SEARCH

May 29, 2017 | In the mid 2000s, just before the financial crisis began, US banks were reporting credit metrics for all asset classes in loan portfolios that were quite literally too good to be true. And they were. The cost of bad credit decisions was hidden, for a time, by rising asset prices. The same aggressive, low-rate environment used by the Fed to artificially stoke growth in the early 2000s has been repeated in the aftermath of the 2008 crisis, only to a greater extreme. Today US banks report credit metrics in many loan categories that are not merely too good, but are entirely anomalous. Negative default rates, for example, are a red flag. A decade ago, the more aggressive lenders such as Wachovia, Countrywide and Washington Mutual were actually reporting negative net default rates, suggesting that extending credit had no cost – in large part because the value of the collateral behind the loans was rising. In those heady days of comfortable collective delusions, non-current rates for 1-4 family loans were below 1%, the lowest levels of delinquency since the early 1990s. This situation changed rather dramatically by 2007, when several large west-coast non-bank mortgage lenders collapsed. By the start of 2008, funding for banks, non-banks and even the GSEs was drying up and default rates were rising rapidly. The cost of credit reappeared. Net-charge off rates for 1-4 family loans in particular went from 0.06% early in 2005 to 1.5% by the end of 2008 and peaked at 2.5% by the end of 2009. Today the irrational exuberance of the Federal Open Market Committee has created huge asset price bubbles in sectors such as residential and commercial real estate. A combination of low rates, a dearth of home builders (down 40% from ~ 550k firms in 2008 to ~ 330k firms today) and even less construction & development (C&D) lending (down ~ 30-40%) has constrained the supply of homes. But low rates sent prices for existing homes soaring multiples of annual GDP growth – both for single-family and multifamily properties. Keep in mind that the folks on the Federal Reserve Board think that asset price inflation is helpful – thus the “wealth effect.” Specifically, the FOMC believes that manipulating risk preferences, credit spreads and therefore asset prices helps the economy to generate more income and employment. Many analysts have debunked the notion of a “wealth effect,” but the FOMC persists in this thinking even today. Mohamed E-Erian writing in Bloomberg has it right: “Forced to use the 'asset channel' as the main vehicle for pursuing its macroeconomic growth and inflation objectives – that is, boosting asset prices to make consumers feel wealthier and spend more, and also to increase corporate investments by fueling animal spirits – the Fed has ended up providing exceptional multiyear support to financial markets using an experimental array of unconventional tools and forward policy guidance. Indeed, most investors and traders are now conditioned to expect soothing words from central bankers – and, if needed, policy actions – the minute markets hit a rough patch, virtually regardless of the reason.” In an economic sense, the Federal Open Market Committee is the heart of the Administrative State. The use of the “asset channel” to pretend to boost economic activity is part of the larger delusion at the Fed known as “macro-prudential” policy. The macro-prudential worldview sees the Fed as an all knowing, all-seeing global managerial agency that can somehow balance goosing economic growth using asset bubbles with preventing the associated systemic risks. Note that regulating whole industries and constraining growth is, in fact, a key part of the Fed’s macropru model. Having maintained low interest rates and used trillions of dollars of bank reserves to fund open market purchases of Treasury bonds and agency mortgage paper, the FOMC now faces an asset market that has understated the cost of credit for over a decade. From 2001 through 2007, and then 2009 through today, the FOMC has boosted asset prices – but without a commensurate and necessary increase in income. The Fed has, to paraphrase El-Erian, decoupled prices from fundamentals and distorted asset allocation in markets and the economy. SO the question that concerns The IRA is when will the credit cycle turn and how much of the apparently benign credit picture we see today is a function of the Fed’s social engineering? If this latest round of Fed “ease” is more radical than that seen in the early 2000s, will we see an even sharper uptick in bank loan loss rates than we saw in 2007-2009? Total Loans Let’s start with the big picture perspectives of all US banks using our favorite chart, which juxtaposes pre-tax income with provisions for credit losses in the chart below. Note that quarterly pre-tax income for all US banks has slowly crawled back over $60 billion, resulting in net income in the low $40 billion range. The industry’s average tax rate was just below 30% on the $18.8 billion in taxes paid in Q1 2017. Source: FDIC Looking next at the $9.3 trillion in total loans for all US banks, the picture in the chart below is relatively calm. Note that the rate of non-current loans at 1.3% is still elevated above pre-crisis levels as are net loan charge-offs. Also, particularly note that in 2009 all non-current loans spiked to over 5%, yet net-losses after recoveries (loss given default or “LGD”) peaked at just 3%. Source: FDIC Loss given default at 75% is near the historic lows seen in 2006 and previously in the early 1990s. Think of LGD as the inverse measure of recoveries since the quality of the collateral behind the bank’s loan is the key determinant. Industry LGD for all bank loans fell to a low of 70% in 2014 when the bubble in residential and commercial real estate was roaring. Rising LGD for all bank loans today suggests that the bloom is off the rose in bank loan portfolios. Source: FDIC 1-4 Family Loans The $2.4 trillion in loans secured by 1-4 family residential properties is actually smaller in absolute terms and as a percentage of the bank balance sheet than it was a decade ago. In Q1 2000, loans secured by 1-4 family homes were 32% of total bank loans, but today that same metric is just 25% of total loans. Keep in mind that bank balance sheets have more than doubled since 2000 from $4.3 trillion in total loans to $9.3 trillion today. How’s that for an inflation indicator? Sales of residential mortgages in the agency and government market are also down sharply for all US banks, reflecting a secular migration by banks away from 1-4 family mortgage loans as the asset class of choice for American banks. Compliance risks and high operating expenses make the residential mortgage sector among the lowest return on equity asset classes. With non-current rates still at 3% vs 1% for the decade before the 2008 crisis, the credit quality of bank portfolio loans does not seem to have improved looking at the numbers. Net charge-offs at 0.4% are back down at pre-crisis levels. Looking at the chart below, loan losses seem to have been suppressed for almost two decades starting in the early 1990s. Source: FDIC More interesting, however, is the sharp, falling off the cliff movement of LGD for 1-4 family mortgages. Since the 2008-2010 period when LGDs were near 100% of the total unpaid principal balance, today loss given default for the average bank portfolio home loan is just 40% and lower than at any time since 1990. The chart below really shows the effect on credit performance of the Fed-engineered increase in asset prices since the financial crisis. But when do we revert to the mean? Source: FDIC So while the percentage of 1-4 family mortgage loans past due remains high, LGD is at all time lows. Go figure. Again, the principal driver of low loss rates seems to be the double digit home price appreciation since 2012. Credit Cards Another asset class that has been very popular with investors and the financial press of late is bank credit cards. The industry’s $750 billion in total portfolio credit card loans has seen non-current and default rates rising. The chart below shows noncurrent loans vs. charge-offs. Unlike other loan categories, notice that charge-offs of bad credit card debts are above the rate for noncurrent loans. Source: FDIC Capital One (NYSE:COF) warned last quarter on future defaults. COF saw net charge-off rates rise 42 bps year over year to 2.50% compared to the industry average of 3.6%, a statistic that suggests there are some far riskier books in the industry besides just-below-prime operations such as COF. Further, COF reported that provision for credit losses surged 30% from the year-ago quarter to $1.99 billion. Sadly the FDIC does not release publicly the data on provisions for future losses by loan type, an important piece of information that would enrich the public record. The chart below shows LGD for the credit card portfolio of all US banks. Notice this is a pretty stable metric for loss net of recoveries that fluctuates between 80-90% of the loan amount. Source: FDIC “During the first quarter, banks charged-off $11.5 billion in loans, an increase of $1.4 billion (13.4 percent) over the total for first quarter 2016,” notes the FDIC’s Quarterly Banking Profile. “This is the sixth consecutive quarter that charge-offs have posted a year-over-year increase. Most of the increase consisted of higher losses on loans to individuals. Net charge-offs of credit card balances were up $1.3 billion (22.1 percent), while auto loan charge-offs increased $199 million (27.7 percent), and charge-offs of other loans to individuals rose by $474 million (66.4 percent).” C&D Loans Today the world of real estate construction lending is very different than before the 2008 financial crisis. A decade ago, much of the C&D book was focused on single-family homes. Today banks focus on commercial and multifamily properties. The latter category has tended to be rock solid in the major metro areas, even through the 2008 crisis. From 2008 to 2010, about 1/3 of the ~ $600 billion C&D portfolio for all US banks was charged off, restructured or repaid. New lending dried up. This left a lasting caution on the part of regulators and the industry when it comes to lending on dirt. In the beginning of 2008, the total bank C&D portfolio in the US was $631 billion, but today it is just $390 billion. In 2008, there was $180 billion in 1-4 family residential construction loans held by all FDIC insured banks, but today there is just $70 billion. When you consider the factors behind the lack of supply in single family homes in the US, start with the sharp reduction in credit for the construction sector. And recall that bank balance sheets have grown 20% since 2008, so the proportion of bank portfolios allocated to financing housing construction has also dropped sharply relative to other loan types. Source: FDIC But to really see the handiwork of the FOMC, you need only look at the loss given default for C&D loans. During the early 1990s and the 2008-2012 periods, note that LGD was nearly 100% of the loan amount. Banks in the Southeast and Southwest failed in droves as development loans were taken to the curb and then written off entirely. But since 2012, the market manipulation of the Fed has caused LGDs on construction and development loans to go sharply negative, suggesting that this credit exposure has no risk or cost. In mathematical terms, recoveries on defaults are exceeding charge-offs by a wide margin, suggesting that asset prices for land and improvements are rising very rapidly. There may also be some resolutions of past defaults in the data -- going back five years or more. Source: FDIC So how does this all end? In the short term, look for default rates on consumer exposures to continue rising. But in asset classes like commercial real estate, residential homes and C&D lending, we suspect that the party may continue, at least in statistical terms, through at least the end of the year. After that, however, we full expect to see loss rates and LGDs start to snap back to the middle of the proverbial distribution. As one well-placed bank CEO told The IRA over breakfast, “there are lots of sweaty palms” in the New York commercial real estate market. Read this little missive in The New York Times about the Park Lane Hotel to get a sense of the level of exuberance in the commercial real estate market in Gotham. Without a rather robust confirmation of asset prices with rising incomes, as El-Erian and many others have observed, current levels of assets prices are unlikely to be maintained. In the event, look for bank default and recovery rates to normalize, with a sharp increase in credit costs for lenders and bond investors alike. Trees do not grow to the sky, credit costs are never really negative, and last we looked, Fed chairs cannot fly through the air or spin straw into gold. But they can manipulate asset prices and cause other mischief that, we suspect, represents a net cost to consumers and investors alike. But this is hardly a novel state of affairs. In that regard, we appreciate your comments about our earlier missive, “Buy Britain, Sell Europe.” Many of you challenged our idea that Britain is an enduring nation state, while the EU is merely a bad idea whose sell by date has passed. To address these comments, we refer to one of our favorite reads of late, “Playing Catch Up,” by Wolfgang Streeck. The emeritus director of the Max Planck Institute for the Study of Societies in Cologne, Streeck writes regularly for the London Review of Books . He is ready to suspend democratic processes to support “willing governments” that advance German-style reforms, but Streeck has a cogent view of the European political economy: “Here, as so often in her long career, Merkel is anything but dogmatic, and certainly isn’t beholden to ordoliberal orthodoxy since what is at stake is Germany’s most precious historical achievement, secure access to foreign markets at a low and stable exchange rate. For several years now, Berlin has allowed the European Central Bank under Draghi and the European Commission under Juncker to invent ever new ways of circumventing the Maastricht treaties, from financing government deficits to subsidising ailing banks. None of this has done anything to resolve the fundamental structural problems of the Eurozone. What it has done is what it was intended to do: buy time, from election to election, for European governments to carry out neoliberal reforms, and for Germany to enjoy yet another year of prosperity.” Sound familiar? In the US as well as Europe, what passes for fiscal and monetary policy are merely a series of short-term expedients meant to get us from one day to the next. The nonsense of macro-prudential policy represents the apex of such thinking. As we look out to credit conditions in the US banking sector in 2H 2017 and beyond, the one sure bet is that the cost of credit will not remain suppressed forever. #bank #credit #COF #macroprudential #macropru #FOMC #assetbubble

