and Debt Built the American Dream, ” democratic societies inevitably fail because of fiscal profligacy. And these fiscal demands often come about as the result of or in the aftermath of war. “ I do not think it is an exaggeration to say that it is wholly impossible for a central bank subject to political control, or even exposed to serious political pressure, to regulate the quantity of money in a way conducive to a smoothly functioning market order. A good money, like good law, must operate without regard to the effect that decisions of the issuer will have on known groups or individuals. A benevolent dictator might conceivably disregard these effects; no democratic government dependent on a number of special interests can possibly do so. ” F. A. Hayek Denationalization of Money, Institute of Economic Affairs (1978) Four decades later, Hayek's observation clearly has been proven right. The FOMC has lost control over the size and growth rate of the dollar as a currency. Hyperinflation beckons, at least after we get done with the debt deflation of COVID19. The phone rings and the Federal Reserve Bank of New York buys securities until the market are sated – sometimes beyond that point. And the Fed has been forced to finance a growing offshore float in dollars that now totals some $15 trillion and climbing. As we've noted in past comments, the Fed's efforts have made it cheaper to borrow dollars offshore than in domestic US markets. The offshore demand for dollars is the largest and largely unspoken variable in the FOMC's monetary policy puzzle. Meanwhile, the Trump Administration is dropping helicopter dollars in advance of the November 2020 election. Like a Latin caudillo handing out free groceries on election day, the hundreds of billions in fiscal assistance in response to COVID19 are merely targeted gratuities for a desperate electorate. With all of the “action” from Washington, the lockdown to avoid the worst aspects of COVID19 has probably taken US GDP down at least 10-15% in terms of lost employment and businesses in the services sector alone. The levels of reserves seen in bank earnings so far suggests that depository institutions are expecting a wave of loan defaults far larger than 2008. When JPMorgan (NYSE:JPM) took loss provisions up 450% from the previous quarter, then tightened credit across various wholesale channels, the message was clear: credit needs to tighten, a lot. Exposure at default at most major US banks (Basel I) has gone from the low teens to near 100% in just 30 days. Yet banks are literally awash in cash due to the resumption of QE. Other banks and agencies, including the housing GSEs such as Fannie Mae and Freddie Mac have followed suit, reducing credit availability to a broad swath of the US economy. We even hear tales of the Federal Home Loan Banks liquidating financing positions for collateralized loan obligations (CLOs). Yes, that’s right. The FHLBs were so hungry for business that they were financing “AAA” tranches of CLOs. Outside of the world of eligible collateral that can be pledged as security for loans at the Federal Reserve Bank of New York , the situation is dire. Liquidity has left the market for private label loans of all types. Once again, as in the late 1990s, we see fringe lending products such as marketplace loans and prime jumbo mortgages trading at a steep discount. This morning, the bid for performing prime jumbo loans is in the low 90s. The situation facing the private-label market for prime jumbo mortgages is significant for the banks. Properly seen, the market for government and agency mortgages is only about $9 trillion in unpaid principal balance (UPB). But the $2.5 trillion market in bank owned prime mortgages is really a private label market. Thus when the market bid for prime jumbos disappears, the banks retreat, no longer able to price these assets. Food for thought for the Fed as they consider supporting the market for prime jumbos loans. Just to show you that God does have a sense of humor, just before the COVID19 crisis got underway, the Federal Deposit Insurance Corporation approved the applications submitted by Square, Inc. (NYSE:SQ) , and Nelnet, Inc to create two de novo industrial banks in UT. Square Financial Services, Inc., will originate commercial loans to merchants that process card transactions through SQ's payments system from Salt Lake City. Nelnet Bank will originate and service private student loans and other consumer loans as an internet-only bank operating from a single office in Salt Lake City. Sadly, the markets to be served by these two nonbank pioneers have been badly damaged by the COVID19 crisis. John Davis at Raymond James calls COVID19 “kryptonite” for the once high-flying SQ and says that the economic contraction will hurt both credit card processing volumes and the firm’s infant lending business for years to come. “COVID19 illustrates the cyclicality of the business that simply does not justify a double-digit revenue multiple,” he adds. As this difficult week comes to an end, the financials seem to have settled-down into a trading range at or just above book value for the exemplars in the group. While we do anticipate a wave of loan defaults hitting US banks in coming quarters, the industry should be able to handle the load without any more inconvenience than suspending share buybacks. To us, the bigger question facing financials is when the housing GSEs, Fannie Mae and Freddie Mac, will be forced to seek financial assistance from the US Treasury to fund loan repurchase obligations. Black Knight (NYSE:BKI) reports that the 3.4 million American homeowners now in CARES Act forbearance plans represent 6.4% of all active mortgages. But what about the millions of homeowners who could not qualify for forbearance? How many consumers will ultimately default? Reading the body language of the commercial banks and non-bank lending markets, we anticipate a wave of defaults across a range of asset classes that will be far larger than 2008. Whereas the great financial crisis saw severe credit default events across a range of residential mortgages and related securities, this time the picture looks more like the 1930s. We anticipate that net loss rates will rise quickly from the historic lows seen over the past several years to and even exceeding 100% loss in many asset classes. Prepare accordingly.

