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

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

Summary The Goldman Sachs Group (NYSE:GS) had a record results in terms of non-interest income in Q2 2020, up 66% sequentially and 44% year-over-year. Net earnings doubled sequentially from Q1 2020, again due to market volatility and the impact of the Fed’s strong market intervention. The $13.3 billion in net revenues GS reported in Q2 2020 was up double digits sequentially and also year-over year, illustrating the volatility in earnings that we believe contributes to the low P/E ratio and also the discount to book value for the common shares. GS is the smallest of the global investment banks but the most highly levered of the large US banking groups, with the ratio of LT debt to equity capital of nearly 200% vs 12% for the Peer Group 1 average. The transactional business of GS continues to be both the source of outsized profits and losses, as illustrated by the settlement of the 1MDB scandal in Malaysia. The losses due to the 1MDB settlement essentially wiped out GS profits for the first half of 2020, caused a restatement event with the SEC, and the bank has still not completed the resolution of this matter. Our overall assessment of the quantitative and qualitative factors behind the performance of GS remains negative. The BHC generates more risk than return to its investors, and therefore trades at or even below book value in the equity markets. The financial comparisons between GS and its asset peers among the largest BHCs is not flattering and suggests that GS has serious risk issues due to its business model. Source: FFIEC Although the majority of Sell Side analysts believe that the valuation for GS is below “fair value,” we disagree and instead believe that the heightened risk factors that accompany the bank’s business model tell the tale. Sad to say, like many names in the financial sector, GS is an issuer that deserves to trade at a discount to par. Quantitative Factors At $2.06 trillion in total assets as of June 30, 2020, The Goldman Sachs Group (NYSE:GS) is the fifth largest bank holding company (BHC) in the United States. Less than 20% of the consolidated assets of GS are attributable to the New York state bank subsidiary, Goldman Sachs Bank (USA). GS is the smallest of the global investment banks but the most highly levered of the large US banking groups, with the ratio of LT debt to equity capital of nearly 200% vs 12% for the peer group. When comparing GS to other large US banks, the first factor that requires attention is the bank’s dependence upon non-interest fee income. As a result of the focus on trading and advisory income, GS is far less efficient in terms of asset returns than a typical large bank such as JPMorgan (NYSE:JPM) . Even compared with all of Peer Group 1, GS underperforms. And with the added burden of credit reserve expenses due to COVID-19, the entire large bank group is suffering reduced profitability, as shown in the chart below. Source: FFIEC Non-interest income for GS as a percentage of average assets was 2.74% at the end of Q1 2020 vs just 1.12% for the 123 largest banks in the US that are members of Peer Group 1. The key point is that GS is very much an investment bank and only a relatively small commercial bank, with less liquidity and greater risk per dollar of revenue. The top-level financials for GS are shown below using data published by the Federal Financial Institutions Examination Council (FFIEC) and EDGAR, In Q2 2020, GS’s results were helped significantly by the strong market intervention by the Federal Open Market Committee. The deposit growth seen in 2020 is largely due to the trillions of dollars in liquidity injected into the US banking system by the Federal Reserve. The Goldman Sachs Group (RSSD:2380443) Source: FFIEC, EDGAR GS had a record results in terms of non-interest income in Q2 2020, up 66% sequentially and 44% year-over-year. Net earnings doubled sequentially from Q1 2020, again due to market volatility and the impact of the Fed’s strong open market operations. The enormous swing in earnings results illustrates one of the key reasons why we consigned GS to The IRA Bank Dead Pool last year, namely the huge variability of the bank’s results both positive and negative. GS made some progress in terms of building its deposit base in 2020, but much of the increase was due to bond purchases by the Fed. Yet even as GS builds its Marcus retail banking platform, the loss profile of the loan portfolio displays above-peer losses typical for larger banks. The loss rate for GS is now more than two-times peer, as shown in the chart below. Source: FFIEC While the GS loan portfolio has grown, the bank’s loan pricing reflects an above-peer target coupon rate that is 150bp higher than its large bank peers. The 55bp of default in Q1 2020 maps to a “BBB-” default rate equivalent. This level of net credit loss is 2x the Peer Group 1 average and puts GS in the same neighborhood as JPM and above that of U.S. Bancorp (NYSE:USB) . Source: FFIEC Notice how the pricing of GS loans dropped nearly a point in Q1 2020, suggesting that the bank is having difficulty sourcing assets. The competition among large banks for equally large assets is intense and likely to increase as 2020 comes to a close due the the Fed’s operations. Just 40% of the GS bank unit’s assets