May 22, 2017 | In this issue of The Institutional Risk Analyst, we speak to Sanjiv Das, CEO of Lonestar’s Caliber Home Loans, a home mortgage originator and servicer established in 2013 by the merger of Caliber Funding and Vericrest Financial. Prior to joining Caliber, Das served as Executive Vice President, Global Financial Solutions at First Data Corporation (NYSE:FDC), where he led the international business and played an instrumental role in taking the company public. He has also held executive management positions at several other companies, including the CitiMortgage unit of Citigroup (NYSE:C) Das spoke with The IRA’s Chris Whalen last week. RCW: Sanjiv, thank you for talking to us. We first met you back in your days at CitiMortgage and since then you’ve done a lot of great things. Bring us up to speed on Lone Star/Caliber Mortgage and this new platform you’ve created for loan originations and servicing. SD: Thank you. Caliber is now among the top four non-bank lenders in the US mortgage market. We have a distributed model of sales professionals focused primarily on purchase loans. About three quarters of our volume is in purchase loans. Caliber's entire platform is engineered to partner with realtors, builders and brokers to enable financing home purchases across the nation. RCW: It is notoriously difficult to build a true retail channel through realtors, for example, as opposed to the advertising driven, direct to consumer approach of say Quicken. SD: Caliber's phenomenal growth is based on its dedicated loan officer distributed model, and is a testament to the fact that our Distributed Sales model and Quicken's Direct model, can both co-exist in a low-touch/high-touch world. Generally speaking, Direct lenders specialize in low touch refi's whereas Caliber specializes in Purchase. Caliber leverages its technology and digital capabilities to help our loan officers provide Realtors, Builders and Brokers transparency and confidence for their customers who are a buying a home. Our Distributed Sales and Operations model eases the complexity of getting approved for a mortgage and gives homeowners and realtors/builders the highest confidence of closing on time. Our entire team works like a trusted home purchase advisor. RCW: Well that is certainly a fortunate choice given that refinancing volumes have fallen by a third since the start of the year vs 2016. The MBA is looking for maybe 10% in purchase volumes, on the other hand, which is good news for Caliber. SD: Caliber’s model has worked very well. By focusing on strong realtor and builder relationships, with a primary focus on purchase transactions, our growth remains very solid despite the cyclical nature of the mortgage industry. We grew from $12 billion in loan originations in 2014 to $26 billion in 2015 and $41 billion in 2016. This is a great testament to a well implemented and robust Distributed Sales model. We are confident we will continue to grow in 2017. RCW: What drove your success? What took you down the road of focusing in home purchases? SD: Quite simply, there were not that many firms specializing in helping people buy homes. People define themselves as either Mortgage companies, tech companies or fintech companies, whereas at Caliber we define ourselves as a home purchase company. In Caliber’s business model, technology and digital capabilities enable the loan officer and realtor to provide a best-in-class homebuying experience, instead of front running the loan officer. We realize that even today, buying a home can be a complex, intimidating process. We believe our distributed sales model with best in class technology and digital support creates a high-confidence environment for buying a home. RCW: And I imagine that the realtors welcome your model as well. You are both focused on relationships. SD: That’s absolutely correct. The realtors know that Caliber is singly focused on closing purchase loans and can handle complex transactions that require extra diligence in some situations. The realtor-loan officer relationship is extremely important in ensuring the homebuyer has all the confidence they need to close on a home, no matter how complex. By the way, despite what's said about millennial home buying behavior, it is interesting to note that approximately 35% of our customers are millennials. This means that while people shop for rates online, a vast majority still turn around and come to their broker, realtor or builder to get a mortgage during the process of buying a house. The IRA: Given the enviable position you have created for Caliber in the purchase channel, how do you see the rest of the market adapting – or not – to fall-off in refinancing volumes? SD: We anticipated that the refi boom would eventually subside. There is a lot of evidence that Q1 was difficult for many refi players. We expect that many smaller, less-capitalized players will exit the market. Caliber has the advantage of scale and capital. As part of this, we fully expect to see a number of acquisition opportunities with the right retail sales partners, this year. The IRA: We have that situation now. We could see 10-20 percent of the seller/servicers in the GNMA market exit the space in the next 12 months. They’ve been hanging on by their fingernails as the cost of servicing trebled. SD: That’s true. Non-bank players that will be successful in this coming cycle will be those that have capital, scale, efficiency and a robust business model. It sounds contrarian, but Caliber has been waiting for a year like 2017 to separate those of us that are extremely well capitalized from the rest. The IRA: Well, you worked at Citi with some of the best minds in the risk business. But the idiosyncratic risk of smaller businesses sometimes makes the financial analysis irrelevant. SD: Yes, as leaders in this sector, we understand capital and liquidity risk extremely well and have spent a considerable amount of time with the Agencies around how best to de-risk the industry in the event of a liquidity risk faced by smaller, less capitalized players. I'm delighted to report that the agencies and regulators understand the issues and are aligned with us in finding more robust solutions for the mortgage industry. The IRA: It is interesting that you are focused on the consolidation opportunity in the mortgage industry. Certainly helps to have the folks at Lonestar behind you. Much like Apollo with Athene and their subsidiary Amerihome Mortgage and then Fortress with NationStar and New Residential. Do you retain your entire MSR? Do you think about alternative financing for the MSR, kind of “capital light” if you will? SD: Yes we are very fortunate to have Lonestar behind us. They are extremely disciplined and assess us on our financial strength as a standalone company. We look at consolidation opportunities on the basis of the strength of our own balance sheet. We retain our MSR. With regards to alternative financing structure, we are constantly evaluating the most efficient capital structure for the company. We are very fortunate to have some great anchor financing partners in helping us explore new, cheaper ways to financing. The IRA: Do you sell any of your excess servicing strip (ESS)? Or do you carry the whole asset? SD: We carry the whole MSR asset. The IRA: How do you see the economy and the mortgage market going forward? The numbers from the MBA are pretty gloomy, both the loan origination numbers and their forward estimates for GDP. SD: We are taking a wait-and-see attitude on the economy. I would have thought that home buying would have picked up more significantly by now. It's clear the supply-demand imbalance is causing stress on home affordability. It will be interesting to see how future interest rate increases will impact home buying behavior. I feel comfortable about how Caliber is positioned in the purchase market, but I do think that 2017 will be an important inflection year in purchase. The IRA: The credit box is clearly opening. SD: There are a large number of customers who were impacted in the 2008 crisis with a good credit history that want to get back into mainstream borrowing. Many bank lenders are not ready for that. Good quality, non-agency eligible borrowers who demonstrate the ability to repay are a newly emerging market. We see that as an opportunity to work with these customers in a responsible way. The IRA: Are these scratch and dent sort of borrowers? SD: These are people who’ve had an event that disqualified them for an agency loan. Of the production that we have done, the delinquency rate experience has been extremely low. The IRA: How do you view the regulatory world? With the election of Donald Trump, the industry is hoping for some relief. SD: I take a slightly different view of regulatory matters. I’ve always believed that as long as lenders continue the highest standards of underwriting and risk management, regulation can be a good ally. The IRA: The simple answer is that by and large most large banks and non-banks are horribly inefficient. Platforms like Caliber and Amerihome are new, integrated operating and data platforms. The difference in efficiency, including avoiding errors, is staggering. SD: That is absolutely correct. Large banks had multiple platforms in the mortgage business, as a result of acquisitions that never got integrated. Now at Caliber we have one platform. By definition, we get it right. The IRA: Thanks for your time Sanjiv. #Caliber #SanjivDas #Lonestar #Citimortgage #CFPB

“Europe is now a continent of widespread economic misery, of financial collapse, of disappearing faith in ‘mainstream’ political parties and rising support for ‘extremist” parties, of a loss of sovereignty and thus of legitimacy and democratic control, and of the destruction of law, both domestic and international, by the judicially larcenous European Court of Justice (sic).” Bernard Connally Rotten Heart of Europe: The Dirty War for Europe's Money 1997/2012 May 16, 2017 | With the elections in France safely recorded as a win for the pro-EU forces, the bull migration back into European equities has begun. Our usually sensible friends at Barron’s declare the raging bull buy signal on this week’s cover: “Buy Europe.” And by Europe, they mean excluding the United Kingdom. “Given attractive valuations, diminished political risk, low interest rates, and a pickup in global growth, international markets, and Europe in particular, could finally start to outperform,” declares none other than Vito J. Racanelli. The driver of the EU bull trade? Emmanuel Macron’s ambitious plans to rebuild the eurozone. His plan has been backed by Germany’s Finance Minister Wolfgang Schäuble, who wants to push deeper European Union (EU) integration. Go deeper or go home pretty much sums up the situation facing the Europeans. Most analysts have been focusing on the downside for the UK in a BREXIT scenario, but we wonder whether the EU is really viable – with or especially without the UK. Even as the cheering for the victory of Macron is dying down in Paris, officials of the International Monetary Fund are preparing for a new debt bailout for Greece. And then comes Italy. The IRA also notes that the “experts” have consistently underestimated the prospects of the UK post BREXIT, all the while waxing effusive about Europe. The dire predictions regarding the future of the UK economy, for example, have been largely wrong. The experts seem to miss the basic fact that the UK is a key player in global finance and will continue to be after it leaves the EU. United Europe, on the other hand remains a badly flawed work in progress that, for our money, has a better than 50/50 chance of outright failure. Everything written two decades ago by former EU economist Bernand Connolly in his classic book “Rotten Heart of Europe” has been proven correct