New York | This week in The Institutional Risk Analyst , we ponder the state of the bezzle, that fluffy, frothy portion atop the political economy that feeds the purveyors of fraud and dubious financial schemes. Six months ago, the bezzle seemed set to expand infinitely thanks to the largess of the Federal Open Market Committee . But now with the COVID19 disaster, all of the air has been let out of the global economy, leaving those who feed on the bezzle scrambling. The term bezzle, lest we forget, was coined by John Kenneth Galbraith in his classic 1961 book, “The Great Crash of 1929.” Our friend Mark Melcher at Prudential Securities loved to describe the current state of the bezzle in his research. Galbraith himself describes the bezzle as the “inventory of undiscovered embezzlements,” that grow in times of rising markets. He wrote: “At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.” Under the strange regime put in place by the FOMC after 2008, markets are inflated with fiat money to avoid any hint of asset price deflation. We are told that falling interest rates are meant to encourage employment, but the worst examples found in the world of finance are the real winners with quantitative easing. The generous estate of zero net-cost leverage allows for ever greater acts of fraud and chicanery, all floated upon a cushion of hysterical investor demand and a newly minted pile of fiat paper dollars. Yet such an artificial market bubble is hardly stable, to invoke Nassim Taleb’s “black swans,” particularly when the civil authorities in many countries decided to shut down their economies for three months. James Glassman stated: capitalism without bankruptcy is like Christianity without Hell. Well, thanks to an understandable overreaction by civil authorities to COVID19, America is seeing a wave of insolvency unlike anything experienced in the past century. Now that the bezzle has basically disappeared, the speculative classes are left to rationalize strategies that, just 90 days ago, made sense. Let’s ponder some of the winners and losers as the proverbial tide goes out, exposing millions of failed companies, denuded business strategies, defaulted securities and busted individuals. Some of the biggest losers in the wake of the great flushing are investors in commercial real estate. The new age pyramid scheme known as WeWork probably jumps to mind first, a debt driven speculative plan hatched by a barefoot visionary whereby temporary workers would support retail pricing for office space and free snacks. WeWork did not make sense before February of 2020. Now it is just completely ridiculous. Low rates care of the FOMC made WeWork possible. Another favorite example of the age of QE is Wirecard , Germany’s technology darling which has been under assault by the financial media and investors due to questions about the accuracy of the firm’s accounting. Even after a much anticipated examination by KPMG , questions about Wirecard remain, in part because the firm apparently cannot produce bank records to substantiate claimed revenue to the tune of $1 billion. The Financial Times notes that KPMG could not confirm “that the sales revenues exist and are correct in terms of their amount, nor can it make any statement that the sales revenues do not exist and are incorrect in terms of their amount.” Certainly, this report fills us with confidence. And then, of course, there is the iconic speculative fraud of the age of zero interest rates, Softbank , which naturally has put cash into both WeWork and Wirecard . How the FOMC did not get awarded free call options on Softbank for enabling these and other “investments” by guru visionary Masayoshi Son we’ll never know. A century ago, two guys named Morgenthau and Brandeis would be fighting for the honor of putting Masa San in state issued garb. The Real Deal reports that Softbank is preparing to write down its stake in WeWork to basically zero . “Every writedown takes WeWork’s carrying value closer to reality. Clearly the value is zero,” Kirk Boodry , analyst at Redex Holdings , told Reuters . The creditors and owners of the select real estate chosen by WeWork are now busted too. In fact, the owners of commercial and residential properties in most major metros around the US have seen a good portion of their tenant base literally disappear in the past 60 days thanks to the Great Lockdown. Rent collections are down sharply and many of these absent tenants may never return. Notice that REITs with commercial and retail exposures are faring rather badly, but specialty REITs such as American Tower (NYSE:AMT) are actually up. When we are all living a bad version of “Return to Thunderdome,” with House Speaker Nancy Pelosi in the lead role, at least we’ll have 5G. Empire State Realty Trust , the owner of the Empire State Building and 13 other commercial properties in the New York region, last week reported in its first-quarter earnings that it collected only 73% of its April office rents and 46% of its retail rents due in April. We expect to see even worse numbers from the equity REITs in May. We hear reports of residential and commercial tenants fleeing New York or demanding rate reductions from landlords, with obvious downward pressure on pricing for vacant space. Listed rates for rental apartments are in free fall. Landlords will essentially need to eat lost rents on millions of small commercial properties or see the space go vacant. And even if landlords do eat 90 days of lost rent, many small businesses may fail anyway due