are deployed in lending vs 25% in investing activities and the rest in “other” assets, according to the latest disclosure from the FDIC. New loans and leases were just 15% of the group’s total consolidated assets at the end of the second quarter, although the growth rate for new loans is well into double digits and more than 3x the average of 9% for the banks in Per Group 1. The larger issue raised by the slow growth of the firm’s commercial banking business has to do with the overall GS cost of funds and the firm’s refusal to consider growth through acquisitions. While in terms of total assets GS ranks fifth among large US bank holding companies, in terms of deposits Goldman Sachs Bank (USA) with $200 billion in total assets ranks 14th between Charles Schwab Bank (NYSE:SCHW) and the US unit of HSBC Holdings (NYSE:USBC). The chart below shows the relative cost of funds for selected large banks. Notice that GS has a higher cost of funds overall than Citigroup (NYSE:GS) but has a yield on earning assets that is significantly lower. Only about 1/3 of Citi’s assets are funded with core deposits, making the comparison even more striking. The fact that the cost of funds for GS is so high relative to subprime lenders such as Citi makes the point with respect to the long-term business model of Goldman Sachs. Source: FFIEC As a matter of sheer size of balance sheet, GS is simply not competitive with its larger bank peers. Viewed from the perspective of funding costs, GS is clearly not as efficient as are other BHC’s. Indeed, these larger depositories provide funding to GS and other securities dealers. The primary focus on the brokerage unit and on non-interest sources of income as part of the firm’s business model places GS at a distinct disadvantage compared with core deposit rich institutions like JPM and USB. Even Citi and CapitalOne Financial (NYSE:COF) , which use brokered deposits to fund their consumer loan books, have cheaper funding costs than GS. Source: Bloomberg (July 24, 2020) The $13.3 billion in net revenues GS reported in Q2 2020 was up double digits sequentially and also year-over year, illustrating the volatility in earnings that we believe contributes to the low P/E ratio and also the discount to book value for the common shares. Even with the selloff in March, GS continues to trade at a significant discount to its peers. JPM trading at 1.2x book value and USB flirting with 1.3x book, the fact of GS trading 20% below book value and the widest credit of the group in credit default swaps (CDS) speaks volumes as to how investors perceive the risk/reward ratio of this more than century old business. Qualitative Factors The qualitative analysis of GS starts with the conversion of an SEC-regulated investment banking firm into a Fed-supervised BHC a decade ago. This superficial change led to GS focusing time and management attention on organically growing the banking business, but only as a means of enhancing existing business lines in trading and investment banking. GS talks about “building the bank,” but the actual change in the business model falls short of the rhetoric. The transactional business of GS continues to be both the source of outsized profits and losses, as illustrated by the settlement of the 1MDB scandal in Malaysia. On July 24, 2020, GS issued an announcement that it had reached an agreement in principle with the Government of Malaysia to resolve all the criminal and regulatory proceedings in Malaysia involving the firm relating to 1Malaysia Development Berhad (1MDB). “Goldman Sachs has agreed to a $3.9 billion settlement with Malaysia as it begins to put behind it a kleptocracy scandal that changed the course of politics in the country,” reports The New York Times . While global banks face many different types of operational and reputation risks, the investment banking business of GS seems to generate these serious loss events with greater frequency and in larger size than other banks. In the recent past, GS management has expressed a desire to move more business “in the bank’ to capture internal financing revenues, interest on loans that was heretofore paid away to larger depositories. This is a fine strategy, but the GS bank unit is still too small to really fund the operations of the entirety of GS as a firm. That is essentially the quandary that faces GS. Management has made clear that the hurdle for considering “inorganic growth” is very high. This is, in simple terms, a way to say that GS will not consider significant acquisitions. We have written in the past of merger possibilities such as First Republic Bank (NYSE:FRC) with its strong asset management business. Another possibility is KeyCorp (NYSE:KEY) , a leader in commercial real estate lending and servicing, with over $100 billion in retail core deposits. The potential home run? Merge GS with U.S. Bancorp, the smallest money center with $400 billion in deposits, a significant lending, payments and trust business and the lowest cost of funds of the top ten banks. But GS management refuses to consider a transformational acquisition, apparently because it means the end of the banker/trader culture. As GS CEO David Solomon said in October 2019: “I think one of the things this management team is trying to do is to think broadly both about our organic growth, but also potential opportunities over time for inorganic growth. I’ve