and then some. Last week we got to catch up with Brian Barnier of ValueBridge Advisors LLC, who we first met while fishing up at Leen’s Lodge in Maine. He confirmed our suspicions that the EU project is in far more fragile condition than its departing member. More, Barnier says that most models of the long-term impact of BREXIT on the UK are fatally flawed and often rely only on aggregate averages for inputs, ignoring extensive details from statistical agencies in Europe. Barnier is an economist who asks questions. Rather than just accepting the output from a given model or data source, he likes to ask what is in the model. Like fully understanding what is in the chopped salad at the Greek diner. And he delights in asking model-building economists uncomfortable questions like “are you using the correlation factors from the SAS package or are you calculating them yourself?” For example, Barnier wonders why so many analysts projects a ponderous EU process for negotiating trade agreements with the UK – especially when the UK already has a dozen trade agreements ready to go and others in process. Good question. When he is not consulting for institutional investors, Brian is the proprietor of Fed Dashboard & Fundamentals , a portal dedicated to spreading economic enlightenment by highlighting errors and discrepancies in official data and how it is used to guide official policy around the globe. In a recent FDF comment, he noted that “BREXIT will unnecessarily hurt shoppers in the UK and EU unless governments recognize that prices of different products don’t necessarily move together and that inflation doesn’t necessarily cause growth.” “In the Euro area, consumers have enjoyed low average price increases over the past few years; often buying more as prices fell. This defied the European Central Bank’s (ECB) expectations that rising prices over time are needed if purchases are to grow. Thus, the ECB reacted to the perceived danger with aggressive monetary medicine,” Barnier continues. Of course, the whole point of “quantitative easing” in Europe has not been to promote growth but instead as a palliative form of hospice care for insolvent sovereign debtors such as Greece and Italy. The decline of inflation from 5% peak in 2009 to half that rate today certainly is a problem when it comes to monetizing sovereign debt. As Moritz Kraemer, S&P's head of sovereign ratings, told Tom Keene of Bloomberg News this week, the credit standing of EU nations is “going sideways” rather than improving. He also notes that unemployment in the EU is almost 10%, far higher than before the financial crisis. But Kraemer, like most observers, persists in thinking that the UK is the big loser in BREXIT. Thus we sat up in our chairs when Barnier next advanced the view that the EU and not the UK is most threatened by BREXIT. The whole bull thesis about Europe is that the French elections open the door to new prosperity in Europe while the UK must carefully negotiate an exit with Brussels. Barnier, on the other hand, declares that the negotiations are over and that the UK government led by Theresa May basically told the EU to sod off when it comes to large alimony payments. A “disastrous” meeting at the end of April between British Prime Minister Theresa May and European Commission President Jean-Claude Juncker apparently marks the end of any idea of a large British payment to essentially buy a smooth exit. As Juncker said of May: “I have noted that she is a tough lady.” Right. Wolfgang Münchau, writing in the Financial Times , thinks the EU miscalculated the mood of the British people when it offered David Cameron "a rum deal" before the Brexit campaign began in earnest. He adds that Brussels should learn from that error and be sure not to repeat it. And the mood of PM Theresa May is particularly noteworthy. We recall the excellent essay last Fall in The London Review of Books , “ Home Office Rules ,” by William Davies. He explained that: “[May’s] long tenure (six years) and apparent comfort at the Home Office suggests that the mindset may have deepened in her case or meshed better with her pre-existing worldview. This includes a powerful resentment towards the Treasury, George Osborne in particular (whom she allegedly sacked with the words ‘Go away and learn some emotional intelligence’), and the ‘Balliol men’ who have traditionally worked there. In making sense of May’s extraordinary speech at this year’s Conservative Party Conference, the first thing to do is to put it back in the context of her political experience. For her, the first duty of the state is to protect, as Hobbes argued in 1651, and this comes before questions of ‘left’ and ‘right’.” He continued: “Home secretaries see the world in Hobbesian terms, as a dangerous and frightening place, in which vulnerable people are robbed, murdered and blown up, and these things happen because the state has failed them. What’s worse, lawyers and Guardian readers – who are rarely the victims of these crimes – then criticise the state for trying harder to protect the public through surveillance and policing.” Indeed, May could be as much of an outsider as Donald Trump, albeit one that grew inside the state from a career as a professional politician instead of from outside as a business mogul. And she leads Britain combining a decidedly domestic political perspective with a deep knowledge of the workings of that country’s administrative state. The best advice for President Juncker seems to be don’t mess with this lady. With the EU itself predicting flat GDP growth below 2% through 2019, it is hard to get behind some of the enthusiasm of our colleagues for the European trade. The fact that the Germans and French are falling in love again does little to cheer the nations of Eastern Europe, which are among the most dynamic and fastest growing parts of the EU. In fact, the rush into Europe looks an awful lot like the bull market stampede last October that took US financials up 20 and even 30% and more by the end of March. There are increasingly hyperbolic comments coming from Sell Side analysts about European valuations relative to opportunities in the US and Asia. But when we consider the underlying economy, it seem hard to reconcile the exuberance with the appalling data. Meanwhile we note that Greek Prime Minister Alexis Tsipras seems to be running out of political support and Greece is running out of cash, again (despite the current account surplus). Say what you might about the promise of Europe, the UK made the right decision to keep a foot outside of this experiment in statecraft. And say what you will about the new “unity” in Europe after the Macron victory, the UK has ‘first-leaver” advantage. We are far more bullish than the consensus on the prospects for the UK economy separate from the eurozone and far more cautious on the European project. To us, the UK is going to evolve into the Singapore of Europe as what remains of the EU must decide if they will pay the price of unity. So far, the EU’s response to that question has been QE care of Mario Draghi and the European Central Bank. But the only way that the EU can survive is to take a more aggressive and authoritarian approach towards weaker members. Thus we see Wolfgang Schäuble tightening his grip on Greece even as political tensions in that country continue to grow. The Daily Express notes that Greek protesters took to the streets in recent days to react to more demands that the country cut pensions by up to 18 per cent. Rather than new unity in Europe, we see a continued process of the Huns bullying the weaker nations, first up being Greece and then likely followed by Italy. This is hardly a formula for economic recovery and growth. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

May 9, 2017 | In an October 1925, speech in Birmingham, Michigan, Senator James Couzens , the business partner of Henry Ford, sketched out a vision of "good" businessmen, who are ethical, and "bad" businessmen, who are unscrupulous in their dealings with the public, the ultimate consumer. If you protect the markets from fraud, Couzens argued, you ultimately protect the consumer. The optimistic assumption in the 1920s was that industries could be exhorted and led to ethical behavior by the example and standard-setting of their own business leaders. Today we have given up on people doing the right thing without coercion. Instead we rely upon regulators and experts of varying flavors to moderate and oversee commercial behavior. Thus there is a bias in favor of regulated industries and a negative view of the private sector. For example, there is a constant refrain from the regulatory community when it comes to commercial banks vs. nonbanks. Simply stated, the latter are seen as acts of evil that are inferior to regulated institutions. Leonid Bershidsky, writing for Bloomberg View awhile back, embodies this perspective, chiding “shadow banks” for engaging in “regulatory arbitrage” vis-à-vis the blessed world of regulation. But nothing could be further from reality. Non-banks represent the private sector, the baseline for economic activity. Banks are government sponsored entities with implicit sovereign support. Most of the major rating agencies, for example, assume a degree of “lift” for the credit ratings of the largest US banks because of the presumption of support for the depositors of these mega depositories in times of crisis. We should remember that the regulators who supposedly make commercial banks safer than non-banks have an appalling track record. One word: Citigroup. Regulators failed to predict or avoid financial crises such as 2008 and 2001 before that, to name just two financial events. Our beloved regulators pander endlessly to consumers, but routinely ignore acts of fraud in the world of securities and institutional investors. The false narrative says that the abuse of consumers caused the 2008 financial crisis, but in fact it was widespread securities fraud by the largest banks. Nonbank lending institutions actually must play by the same rules as the banks, except they have no balance sheet and no cheap backup funding from the Federal Reserve Bank or Federal Home Loan bank. Non-bank mortgage firms, for example, are forced to affirm their credit every day because they often fund their business via short-term bank loans. Non-banks with investment grade ratings typically run at leverage ratios of 5:1 or less, but some asset classes such as aircraft, rail cars and other types of transportation assets can and do support higher leverage. Regulated banks by comparison can run at 15:1 leverage on balance sheet and more if they use off-balance sheet (OBS) financing, the core systemic risk issue behind the 2008 financial crisis. Just as large corporations use OBS transactions to hide taxable income offshore, (see The National Interest , “America Reaps Few Benefits from Trump's Tax-Cut Proposal” ), commercial banks have long used special purpose entities to hide leverage. Think about that for a minute. Even with the bank’s huge advantages over non-banks in the form of public subsidies such as the discount window and federal deposit insurance, structural subsidies that support higher leverage rates, regulated banks still feel the need to cheat in terms of disclosure of risk exposures squirrelled away in a special purpose vehicle somewhere offshore. The behavior of regulators and journalists generally towards non-bank companies illustrates the statist drift towards a largely regulated environment in the world of finance. In the fantastic world of “macroprudential” policy, regulators soar like star ship pilots who guide the economy and oversee financial institutions simultaneously. European Central Bank governor Mario Draghi typifies this “superman” syndrome. But central bankers do not see all banks as being created equal. For macro economists turned central bankers, a few large banks are preferred to a myriad of smaller banks and non-banks, which are all seen as too troublesome (to regulators) to have any economic utility. Regulators are openly contemptuous of smaller banks and non-banks alike, one reason why the research community treats non-banks firms with such slight regard. Just to illustrate the enormous skew in the thinking inside the Federal Reserve System, an April 10, 2017 blog post by The Federal Reserve Bank of New York, “Financial Crises and the Desirability of Macroprudential Policy,” actually advances an explicit justification for subsidizing large banks in times of market stress. The blog states: We use the model to consider a subsidy on bank equity issuance. That is, for example, for every $1.00 in equity raised, the government would contribute an additional $0.10 in equity. The goal of this regulatory scheme is to induce banks to raise more equity, thereby contributing to strengthening their balance sheets. The first thing to notice is that the folks at the FRBNY are worried about absolute levels of capital rather than bank behavior. In times of market stress, whether a bank is raising capital or not generally does not matter. The reserve of confidence with the bank’s counterparties does matter. The confidence of financial counterparties is a reflection of consistency and character, not capital. Focusing on good governance and the presence of dubious OBS financial transactions is more important for crisis avoidance than the level of capital. Only the fact