to the economic dislocation caused by the Great Lockdown. As we’ve noted in past missives, the rate of price appreciation in commercial real estate (CRE) over the past five years drove loss rates post-default negative, just as was the case with residential exposures. Now, however, the dread externality known as COVID19 has evaporated a big chunk of the services sector. This, in turn, is leading to defaults and requests seeking forbearance that only find parallels in the early 1900s. We suspect that the downward skew in loss given default (LGD) seen in all real estate exposures will normalize and start to climb above 100% in some cases. The chart below shows LGD for bank-owned multifamily properties and our guess as to what Q1 and Q2 are likely to show once some significant adjustments and restatements of Q1 losses are eventually tabulated. Notice that we expect to be above 80% LGD for bank multifamily exposures by Q2 2020. The 30-year average LGD for bank owned multifamily loans is 70%. Source: FDIC/WGA LLC We know of a number of businesses in the NYC area that have received PPP loans from their banks. Many will only use a portion of the funds and will return the balance, but with the big positive of keeping their staff employed and health insurance intact. But the sad fact is that many smaller businesses will not be saved and their employees and owners are now busted flat. We observed in an earlier comment that the world of jumbo loans for banks and investors has pretty much stopped. We know a couple of lenders, each owned by Buy Side sponsors, who’d forsaken the world of agency lending for making non-QM mortgage loans. Through February 2020, these firms were doing growing volumes in non-QM loans, which were being purchased by banks, REITs and hard money investors. Today, however, these lenders have pivoted, disavowed non-QM and returned 100% to government lending in the FHA and Ginnie Mae market. Government lending, as it was a decade ago, is the only stable market in residential housing finance today. And remember, non-QM lenders never lose the risk of claims based upon the ability to repay (ATR) rule that was put in place in 2010 by the Dodd-Frank legislation. Remember those three letters: ATR. As the true extent of the pull-back in many real estate markets becomes apparent, look for groups of trial lawyers to start testing the ATR rule as the basis for tort claims against some of the larger non-QM lenders -- and the Buy Side players who financed these activities, firms like PIMCO and Blackstone (NYSE:BX) . Meanwhile, the earnings from Fannie Mae and Freddie Mac last week suggest dreadful days lie ahead for the GSEs. As we noted in National Mortgages News (“Why the FHFA's latest move undermines the MBS market” ), Washington is now the problem in conventional loans. The Federal Housing Finance Agency has effectively been taken over by the Cato Institute , which wants to implement free market principles just as the housing sector faces its worst challenge since the Great Depression. For years conservatives wanted to shrink or even kill the GSEs. Now the opportunity arrives. At precisely when we need the mutualized risk sharing power of the GSEs to support 1-4s, the FHFA is trying to shrink the GSE’s role in housing. Dick Bove of Odeon writes that FHFA Director Mark Calabria believes that “the government should not be in the housing industry; The government sponsored enterprises (GSE) should be taken out of government. No bank is too big to fail.” What the COVID19 event proves in housing is that in times of stress, no amount of private capital can support $11 trillion in single family housing assets or another $1.5 trillion in multifamily properties. Banks own a quarter of the 1-4 family housing market, the FHA/VA/USDA about 18% and the rest – about $6 trillion in loans -- is supported by the GSEs. Without financing support, we expect residential home prices will start to fall in many markets around the US before the end of 2020. Meanwhile, the REITs and funds are the chief victims in this cycle. Think L Shaped recovery in services, and related CRE and multi-family assets. The hard money investors we work with in the market for CRE, small commercial and non-QM residential loans see lots of opportunities, but also a lot of risk. The current judgement seems to be that we need to be thinking about 40-50% discounts off peak valuations to make the risk/reward equation start to make sense. As we consider the wreckage in the credit markets caused by the Great Lockdown, a couple of things to ponder. First, the response to COVID19 is doing more damage than the disease itself. The dislocation to the economy, especially the real estate and services sectors, will set back global economic growth by decades. Second, the unwillingness of politicians to admit that the universal lockdown was a mistake is now a major obstacle to moving forward. We need to protect the vulnerable and send everybody else back to work, without masks and social distancing. Otherwise the global economy is headed for depression like conditions for decades to come. And finally, the damage inflicted on the speculative classes in the past 90 days is just the appetizer. The unwind of leverage in real estate and many parts of the world of secured finance is just starting. Aircraft leases? Hotels? Casinos? Yet the agency loan sector, including government guaranteed residential and multifamily loans, will be an island of stability in a sea of woe. The deflation of the bezzle may be very painful indeed.