said on this call and previous calls, the bar for us to do something inorganically, especially something significant inorganically is very, very high. At the same point, it’s the job of this management team to have a point of view and to be doing work and to be thinking about opportunities that can expand our franchise.” With the bar set very, very high for a GS acquisition, this leaves only the existing GS strategy of organic growth in the bank and sticking to the existing securities and asset management businesses. This means battling just about every major financial institution for affluent retail customers with cash and investment AUM. Acquiring and retaining high net worth customers for a private bank model is expensive and extremely difficult. This particular demographic of investor does not typically provide stable deposits or assets upon which to build a banking business. The acquisitions of United Capital and, more recently, the Folio RIA platform illustrate that GS remains focused on growing the asset management businesses. In the world of capital markets, GS is the leading advisory firm but is engaged in a Darwinian struggle for survival with JPM and the other major universal banks of Europe and Asia. All of these universal banks have bigger balance sheets with bigger deposits than does GS. Many of the competitors of GS, including Morgan Stanley (NYSE:MS) and UBS Group (NYSE:USB) have chosen to emphasize asset management at least equally with transactional businesses. UBS trades significantly below book value, but MS which boasts two depositories that are twice the size of the GS bank unit trades, above book. One way to measure the outsized enterprise risk of GS is to compare its total derivative footings with other large banks such as JPM and Citigroup, and Peer Group 1. At the end of Q3 2019, the derivatives positions of GS equaled more than 5,100% of average assets. The comparable levels for derivative dealers such as JPM and C, respectively, were 1,800% and 2,400%, respectively. The averages for USB and COF were at or below 100%, suggesting that GS has deliberately chosen to take outsized risks in derivatives, mostly interest rate contracts, in order to enhance earnings and returns, and implicitly make up for its relatively small banking business. Source: FFIEC Going down the list of categories of GS non-interest income, investment banking is highly competitive with zero visibility on future revenue. More, it is from the investment banking side that arise large operational risk events such as the 1MDB fraud and resulting fiasco in Malaysia, an event that cost GS billions in losses and incalculable damage to its reputation. In the specific case of the 1MDB affair, the Goldman bankers apparently paid copious bribes to win an investment banking mandate that turned out to be a fraud. Now GS has paid a settlement and related expenses that are several time total fees earned from the fraud. The 1MDB settlement wiped out the excellent Q2 2020 results and, indeed, consumed the earnings for the first half of the entire year. What is now called Global Market is the largest line item at GS and represents the firm’s trading and services activities, really the heart of the business. Trading in equities, along with fixed income, currencies and commodities (FICC), are the stock and trade of Goldman Sachs, but also illustrates why the firm won’t buy another bank. The results in FICC are variable with the markets, but GS is a firm of the markets. In an expanded organization that encompassed a larger, retail depository, the GS FICC traders would no longer be the center of attention. Indeed, they would rightly be seen as a significant source of risk. The Asset Management line at $2.1 billion in net revenues is about the same size as Investment Banking and the Lending and Investment lines on a run rate basis. Again, this business is incredibly competitive with shrinking margins that are visible among global asset managers. With total assets under supervision of $2.1 trillion, GS Investment Management unit generated net revenue of $1.67 billion or less than 1% of AUM. This was down 18% YOY, again illustrating the volatility of financial results at GS for a line item that should be stable. Consumer and Wealth Management is the smallest line item at GS at $1.3 billion in Q2 2020, down from the previous quarter but up by the same amount YOY. The senior unsecured debt of GS is rated “A3” by Moody’s vs “A2” for larger peers such as JPM and Citi. Part of the logic of ratings is market share, which in turn informs the analysis of profitability and the stability of the enterprise. The uncertainty with respect to non-bank income, the significant op-risk and leverage, and the steady shrinkage in run-rate operating income over the past 5 years, supports a negative qualitative assessment. Assessment: Funding, Business Model & Risk Our overall assessment of the quantitative and qualitative factors behind the performance of GS remains negative. The BHC generates more risk than return to its investors, and therefore trades at or even below book value in the equity markets. The financial comparisons between GS and its asset peers among the largest BHCs is not flattering and suggests that GS has serious risk issues due to its business model. The returns on the visible business are adequate but also extremely variable, this due to