that the government is the buyer of large bank equity, in the FRBNY proposal, would provide additional credit support to the issuer. Thankfully, the article does note that, above a certain level, a subsidy for large banks is “a cost to society with little or no benefit.” But the FRBNY article never asks if, as a general matter, it as a good idea to support a large, zombie banks with public funds. Like large auto manufacturers, the largest banks generally don’t even earn their nominal cost of capital. Is it really good public policy to support these regulated monopolies at any time? Maybe President Trump is right when he considers breaking up the top four money center banks. What would a mega bank break up entail? Easier than you might imagine. If we disassembled the four largest banks and ended up with 6-8 specialized consumer and wholesale banks with between $500 billion and $1 trillion in assets, the US markets would function far better. Add to that another 8-10 large non-bank broker dealers led by the likes of Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), focused on capital markets and wealth management, and you have an extremely competitive and dynamic capital finance marketplace. Hint: There are several new, emerging broker dealers that are owned by Buy Side firms. For good measure, let’s consolidate the top 20-30 non-bank mortgage seller/servicers down to about 4-5 large platforms, each with hundreds of thousands of loans in their servicing portfolio. These larger mortgage platforms will be more stable in terms of liquidity, perhaps profitable and, maybe, would actually have the money to invest in technology. We might even introduce these large non-bank mortgage firms to some large community banks. Hey, you never know. Suddenly the “risks” of non-banks may start to take on a new complexion for members of the public research, journalistic and regulatory communities. The point of this tirade is that non-banks are not “bad” banks. They just don’t have the fat subsidies that federally insured and regulated commercial banks take for granted. If we focused on important issues, namely preventing systemic crises via regulation of deceitful OBS transactions and broadly enforcing rules against securities fraud, the entire concern about capital for banks and non-banks alike would assume a far smaller part of the public narrative. You can tell a good bank or non-bank from a bad apple by whether they (or their clients) cheat on disclosure of risk and/or taxes in their off-balance sheet transactions, the ultimate source of systemic risk. For example, if a bank or non-bank has a whole department that specializes in constructing innovative tax and/or investment strategies for clients using offshore financing vehicles, then beware. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

May 13, 2017 | What do the US residential housing market, the stock market and the dollar all have in common? All of these markets represent bubbles created and driven by the aggressive social engineering of the Federal Open Market Committee. Will live in an age of asset bubbles rather than true economic growth. The investment world is skewed by the latest round of monetary policy experimentation by the Fed, including years of artificially low interest rates and trillions of dollars in “massive asset purchases,” to paraphrase former Fed Chairman Ben Bernanke. These bubbles are caused and magnified by supply constraints, not an abundance of credit. Whether you look at US stocks, residential homes in San Francisco or the dollar, the picture that emerges is a market that has risen sharply, far more than the underlying rate of economic growth, due to a constraint in the supply of assets and a relative torrent of cash chasing the available opportunities. Likewise with the dollar, the image of the financial markets is one of constraints rather than policy ease. Since the middle of 2014, the value of the dollar against major currencies has risen sharply, suggesting a shortage of liquidity or at least a relative preference for dollars vs other fiat currencies. The vast flow of foreign direct investment drawn into the US and then into asset classes like residential and commercial real estate illustrates the abundance of global dollar liquidity and relatively scarcity of assets. Even with the supposedly accommodative policy by the FOMC, key measures of market liquidity continue to suggest either price and/or structural constraints, both in the US and overseas. Looking at the effective cost of dollar credit, for example, illustrated by the notorious London Interbank Offered Rate or LIBOR, the cost of borrowing dollars in Europe has risen steadily risen since the Middle of 2015. Again, the chart below makes us wonder if the good folks on the FOMC appreciate the degree of fundamental demand for dollar credit. With the end of the Mortgage Bankers Secondary Market Conference in New York, American lenders face a market with new origination volumes down 25-30%. Meanwhile, the reinvestment of prepayments on $1.7 trillion worth of mortgage backed securities (MBS) held by the FOMC is essentially taking up new bond issuance by Fannie, Freddie and Ginnie combined. We have been on the record saying that the FOMC should adjust its portfolio now to accommodate private market demand for yield. And there is no need for actual sales. Simply ending the Fed’s reinvestment of mortgage bond prepayments would allow the interest rate markets to find a natural level and, to us, give the Fed a more accurate picture of demand upon which to adjust supply. "I think they're aiming for something in the vicinity of $2.3 to $2.8 trillion, something like that," former Fed Chair Ben Bernanke said Monday on CNBC's "Squawk Box." Ending reinvestment of the Fed’s MBS portfolio would lead to a net monthly runoff rate in high double digit billions of dollars. Or to put it another way, it is time for the FOMC to get out of the way of the private market. Shrink the Fed’s bond portfolio and credit the reserve accounts of the banks. It seems that many market indicators such as the dollar and LIBOR suggest a market that is either schizophrenic or dysfunctional. Our guess is the latter, in part due to excessive prescription-based regulation of traditional banking and finance, particularly low-margin money market businesses which are being abandoned by the big depositories like JPMorgan (NYSE:JPM) and The Bank of New York Mellon (NYSE:BK). There are seismic changes going on in the world of trading cash securities and collateral lending, changes that see a host of non-banking firms returning to this traditional nonbank space. Staring at these charts for the dollar and LIBOR, we wonder how much of the upward price movement is caused by legal and regulatory changes occurring over the same periods. The clear question from all of this: What happens when this latest dollar super cycle ends? Given that zero or negative rates elsewhere are driving much of the emigration into American assets, why should the dollar ever selloff, right? Regards the prospect of a dollar drop, Megan Greene tells us on Twitter that “Only way I see it in the short-run is if everyone else gets in trouble and the Fed opens swap lines w other CBs to supply QE #unlikely We hear all of that, but can’t help but ask the question. All things do come to an end, including the seeming ability of the FOMC to painlessly levitate the fortunes of heavily indebted nations on a sea of easy dollar credit. This works really well when the dollar is strong, otherwise not so much. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

April 29, 2017 | Last week The IRA’s Chris Whalen participated in the Executive Roundtable in San Francisco, hosted by the Morrison Foerster Law firm. We got to hear from a lot of different representatives of the mortgage and fintech sectors. The big worry at the table is that production of new mortgages in 2017 is down about 30% compared with last year due to the rise in interest rates following the November election of Donald Trump. Trump politics drives interest rates higher and mortgage production falls. Just as the Executive Roundtable meeting was ending, news crossed the screen that the Consumer Financial Protection Bureau (CFPB) and a number of states were imposing new sanctions on mortgage servicer Ocwen Financial ( NYSE:OCN ). CFPB head Richard Cordray (pictured above) was formerly attorney general in OH, where he used his legal power to extract millions in settlements from private mortgage companies. A key political ally of Senator Elizabeth Warren (D-MA), Cordray represents a new generation of liberal politicians who use the power of regulation to impose legal settlements and fines as a means to achieve political power. Trial lawyers and event driven hedge funds follow Warren and Cordray like crows. White House economic czar Gary Cohn reportedly gave Cordray an ultimatum over dinner a few weeks ago to resign from the CFPB. Cordray declined President Trump's invitation to leave public life and instead launched a new assault on subprime mortgage servicer Ocwen Financial, which was accused last week of operational deficiencies by the CFPB and a number of states. Regulators have been bleeding Ocwen dry with fines and monitoring costs for years, but this latest move by Cordray amounts to a not-too subtle “Foxtrot Yankee” to the Trump Administration. Just by coincidence, as the CFPB and states announced their action against Ocwen, the stock was simultaneously hit by waves of short-selling from hedge funds and several new class action lawsuits, all this in less that 24 hours. This week, subscribers to Whalen’s Financial-Technology Investor can read my assessment of the Ocwen situation. Click this link for information about the special offer for readers of The Institutional Risk Analyst. There was much discussion in SF last week about efforts to expand the mortgage credit box. The good news is that interest rates are falling, with the 10-year Treasury now down to 2.2% from the peak of 2.6% several months ago. The tentative bad news, however, is that mortgage volumes are only slowly starting to recover at all from the Trump Bump. The first quarter of 2017 was for single-family mortgages what Q1 2016 was for commercial real estate asset-backed securities (ABS) – that is, dreadful. Down a lot more than 30% to put it mildly. Mortgage origination pipelines seem to be better in April, however, and mortgage banks are now delivering loans into agency securitizations with 3% coupons instead of the 3.5% coupons seen at the start of 2016. Our friend and TBA market watcher Adam Quinones at Reuters writes: “The range is no longer the range and while breakout energy has been largely contained thus far, the rally is impacting pipeline hedging strategies. Naked C30 pricing now pays a premium on 3.75 and 3.875 notes. That puts FNCL 3s back in the delivery mix. Once lenders start showing these levels to LOs [loan officers] in size, late 2016/early 2017 borrowers will see their option jump in the money. Swapping coverage down-in-coupon is an aggressive decision at this point but everyone should be preparing for a sudden shock in pull-through volatility. One or two major aggregators flipping to BestEx [best execution] the buyup is all it takes to trigger a mini-churn event here. Don't think originators are that responsive to a small dip in rates? Think again. It was a rough Winter.” In other words, the attractiveness of selling residential mortgage loans into agency markets is growing as rates fall. More, residential mortgage refinance volumes may come back later in 20017 -- assuming that Washington does not cause another "bump" in interest rates. But watch that interest rate and spread volatility. Another topic that came up at the Executive Roundtable during discussions of the Trump Bump was whether the major banks and especially JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC) would re-enter the market for Federal Housing Administration (FHA) loans. The short answer is not yet, both because of concerns about punitive action by the Department of Justice and other, operational factors. JPM chief Jamie Dimon has been very clear on his views of the Washington situation and the financial and reputational risk that comes from originating FHA loans in his shareholder letters. One suspects that this issue is on a list somewhere in Washington, but the recent actions by the Consumer Financial Protection Bureau (CFPB) against Ocwen Financial hardly inspire confidence in this regard. And the Department of Justice litigations with both PHH Corp (NYSE:PHH) and Quicken Mortgage continue unabated. But some banks like the FHA market. Mortgage industry Maven Rob Chrisman notes that WFC is already changing pricing on FVA loans to become more competitive: “Regarding FHA loans, did you see Wells Fargo's price changes for low balance FHA loans this week? (Starting May 1, see how the pricing works for a low-FICO borrower, and you're calculating in a 3, 4, or 5-point hit.) It is generally believed that JPMorgan Chase would return to offering that program on a competitive basis IF the regulatory, and penalty, environment changed. And if they do, the market share will be taken from smaller independent mortgage banks who have been enjoying the profits.” Chrisman further notes that mortgage banking earnings for JPM, WFC, and PNC Financial (NYSE:PNC) were down in the first quarter but largely in line with expectations. The decrease in Q1 2017 earnings was driven by lower origination volumes, he notes, while gain-on-sale (GOS) margins were mostly flat. “JPM's mortgage origination volume of $22.4 billion was down 23% Q/Q from $29.1 billion while WFC's origination volume was down 39%. WFC's application pipeline was down 21%, which was slightly worse than expected. Both companies reported flat gain on sale margins,” Chrisman reports. The bottom line with the big banks and the FHA market is that when the risk-adjusted returns make sense and the threat of government litigation subsides, then the banks will return. So much of banking today is a function of risk-adjusted returns, both operationally and from a regulatory perspective. If the numbers don’t meet the economic and regulatory hurdles, then the banks will shed market share or even get out of the asset class entirely. Single family home finance has been a chief victim of the emigration of banks out of residential mortgage originations, but the same risk adjusted returns calculus is also pushing many banks out of prime auto lending and ABS. The numbers in prime auto simply do not work when you consider the rising cost of loan origination and servicing, the indirect regulatory risks, and the poor execution into ABS. The decision by Citigroup (NYSE:C) to sell its mortgage servicing business illustrates this trend. But also recall that WFC got out of residential mortgage lending entirely in the early 1990s. Mortgage lending is a negative cash flow business and servicing too has historically been a cost center at most banks. Legacy banks and non-banks, as a result, both suffer from profound operational inefficiency. Historically banks could subsidize the lending and servicing businesses, but less efficient non-banks cannot, especially the monoline servicers will no significant lending business. One reason that shops like Flagstar (NYSE:FBC), PennyMac (NYSE:PMT) and new entrant Amerihome, which is owned by insurer Athene (NYSE:ATH), are able to be successful is the fact of being both a lender and servicer. Operating efficiency and capital markets sophistication, however, are other key advantages enjoyed by these relatively new, large and growing platforms. Another fascinating aspect of the conversation in SF was fintech and how different players were disrupting the established order. We heard presentation from SoFi, who has figured out a way to use restricted stock units (RSUs) from millennials working at tech companies as part of the income calculation for a jumbo mortgage. The logic goes that an RSU counts as income on your taxes, so why not include as part of the assessment of ability to pay and DTI. Is this a great country or what?? We also heard from Donald Lampe, Partner at Morrison Foerster, on the outlook for regulatory reform. “Not clear where Dodd-Frank reform fits into the Trump agenda, but evidently not in top three,” notes Lampe, who is based in Washington and is an astute observer of the political process. “Dodd-Frank statutory reform is not easy in Congress, especially in the Senate – it’s still gathering steam in the House. And even the Courts (D.C. Circuit) will have a say in any reforms,” he cautions. Doug Duncan of Fannie Mae and Mike Fratantoni of the Mortgage Bankers Association held forth on the outlook for the economy and the housing sector. Suffice to say that MBA has GDP growth at 2% this year, declining to 1.9% in 2018 and 1.7% in 2019 – even with Trump factored into the equation. They see total loan originations down 25% at $1.6 trillion in ’17 and ’18, then rising back to $2 trillion in 2019. Not good news for originators focused on loan refinancing. So the basic prognosis for the mortgage industry is that volumes will remain depressed by substantial shrinkage in refinancing volumes, but look for some purchase volume growth as the proverbial credit box widens accordingly. The sudden buzz around new products such as fractional interest mortgages in going to be sustained and grow louder as originators and aggregators look for new and innovative ways to fill the purchase loan pipeline to drive ABS issuance. In this regard, note the new blog created by Weiss Analytics focused on the US housing sector. The latest blog posting from Weiss notes that “US Housing Crosses the Great Divide” as the number of homes rising in heretofore red hot markets is starting to fall, even as the number of homes falling in value is increasing. Unlike other measures of home price appreciation, Weiss actually values tens of millions of individual homes. Could the secular bull market in single family homes going back to 2012 finally be ended? Don’t look for home prices to fall very much, but the continuous rise in home price appreciation at multiples of income and GDP growth may have finally outrun consumers’ ability to borrow and pay. But like public stocks, the residential home market faces a persistent shortage of supply, which will likely keep valuations from falling too much in the most desirable locations. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

“Anyone taken as an individual is tolerably sensible and reasonable – as a member of a crowd, he at once becomes a blockhead.” Friederich von Schiller Quoted by Bernard Baruch April 17, 2017 | The term "magical thinking" refers to how children believe that their thoughts have a direct effect on the rest of the world. So last week we learned that the Trump Bump is not real. Lower taxes, increased spending, these were never really serious goals, but merely political talking points. Charles Gasparino and Brian Schwartz of FoxBusiness also suggested that the proposed cut in corporate taxes would instead mutate into a repatriation scheme a la Argentina and Italy. Corporate tax cuts are dead, but "a percentage of the money returning to the U.S. would be used to finance an infrastructure fund to build the roads and bridges that President Trump has recently been touting,” they report. This is bad news for Wall Street, where lower corporate taxes have been a key underpinning for the recent exuberance. As the Don mutates before our very eyes, his promise of big things and thus the outsized impact of same on financial markets will also change – and dramatically. President Trump’s change of mind on corporate tax cuts certainly goes against the happy consensus view. The move in the stock market from the latter part of last October to the beginning of March 2017 can only be described as a speculative episode, to paraphrase John Kenneth Galbraith. As he wrote in A Short History of Financial Euphoria : “Regulation and more orthodox economic knowledge are not what protect the individual and the financial institution when euphoria drives up prices, and to the eventual crash and its sullen and painful aftermath. There is protection only in a clear perception of the characteristics common to these flights of what must conservatively be described as mass insanity. Only then is the investor warned and saved. There are, however, few matters on which such a warning is less welcomed.” Indeed, while the raging bulls raised up Bank of America (NYSE:BAC) nearly 60% in four months and pushed the yield on the S&P 500 below 2%, the reality of the Trump Administration and its truly conventional nature was becoming apparent. The big statements and big ideas are abandoned without remorse as the President seeks leverage, to paraphrase our friend Jim Rickards. A key takeaway from earnings so far is that we have confirmation of a slow-down in lending and a related slowing of the economy. Retail is also in a downward phase, although the stalwart optimists in the crowd believe that the numbers will improve later in the year. And Chinese GDP beats expectations. The other obvious takeaway from earnings is that we’re pretty deep into the current credit cycle. If anything, the Fed should be thinking about mild easing. But instead Janet Yellen & Co are trying to “normalize” rates as the economy slows. The chart below shows yield on the 10-year Treasury bond less the yield on the 2-year Treasury note. Not only are interest rates falling rather than going up, but the yield curve is also flattening as the difference between long and short interest rates is squeezed. This is not a bullish chart needless to say. But even less encouraging is the juxtaposition of real GDP and the federal funds rate, an important chart that reorients your thinking about just where we are in relative economic terms and in particular the definition of “normal.” The chart below shows these two relationships and suggests to us that getting short-term rates to 3% is going to be a near impossible task. We are waiting to hear from BAC this week to see just how our favorite zombie girl justifies those impressive forward estimates for revenue and earnings growth. More than any of the top banks, BAC has reduced operating costs and positioned the bank for growth – this after years of bloody, slow-motion restructuring. But rising interest rates will not help bank earnings, especially when interest rates are going down. Readers of The IRA will recall that we took the view after 2008 that BAC should have put the parent holding company through a Ch 11 bankruptcy to accelerate the restructuring process. But today, fact is, the bank’s selling, general and administrative expenses start with a “5” as in $54 billion rather than a “7” as in $72 billion in 2014. With a 16% estimate for 2017 earnings and 21% for 2018, its does not take a lot of imagination to see why BAC moved as far and as fast as it did, but that’s all over now as the song says. The promises by Donald Trump during the 2016 election have been replaced by conventional thinking and even more conventional people to think them. Witness reports from Politico that President Trump is expected to nominate former Treasury undersecretary Randy Quarles as the Federal Reserve's top bank regulator. Quarles is a big time member of the establishment, a veteran of the George W. Bush administration and managing partner at equity investment firm The Cynosure Group. “I don't think the folks who voted for Trump thought they were voting for Randy Quarles, although I like the Dickensian name,” notes one DC insider. “Quarles is a Bushie and could be weaker than Tarullo.” CompassPointLLC opines politely that “Our sense is that Mr. Quarles will be viewed as a pragmatic deregulatory force.” But Washington’s premier investment bank avers that “tax reform expectations in D.C. continue to temper. Our view remains that political and policy realities will slowly grind broad tax reform efforts into a narrower tax relief package with corporate rates of 25-28%.” So the good news and the bad news rolled up together is that the Trump Revolution is over. All of the talk of change, tax cuts and new policies is rapidly giving way to a very conventional Republican Administration populated by bankers from Goldman Sachs. To get a good bearing on President Trump, think of the first term of President William McKinley combined with the latter years of Ulysses Grant. For Wall Street, the end of the Trump Revolution portends a return to the October 2016 status quo ante, with all of the attendant difficulties and discomfiture. We can’t say for sure that BAC will go all the way back to $16 per share, where it started its remarkable journey last October. But even at the $22 close on Thursday, BAC was still trading below book value, a remarkable, even magical commentary in these increasingly conventional times. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