the highly competitive markets where the bank operates. But it is due to the hidden, operational and reputation risks that the bank’s market valuation suffers. In addition to the outsized risk characteristics of the GS investment banking business, there are three basic factors that inform our negative view: Liquidity GS is dependent upon the capital markets and other banks for liquidity. For example, the bank’s net time deposits > $250k are actually negative due to the fact that the bank maintains more deposits at other banks than it maintains for the bank’s customers. Unlike the asset peers of GS, which can essentially fund themselves internally, GS remains more of a brokerage firm than a bank. The dependence on non-core funding at GS is over 80% of total funding, placing the BHC in the 97th percentile of Peer Group 1. To address this shortcoming, GS needs to grow the core deposit base of its subsidiary bank via acquisitions. Given the competitive landscape, it is unlikely that GS can achieve this level of deposit expansion via organic growth in the near-term. Business Model The financial results of GS are primarily determined by the performance of the Global Markets area, which accounted for over 50% of net revenue in Q2 2020. The degree of variability in such areas as trading equities and FICC due to idiosyncratic and market risk factors makes it impossible to estimate what the firm will achieve in terms of performance in future periods. Simply stated, there is no visibility on the single largest portion of the GS business and there is no real solution to change the opaque nature of the capital markets and investment banking business. Risk/Return The business model choices made by GS management evidence a tolerance for risk and an indifference to compliance norms such as know your customer that are disturbing. The 1MDB disaster is just the latest such example. As an investor with equity exposure to GS, you must be comfortable with the likelihood that new operational risk events will occur in the future. Given the negative factors of liquidity and visibility, we believe that it will become increasingly difficult for GS to grow and deliver consistent profits given the competition from JPM and other larger global universal banks. We believe that an appropriate acquisition of a regional bank with substantial core deposits would greatly enhance the stability and risk-adjusted return on capital (RAROC) of GS. Such a change, however, implies less emphasis on trading equities and FICC, the traditional core revenue lines of the firm. To us, the bottom line with GS is that CEO David Solomon et al must either 1) buy a bank of similar size deposit base or 2) be acquired by an even larger depository down the road. The former strategy path allows GS some considerable latitude in terms of the choice of merger partner. The latter path may occur at a less than optimal time when the firm is under stress. Just as the remnants of Bear, Stearns & Co & Lehman Brothers were absorbed by larger universal banks during periods of market contagion, the same fate potentially awaits GS unless they accept the fact that size (that is, liquidity) matters a decade after 2008. The major obstacle to executing on an inorganic strategy is 1) the weak market valuation of GS equity and 2) the reluctance of GS management to be absorbed into a larger banking organization. The relatively flat, non-bank configuration of a broker dealer such as GS is at odds with the pyramidal management structure found in larger federally insured depositories. The level of risk appetite permitted in the GS investment bank would likely be tempered and, indeed, would decrease to align with that of its larger peers, resulting in a slow market share decline for GS. So long as the management of GS remains unable or unwilling to change, we believe that GS is going to continue to trade at a significant discount to its asset peers among large US banks. At 0.85x book value and a 10.5 P/E ratio as of the date of this IRA Bank Profile, GS is hardly a compelling value. The three-month market beta of 1.5 illustrates the greater volatility in this issuer than the S&P 500. In terms of credit, the elevated spreads in credit default swaps, for example, again suggests that the market sees GS as a higher risk counterparty. Although the majority of Sell Side analysts believe that the valuation for GS is below “fair value,” we disagree and instead believe that the heightened risk factors that accompany the bank’s business model tell the tale. Sad to say, like many names in the financial sector, GS is an issuer that deserves to trade at a discount to par. The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Profile is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Profile. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