April 19, 2017 | This week provides an interesting comparison between two “financials,” Bank of America (NYSE: BAC) and Goldman Sachs (NYSE:GS). The former is the best performing large bank stock in the US over the past six months, while the latter just disappointed on both revenue and earnings. Before we get into that, the link below announces the launch of my new venture with the folks at Agora Financial, Chris Whalen’s Financial Technology Investor . There is a special limited time offer for readers of The Institutional Risk Analyst . Please take a moment to read this exciting announcement. Become a Charter Member of Christopher Whalen’s Financial Technology Investor Now let’s consider GS, one of Wall Street’s leading investment houses and also one of the most political banks in the world. There are two kind of Goldman partners – deal guys and politicos. The latter category include the likes of Robert Rubin, Hank Paulson, Jon Corzine and now Gary Cohn. Quite a list, yes? In fact, there are about a dozen or so former Goldman Sachs bankers working in the Trump Administration. This either means that the financial world is headed for a crisis or the Mother Ship on Broad Street is in some serious kimchi. Looking at the latest financial results, our informed guess is the latter. As Goldman’s CFO Martin Chavez put it: “We did underperform.” Jim Cramer at CNBC put it better: “Talk about not executing.” GS fell to a five month low yesterday after missing on both earnings and revenue. Normally the Street analysts set the bar on forward estimates pretty low, so a miss is pretty bad – especially when you are Goldman Sachs. The other issue is that the chief financial officers of large cap financials usually have a couple of cents worth of earnings in their pockets to help meet or beat, so when you miss large that is even more disturbing to investors. So what happened? Investment banking was actually up 15%, but the other business lines missed and by a wide margin. Most notable was the 22% drop in fixed income and commodities trading in institutional client services. Investment management results also fell, driven down by a 46% decline in incentive fees. Q: Was there a loss that caused the big move in results in fixed income and commodities trading in institutional client services? GS says no. Awfully big move for a failure in execution. But with all that said, the net revenue line was down just 2% sequentially and actually up 27% year-over-year, but the GS stock got hammered anyway. Remember that Q1 2016 was awful for the Street, so the YOY comparisons require a lot of seasoning. The sizable increase in operating expenses then put the kibosh on a happy ending, leaving GS with flat net income sequentially but up 80% YOY. Indeed, leaving aside the sharp rise in expenses, the YOY comparisons for all of the GS business lines were not bad, yet investors turned their backs on Goldman. Maybe more than the numbers, the damage to the aura of invincibility of the House of Goldman may be the real story in this quarter’s financial results. Meanwhile, BAC managed a significant beat in terms of both earnings and revenue. Keep in mind that going into this week, BAC had Street estimates for earnings and revenue growth that are normally associated with tech companies. In particular, BAC has taken operating expenses down more than 30% over the past five years. Operating income has stayed remarkably steady in the low $80 billion range, leading to an 1,110% improvement in net income over the past five years. What is remarkable is that CEO Brian Moynihan did not get much credit for his expense reductions until the election of Donald Trump last November. BAC then sprinted, leading the large cap financials higher, outdoing JPMorgan (NYSE:JPM) by a 2:1 margin. Total income for BAC was up 10% YOY to $22 billion, but expenses rose as well and yet were flat YOY. All of this cost cutting led to earnings up small vs Q4 2016 and $1.3 billion YOY. Fully diluted earnings were 41 cents vs 28 cents a year earlier. Hoo Rah! All of the progress made by BAC is of course splendid, but Wall Street has a notoriously short memory. Just ask the folks at Goldman Sachs. So if BAC is really going to hit the 16% earnings growth estimate for 2017 and the 21% estimate for next year, Brian Moynihan is going to need to pull multiple bunnies out of the proverbial top hat. To be specific, that means getting quarterly net income up to $5 billion by the end of 2017 and $6 billion by the end of 2018. This implies a significant increase in the assets and revenue of BAC that we simply cannot see happening in this environment. We give kudos to BAC for the great performance over the past five years, but fade the forward Street estimates on earnings and revenue growth please. Of course, nothing is impossible, as proven by the remarkable job of cost cutting and expense containment achieved by BAC so far. But if BAC can get run rate quarterly net income up to $5 billion plus by year end, then maybe this long neglected stock will manage to stay above book value. Then JPM will need to start running faster. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

April 12, 2017 | Since the November 2016 election, large cap financials have moved sharply higher, in the case of Bank of America (BAC) up almost 60%. This spasmodic upward movement in reaction to the election of Donald Trump reflected both the collective desire of professional managers to increase allocation to financials but also the shared frustration of investors with the chronic under-performance of large banks. Let’s face it; there’s a whole generation of managers on Wall Street who made their careers buying big banks. These torpid zombies may not have very good financial metrics, but the roar of the Buy Side crowd managed to push financials to more than a quarter of the market cap of the S&P 500 during the 2000s. Today financials as a group are not quite half that portion of the broad market and for a reason: large banks are horrible financial performers. Flat revenues, strained earnings and buckets of headline risk do not make for peaceful slumbers in the world of Buy Side managers. Just look at the self inflicted wounds at Wells Fargo (NYSE:WFC). And ask yourself if anybody, anywhere would have predicted three years ago that Warren Buffett’s favorite big bank would be clawing back CEO comp and, yes, effectively cutting off fingers and toes for public giggles. Yeah? Can’t make this stuff up. Since BAC peaked a bit shy of up 60% on March 1st at a whole $25 and change per share, our favorite zombie girl has been giving back those hard won gains. The House that Brian Moynihan kinda, sorta owns, by default, closed at below $23 yesterday and our guess is that the best performing large bank of the past six months will give up more in coming weeks. Consider the fact that in the upward whoosh of the Trump Bump our friends at BAC actually outperformed the other large zombie banks and by a wide margin. BAC is still up 40% since the election of Donald Trump, while JPMorgan is up a mere 25%, WFC under 19% and Citigroup (NYSE:C) right on 20%. There are so many managers that have waited so long for Brian and BAC to take flight that they simply could not help themselves. As we told Jeff Cox and our pals at CNBC the other day , our guess is that nothing in earnings this week or next is going to prevent these large cap financials from giving up more ground in coming weeks. The fact that the Street has BAC with a up 9% revenue estimate for Q1 ‘17 can only be interpreted as an act of extraordinary generosity, especially when you consider that the full year estimate is just half that number. But even if we assume 9% up revenue for the full year, admittedly an amazing suggestion, does the current market value of equity of BAC make sense on any planet in the solar system? Then there is Citi, the laggard in the large bank peer group and for a reason. The Street has Citi up 2% on revenue in Q1 ’17 and, wait, a whole 2.1% top line growth for the full year. That is just 1/10th of the move in the stock since October. But somehow the house that Bob Rubin almost destroyed single handedly in the 2008 will do plus 4% revenue growth in 2018? You really have to respect Street analysts for their ability to see the bright side of the picture no matter what the actual numbers may suggest. The Street has WFC up a whole 0.5% on revenue this quarter and 4.3% for the full year 2017, another act of selfless generosity based upon the bank’s shaky state of governance and the sharp decline in mortgage origination volumes. We are still getting over the fact that WFC publicly got ripped a new orifice over hedging its mortgage book last quarter. Like, really?? If the biggest mortgage bank in the world cannot hedge its mortgage servicing book, then why are we even here? But then again, the shambles in the bank’s CSUITE really answers that question. Then finally we come to the House of Jamie, JPMorgan (NYSE:JPM), which actually underperformed BAC in the upward surge we all know as the Trump Bump. The Street has JPM up 3.3% on revenue in Q1 ’17 and a whole 3% for the full year. Looking at the plus 25% for JPM at yesterday’s close, we need to ask the question. Even if Jamie manages to beat the +15% Street estimate for earnings, does the outlook for the business really justify a 25% move since October? No it does not. As the chart below illustrates, there is no real growth in bank earnings when you look at the industry as a whole. The dollar revenue of interest earnings is rising, this due to the growth of bank balance sheets, but there is no corresponding expansion of income as a percentage of earning assets. The top four banks discussed in the post account for about half of industry assets, so the general does inform the view of the particular. Source: FDIC As we noted in the last issue of The IRA , the yield on earning assets for all US banks has been falling since 2008 thanks to the social engineering of Janet Yellen and her colleagues on the Federal Open Market Committee. Quantitative easing is bad for the economy and for banks as well. But don’t blame Jamie Dimon or Brian Moynihan for the stagnation of bank revenue and earnings. That honor belongs to the FOMC, their colleagues among the ranks of the bank regulators, and ultimately Congress. Give President Trump’s comments about deregulation and stimulative fiscal policy credit for driving up the value of financials generally. And thank the generosity of credulous investment managers for the fact that large cap financials have not fallen farther faster as the exuberance of the Trump Bump fades. Fact is, the Buy Side just loves the big banks, this even though the real value creation comes from smaller names. But we continue to believe that in the absence of a remarkable increase in bank revenue and earnings this week and next, the market value of equity for the four zombie dance queens is likely to go lower in the near term as value and stock prices return to balance. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

April 9, 2017 | This week brings the start of Q1 2017 earnings for many banks, large and small. In order to better inform the subsequent prognostications, we borrow a line from the Passover Seder and ask: why is this bank different from all other banks? This question is not only important to understanding bank financial performance and earnings, but also to appreciate the subtleties of the evolving regulatory narrative in Washington around big banks and “too big to fail.” Last week, White House economics czar and former Goldman Sachs President Gary Cohn let it be known that the Trump Administration was considering legislation that would separate the retail banking business from institutional and investment banking. In very simplistic terms, this would equate into spinning the old Chase Manhattan Bank out of JPMorgan (NYSE:JPM) or requiring Bank of America (NYSE:BAC) to sell Merrill Lynch. Does anybody in Washington understand how complex and disruptive it would be to impose such a separation? We doubt it. The kerfuffle about breaking up the big banks makes for breathtaking news copy, yet in practical terms this is not easy or even practical to achieve. For one thing, the much beloved retail business is not particularly profitable, but would require a lot of capital support because of its size. The second issue is that the institutional part of the bank, including over-the-counter (OTC) derivatives, also requires a lot of capital on a risk weighted basis, making the actual act of separation considerably more difficult that just discussing it in front of a group of astonished members of the Senate. The big banks certainly are a government-protected monopoly, but they are also public utilities that provide essential services to the US economy. Mess with that in the wrong way and you’ll take points off of GDP before you see any benefits. Let’s take a look at some numbers to get an idea of what’s involved in separating the different pieces of some of the largest banks. The columns below show the total assets of the banking group, the assets of the subsidiary banks, the ratio of Economic Capital to Tier 1 Risk-Based Capital (T1RBC) for the banking business, and risk adjusted return on capital (RAROC), all taken from regulatory disclosure and the TBS Bank Monitor. Source: FDIC, FFIEC, Total Bank Solutions Economic Capital or “EC” measures risk and describes how much capital a bank would need to cover its obligations in three buckets, lending, trading and investing, during a stressed scenario like 2008. Most little banks have too much capital, thus the ratios of EC to T1RBC tend to be less than 1. The big zombie banks tend to cheat when it comes to risk and thus have too little capital, but not for the reasons that people like Minneapolis Fed President Neel Kashkari believe. The trouble with the biggest banks is not the absolute level of capital, but the poor profitability and equally poor disclosure of risk. Like the large automakers, the big banks do not really generate enough profits over the long-term to meet their cost of capital. Thus big banks have EC to T1RBC ratios well-above 1. They are also forced into aggressive stock repurchase cycles to placate institutional equity investors, making it impossible to retain capital. Nominal equity returns in high single digits don’t get it done when your cost of capital is in the teens, but even more revealing is looking at the zombie banks in terms of risk-adjusted return on capital or RAROC. This measure is simply net income divided by Economic Capital, but it is quite revealing in terms of understanding bank business models and behavior. Big banks tend to be in low single digits on RAROC, while smaller banks routinely have RAROCs in the teens or much higher. The story that these numbers tell is important for investors, firstly because the business models of these top institutions are very different. JPM, BAC and Wells Fargo (NYSE:WFC) have the vast majority of their assets “in the bank,” to recall the immortal words of Angelo Mozilo to CNBC’s Maria Bartiromo around 2007 . We recall that discussion as though it were yesterday because it told us that the trouble was coming. Countrywide was soon sold to its warehouse lender, BAC, which had long coveted Mozilo’s mortgage banking operation. The rest is history…. Today the top universal banks tend to operate most of their retail and institutional businesses in the bank, making any separation like removing selected organs from a living body. In order to actually divide the retail from the institutional businesses, you’d need to create a brand new platform to house one of these silos. Think of surgically removing an implanted alien from Lt. Ripley's chest and you get the idea. Trust us when we say that such a change is not the sort of thing to be handled quickly by federal regulators. The lowest RAROC of the group is JPM, which has an enormous amount of trading risk housed in its banking units. While JPM’s bank units collectively have about $200 billion in T1RBC today, the TBS Bank Monitor model calculates that JPM needs over half a trillion dollars in EC to survive a stressed scenario, this largely due to the big trading exposures and the bank’s OTC derivatives book. So if you really want to split up the retail and institutional sides of JPM, you’d probably need to raise additional capital – and lots of it. WFC generates an equally large EC number to that of JPM, but for very different reasons. The largest component of risk for WFC is securities investments, nearly $325 billion of the $384 billion in EC calculated for the bank units of this largely domestic bank holding company. Lending is actually less than 20% of the EC number for WFC and trading risk is miniscule. Thus the key point is that WFC and JPM are very different businesses – but neither is very profitable in terms of nominal equity returns much less RAROC. Likewise, BAC generates an EC number of $438 billion vs its T1RBC of $153 billion, again mostly due to securities investments held by the bank’s investment portfolio. The bank’s lending and trading operations account for just a quarter or $100 billion of the EC calculation. And again, the 3% RAROC is nothing to brag about. When we get to Citigroup (NYSE:C), however, the $361 billion in EC is divided about equally between trading and securities investments, like JPM owing to the large derivatives operation. Citi also has the smallest retail business of the top four universal banks, being now mostly a wholesale bank after the sale of the asset management and mortgage servicing segments. Looking at U.S. Bancorp (NYSE:USB), the most highly valued of the top US banks, the risk profile is very similar to that of BAC and WFC. Most of the risk in the EC calculation is on securities investment exposures, not trading or even lending, which are less that 10% of the $90 billion in economic capital calculated for the bank. USB has no significant securities operations and is effectively an institutional customer of the larger universal banks. Despite the relatively low RAROC, USB trades at 2x book value vs about 1.5x for WFC, above 1x for JPM and at or below 1x for BAC and Citi, the two laggards in the large bank group. Some analysts see these low book value multiples for BAC and Citi as an opportunity, but we think these stocks are fairly valued to put it mildly. Once we get to Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), again the business models are very different. First and foremost, the bank units for GS and MS are relatively small compared to the asset footprint of the broker dealer units, which make up the majority of the total assets at the parent level. The GS bank unit, for example, has mostly trading risk, with virtually no lending or investment exposures in the EC calculation. Even though it is considered a bank, the vast majority of the risk in the GS business is institutional and is contained in the non-bank broker-dealer operations. The retail component of GS is miniscule, which perhaps explains why Gary Cohn thinks breaking up the big banks is such a great idea. Such a change would have little impact on Goldman but would badly disrupt the small investment bank’s larger competitors like JPM. MS likewise has most of its assets and business risk in its non-bank units, but its banking operations have a very different profile than the GS banking subsidiaries. GS has most of its bank’s risk in trading. With MS the two primary banks have most of their risk in securities investments for the bank’s depositors, which are mostly the firm’s wealth management customers. Of the $38 billion in EC calculated for MS, less than a billion is for lending or trading. Both MS and GS are primarily investment houses and both trade at a premium to book value, the two businesses are very different. GS relies far more on trading and investment banking revenue for its profitability, while MS relies more on asset and wealth management. Again, the proposal by Mr. Cohn to separate retail and institutional activities would have little impact on either firm, but would badly disrupt JPM. Now let’s look at some smaller banks to further contrast with the zombie dance queens. The $18 billion asset Bank of the Ozarks (NASDAQ:OZRK) is reporting earnings this week and will be keenly watched for any evidence of credit stress in its commercial real estate book. OZRK had a RAROC of almost 29% at year-end 2016 and a ratio of EC to T1RBC of 0.59%. That means that the EC model in the TBS Bank Monitor sees the bank as being more than adequately capitalized to handle its risks, which are about evenly split between lending and securities investments. The bank has zero trading risk, BTW. So in terms of risk-adjusted returns, OZRK is an order of magnitude more profitable than a large bank like JPM or WFC. It is no surprise that OZRK trade at more that 2x book value and has a large constituency among institutional investors, but also has a pretty volatile stock with a beta of 1.7. Needless to say, the bears like to bet against OZRK on the theory that they are over extended on commercial real estate and related C&I loan exposures. But short sellers beware. OZRK has a very strong credit culture and performed extremely well during and after the 2008 credit crisis. Let’s take another relatively small name, Signature Bank (NASDAQ:SBNY), which is located in Manhattan. This $40 billion asset New York State chartered institution was organized by a group of bankers who originally came from Republic National Bank. Signature focuses on C&I lending to small and mid-sized businesses in the US and have some of the strongest credit metrics in their peer group. While defaults did pop above peer at the end of 2016, the bank has historically tracked below peer in terms of credit losses even during the financial crisis. SBNY had a RAROC of over 11% at year-end 2016, but earned an EC to T1RBC ratio of 2.1, according to the TBS Bank Monitor. While the bank has no trading risk, it does have a large securities investment book, which accounted for more than 90% of the EC risk calculation. Unlike the large banks, however, SBNY is actually sufficiently profitable on a risk adjusted basis to cover its cost of capital. SBNY is a $140 stock that has a beta a little over one and trades at well-over 2x book value. The point of all of the above is that when you peruse bank earnings starting this week, remember that banks large and small are not all made the same. While they have some common business model attributes, they also serve different markets and customers, even among the largest names. And while the biggest banks are certainly government sponsored entities protected from true competition by federal regulation, small banks like Ozarks and Signature represent the private sector. The bottom line is that the arguments about breaking up the big banks or requiring higher capital levels miss the point. The big banks are problematic because they are too large to generate sustained equity returns compared with their cost of capital or risk-adjusted measures such as RAROC. Requiring big banks to raise or retain more capital would cause them to slowly collapse as equity returns headed into low single digits and share repurchases ended. Small banks, on the other hand, generate great equity returns, but lack the liquidity that big investors demand. As we argued in American Banker last December: “Before we can have a rational discussion about how to end the systemic risk posed by the largest banks, we must first understand the root of the problem. First and foremost, the top banks are big because the Federal Reserve and other regulators have over the past several decades allowed and even encouraged a series of mergers between strong banks and weak. By countenancing these mergers and leaving inefficient operations intact, the Fed created enormous firms that are clearly too big to manage and generally do not generate positive risk-adjusted or even nominal returns.” The answer is to the problem of too big to fail is to require banks to become more efficient, not raise more capital, and to allow weak banks to die. We should slowly mandate that the big banks get smaller and also gradually separate dealing activities from the depository over a period of 5-10 years. The good news is that policymakers can address many of the most egregious systemic risks in the U.S. banking system simply by understanding why large banks are big in the first place. The answer starts at the Federal Reserve Board in Washington. #JPM #WFC #USB #BAC #C #OZRK #SBNY #GaryCohn #NeelKashkari

April 6, 2017 | JPMorgan (JPM) boss Jamie Dimon says there’s something wrong with the US economy and he is obviously right. Here’s our short list: * too much public and private debt * too little income and growth * monopolies in banking and other industries * oppressive regulation for all businesses * political muddle and lack of national purpose * confused, irrational monetary policy A couple of weeks before Mr. Dimon was waxing effusive on the state of the American political economy, New York Fed President Bill Dudley told an audience that excessive student debt was holding back the US economy “despite efforts of the Federal Reserve to stimulate economic activity.” Really? We thought that the Fed was engaged in an effort to manipulate asset prices in a desperate attempt to increase consumption. Since economic expansion is a function of population growth and increases in productivity, both of which are basically the flat, the Fed has never had any real bullets when it comes to encouraging growth save orchestrating debt driven asset bubbles. More, unlike the 1970s and 1980s, today simply lowering interest rates has no apparent impact on consumer spending. The past eight years of near-zero interest rates and massive bond purchases by the FOMC has merely put the key issue of debt temporarily on hold while asset bubbles have bloomed around the economy. Which brings us to the ongoing implosion in demand for automobiles. US automakers including Ford (NYSE:F) and General Motors (NYSE:GM) have seen demand for once-popular sedans basically collapse. More, as we noted in a previous post on David Einhorn’s sudden interest in GM, the residual value of used cars is also falling. Key concept: the upward surge in new car purchases was driven by irrational exuberance (aka credit expansion), which in turn was driven by the FOMC’s policies. But apparently the party in less-than prime auto ABS is over. Mark Wakefield of Alix Partners told Bloomberg News he sees volumes falling by at least 300,000 units from the 18 million peak in 2016, but we’d be surprised if the industry can break 17 million units this year given current trends in the industry and, more important, in credit markets. Part of the problem for automakers is that the surge in new credit that enabled consumers to buy cars in part came from captive leasing units and independent auto lessors that are facing growing losses on existing loans and leases. Nearly one in five cars was leased last year and residual valuations are plummeting, especially for passenger cars. The new arrivals in the below prime auto lessor community are going to take a big hit. The next step will be for these smaller leasing firms and banks focused on providing credit to below prime customers to withdraw credit from the system, which will in turn cause auto sales to fall further. Originating and selling prime auto paper has been a break even prospect at best, thus all of the focus of Wall Street was on below-prime originations over the past year or more. Tales of mortgage market in the mid-2000s? Yes. Repeat after we: “Gain on Sale.” Names like AutoNation (NYSE:AN) and CarMax (NASDAQ:KMX) may be able to survive the credit losses likely this year and next, but smaller players in the leasing channel will pull back quickly on risk exposures, reducing the ability of the automakers to move inventory. Needless to say, even as Yellen & Co try to belatedly raise interest rates, the credit cycle has already turned sour. If anything, the Fed should be pondering when to ease. But hold that thought... Bank Earnings Meanwhile in the world of banks, the prospect of Q1 ’17 earnings is hardly causing great joy among Sell Side analysts, especially for the big universal banks with significant securities operations. In Q1 '17 the bond market has again set new records for investment grade (IG) bond issuance, but the economics of debt deals is significantly thinner than for equity offerings. Initial public offerings have dwindled under the social engineering of Janet Yellen and the FOMC. Simply