"Well, I woke up Sunday morning With no way to hold my head that didn't hurt And the beer I had for breakfast wasn't bad So I had one more for dessert…" Kris Kristofferson Sunday Morning Coming Down (1972) Grand Lake Stream | In a moment of serene clarity, Registered Maine Master Guide Les Williams , who has more than 50 years of guiding experience, said: “Lures are for catching people,” meaning people buy lures of many shapes and colors, but the fish mostly don’t care. And of course Les is entirely right. Witness the effectiveness of the bubble-gum colored wacky worm for snaring small mouth bass. Les is known to favor live bait, especially for catching White Perch. In the markets, much the same dynamic applies to people as applies to fish in the inland waters of Maine. The people chase the shiny object of the moment, the current object of attention, but may or may not actually catch fish in terms of value. Thus we see the divergence between bank stocks and, say, non-bank mortgage firms, which recently have been trading like 2008 never happened. In the year-to-date, the KBW bank index is down 30.11%, the S&P 500 is up 6.07% and the mortgage leader Penny Mac Financial Services (NASDAQ:PFSI) is up 48% for the year. Could it be that mortgages are correlated to interest rates? Or more specifically, is the FOMC gunning asset prices for rate sensitive exposures like housing but not boosting consumer price inflation? H/T to Lisa Abromowitz at Bloomberg News for this nice summation of the problem: “Stimulus is going into asset price inflation, not CPI. And the build-up of ever larger asset price bubbles itself pins down the rates market... This combination creates a dangerous environment” where investors are compelled to abandon fundamentals & follow the money: Citi’s Matt King Speaking of interest rates, last week we published a comment in National Mortgage News about the magical nonexistent rate know as “SOFR” or the secured overnight lending rate. SOFR does not actually trade in the markets, but the Fed till expects investors and financial institutions to accept it. As we noted earlier, Fed Chairman Jerome Powell has an opportunity for another graceful policy pirouette. How? By quietly redefining SOFR as being equal to the too-be-announced (TBA) market price for government insured MBS issued by Ginnie Mae. Problem solved. With the equity markets trading off after the latest market surge, the FOMC has its inflation target 10x, but in the wrong part of the economy. The bull market in residential home lending is one bright spot in a skyline with a lot of clouds ahead. Commercial loan losses at banks are leading the way higher -- and fast. As we note in The IRA Bank Book Q3 2020 : “Even as income growth has moderated and now turned negative, credit costs rose again sharply in Q2 2020 to over $60 billion in provisions put aside for future loss. We anticipate that provisions could remain at these elevated levels for the balance of the year or longer. This implies that industry operating income is likely to go into the red in Q3 and especially Q4, when we anticipate a significant credit loss event comparable to the end of 2009.” The FOMC can accelerate lending with low rates, but it cannot ameliorate either the negative impact on credit years from now or the torrent of loan prepayments that could actually drive some investors in agency and government MBS into a loss. Owners of legacy mortgage servicing also face the prospect of reduced or even negative returns due to the early return of capital to note holders. Meanwhile, residential mortgage markets face an extended boom. " On one hand we have the old adage, 'No tree grows to the moon," writes Rob Chrisman . "On the other hand, mortgage loan originators (MLOs) and real estate agents are licking their chops given that 52 percent of young adults live with their parents . What does that tell you about the demand for housing and loans in the coming years?" Meanwhile in Europe, the very low inflation stats for August are causing some speculation in the markets about the next move by ECB President Christine Lagarde . Most market observers believe that Lagarde will respond rhetorically, a reasonable choice for an organization that has failed miserably to achieve its stated targets for inflation and economic growth. The chart below from FRED shows dollar, yen and euro LIBOR c/o ICE . With short-term rates in the US now close to zero, this leaves room for the ECB to experiment further with negative rates, something we suspect Lagarde is too smart to actually contemplate. Both economically and politically, negative rates have been a failure. Going deeper into negative territory would be a mistake for the EU and Lagarde. If anything, both the ECB and Fed need to focus on ways to inflate the income flowing to institutions and individuals before they collapse under the deflationary weight of COVID. Reducing income to investors may drive credit creation in the near-term, but the aftermath of the FOMC’s latest cycle of irrational policy actions may be quite costly to investors and financial institutions in terms of credit losses. Volatility is the given in this market environment, so don't get nauseous when the equity markets fall 20% from recent highs. Note that as the system open market account growth slowed, the VIX spiked sharply higher and remains well above 2019 lows. Do watch those outliers. The mortgage firms like PFSI that today trade above book value may face a very different marketplace a couple of years hence. Meanwhile, the large banks move gently sideways at -30% YTD. And for good reason. There is no visibility on bank credit or earnings. But the Fed will be ready to add more fuel to the fire at a moments notice. As Kris Kristofferson wrote and Johnny Cash sang decades ago, sometimes that breakfast beer tastes so good that the only choice is a second for desert.

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.