stated, why issue public shares when you can tap private equity or float a bond deal at what are still historically low rates? For those who think that rising short-term interest rates will somehow boost earnings, it is interesting to note that the majority of US banks saw net-interest margins decline in 2016 – this as the yield on the 10-year Treasury was rising following the election of Donald Trump. Only trouble, as we wrote for Kroll Bond Rating Agency at the time, is that IG and even high yield bonds were rallying as the T-bond sold off. Hmmm. Below is our famous chart showing the cash components of NIM for all US banks through year-end 2016, using data from the FDIC. Notice how low that the Fed pushed the cost of funds for US banks in order to keep the zombie girls dancing -- just $11.5 billion in the middle of 2015. The same figure was almost $15 billion as of Q4 ’16. Note that income rose more, but only because of the bank lending spree in 2016 which is now ended. Swelling balance sheets enabled the big zombie banks to pretend that they are making more money on good old fashioned leverage, but if you look at the impact on the return on earning assets, the picture is different. The chart below shows net interest income divided by earning assets, which clearly shows that the past eight years of extraordinary Fed policy have been bad for bank asset returns and income. On a risk-adjusted basis, the large bank sector looks about as cyclical as the large US automakers. And since mid-March, spreads on high-yield debt have been widening as investor confidence in the Trump Bump has started to wane. Credit losses for US banks are starting to rise, albeit from a very low base. As the chart below suggests, loss rates on the $9 plus trillion in US bank loans bottomed in 2015 and are slowly starting to increase as the great asset bubble created by Janet Yellen and the FOMC begins to deflate. Ask yourself a question: Are the C&I and commercial real estate credits on the books of the largest US banks and, in particular, in asset backed securities (ABS), significantly better quality than the growth of auto exposures to consumers over the past half decade? The answer is clearly “no” as evidenced by the fact that the major rating agencies are all starting to walk back their ratings on post-crisis commercial real estate exposures . As we wander into Q1 '17 earnings next week, we can’t help but notice that those generous souls at KBW decided to upgrade Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) on the theory that lighter regulation and rising interest rates will boost earnings. Really?? Read our comment on Citi from last week if you have not already done so. The gross spread on C&I and CRE loans at Citi is so low that cash flows from both of these enormous portfolio components could be wiped out by charge offs in a stressed scenario. We differ on both points used by KBW to justify the upgrades of Citi and WFC. First, any reduction in capital requirements is a medium term exercise, in other words, no impact in 2017. Capital is THE solution of choice for the political class when it comes to avoiding the dreaded specter of “systemic risk,” even among conservative Republicans. Don’t hold your breath for significant changes in capital requirements. Second, a flat yield curve sinks all boats. Without a serious change in mind on the part of the FOMC, rising short-term rates and falling 10s to 30s sure does not look like a winner to us. Indeed, if the FOMC goes forward with three more short-term rate hikes in 2017 without starting to sell MBS from the $4 trillion portfolio, look for NIM for the whole banking industry to take a swan dive. In the latest FOMC minutes we see this important tidbit: “participants agreed that reductions in the Federal Reserve’s securities holdings should be gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings.” This passage from the FOMC minutes illustrates that the members of the Fed’s policy making body clearly do not understand what is happening in the bond market. Agency issuance is down dramatically compared with 2016, like minus 15-20% YOY ($300-400 billion) over the course of 2017. If the FOMC really wants to see long-term yields rise in concert with short-term benchmark rates, then selling at least $50-100 billion per month in MBS from the Fed’s portfolio is entirely necessary. If the FOMC keeps to its current plan, however, the curve will flatten, bank earnings will suffer and the US economy will start to contract. Details aside, it will be called the Yellen recession for a reason. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

Over the past decade we have periodically talked to our brother Michael Whalen (MW), Emmy award winning composer, film editor, and now agent to a growing list of performers, about the rapidly changing state of the world of content. With theater admissions and revenues flat, the final break in the Old World of Hollywood came several weeks ago with the major studios announcing a new model for releasing content online almost immediately after the theatrical release. Will we even be watching the Academy Awards in 20 years? The IRA: So Michael, the change in the relationship between the movie studios and theaters that you have long predicted has come to pass. The studios have announced that they will be releasing films to online distribution only weeks after the release to the theaters. Talk a little about the economics of making movies today and how the investors/creators are able to cover costs much less make money. MW: The situation facing the movie industry is a classic case of supply and demand. It is so much easier to produce a movie now than 20 years ago. Technology has knocked-down a lot barriers and walls. Also, another factor is state issued tax credits. Localities are tripping over themselves to have even low-end filmmakers use their states. It might sound like a joke but there are people making quality videos and shorts with their iPhones. The IRA: Hey, we’ve been experimenting with new platforms like Collide. Our friend Stacy Herbert shot a TV segment in Central Park with me and Max for The Kaiser Report last year on an iPhone. Looked great. But it sounds like the traditional distribution channels for films are the victims of innovation. MW: Precisely. Trapped inside this rapidly changing economic environment are theatre owners. They charge $12 - $25 a ticket to watch films that I can rent at home for $4. We live in a time where people under the age of 30 have no real need to go to the theatre to see anything. They watch YouTube on their phones. The theatre chains have done little to make the basic experience of going to the theatre compelling for a young audience. It’s a value conversation: you’ll probably get dinner (for 2), gas for the car, tickets and theatre food. It’s $100+ evening. This better be the best movie ever. Seriously, many people today don’t have the disposal income to go to theaters, much less sports events or other types of live entertainment. The IRA: OK, but how about the films themselves? Brent Lang put out a great piece in Variety recently talking about the whole movie business being in trouble. Do you agree? MW: Yes, the finances around film have never been for the faint of heart. These days, beyond the theaters to the world of content the upside is so much less than it used to be even a few years ago. There are hundreds of new platforms and outlets around the world for quality content - however, no one wants to pay for it. Well, to be fair - - they don’t have the upfront dollars to pay for it. Therefore, most licensing deals are some kind of revenue sharing scheme. The IRA: So you need to find investors for a film and the studios bare no risk for the project? How many films actually make money? Is this like people supporting Broadway shows out of passionate devotion or charity? Does not sound like a business any more. MW: The truth is that investors in these schemes often cannot cover their investments. These are breakeven scenarios at best. In the old days, you could release a decent film - breakeven in the theaters and then the foreign licensing and home video would give you a nice multiple. Now, if you’re lucky, you hope your revenue share deal with NetFlix gives you a little income. The IRA: So is the theater channel now a significant contributor to revenue or are we talking about online as the biggest contributor? MW: Being nominated for an Oscar can translate to a VERY big payday for the movie, its stars and those associated with making the film. That said, Best Picture winners typically earn an additional $14 to $15 million in box office revenue. Movies like, The King’s Speech, garnered $138 million in domestic box office – over $100 million more than was expected before it won. That is very unusual. Moonlight (this year’s Best Picture Winner) had only made $22 million before the award. The IRA: Wow, so a critically acclaimed film may not ever break double digits at the box office? MW: Nope. To date, Moonlight has made $55 million. It is also the lowest grossing Best Picture winner in history. In Hollywood, talent agents and managers estimate that their clients will get a 20% boost in pay for their next film if they win the award for Best Actor or Actress. According to Reuters, an Academy Award nomination can boost ticket sales by one-third and cause a jump in the home video sales and streaming of movies no longer in theaters. When you add-up downloads, streaming and cable TV revenues, the monetary rewards from receiving a nomination can be substantial. The IRA: Ok, so is this something that is attractive to investors or just a passionate crapshoot? MW: Most of the movies that made money in the last 2 years are HUGE “tentpole” franchise movies. This is important because these films typically have the movie itself as one platform of 4 or 5 marketing platforms for an entire project. For example, Disney released “Rogue One” the Star Wars standalone movie. According to Box Office Mojo, it has brought-in $1 billion in worldwide theatrical ticket sales against a production budget of at least $200 million and a marketing budget of at least that much. So, despite HUGE numbers being brought-in, the net profit is relatively small. But Disney has ancillary merchandise, video games, toys, TV licensing and a host of streaming options for this material that will add to the bottom line of the movie - - probably in the $400 - $500 million dollar range after all the costs are deducted. The IRA: Sounds like the big names and titles are the only sure bet. Correct? MW: Yes. For investors, the best course in dealing with film or video content is to finance as big a slate as possible (to increase the statistical probability of having a movie that makes money). Or, to look at creating stand-alone outlets for content. For example, comedian Louis CK directed and produced a video of his stand-up from his show at the Beacon Theatre in NYC. He posted the video on his website in 2011. In a month, 800,000 people had spent $5 to download the concert. To date, he has made millions from a production that cost him $220,000. He has given bonuses to the people who helped him make it, contributed to charity and he shattered how such videos are distributed by doing it himself. Then, the video won a Primetime Emmy® for best live comedy performance. This is the paradigm: great content. Low cost. A simple distribution method that can be driven by social media. Link here to the video: https://louisck.net/purchase/live-at-the-beacon-theater The IRA: So is Louis CK the new role model for content? MW: The key to investing in film is to lower your risk through diversifying – which is obvious. What is not obvious is to lower your expectation on possible returns as well. Unless you have a sophisticated multi-platform release where multiple income streams can help recoup your “hard dollars,” you will probably fail. The percentage of movies that break even in 2017 is at its lowest level in history. Even with multiple streams of possible income, we know that film finance is risky at best. However, streaming models work when the actual cost of production is low. So, look for intense downward pressure on costs, more and more supply of content and fewer reliable financial outlets for this content in the United States and in other territories as “winners” and “losers” begin to emerge in the video streaming market. Said another way, do your homework and make sure you understand the distribution deals that you are getting involved with BEFORE you sign. Some investors “roll the dice” with such deals without fully understanding the dynamics. Frankly, there’s not enough financial headroom to mess around like that on a typical deal. The IRA: Sounds like investing in blockchain startups….. MW: Finally, the premium that is paid for “known” talent is ending. In its place we see increased emphasis on content that is compelling and well made. Yes, “A” list actors will continue to command fees for the foreseeable future – however, more and more, those fees will be replaced by rev share models that put that actor’s ability to attract to the test every time out. Don’t be afraid to put those types of deals in place and be ready to reward actors and other “top-line” personnel who bring the most allusive currency of them all: attention. The IRA: Thanks Michael. #content #hollywood #michaelwhalen #theaters