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July 17, 2025  | President Donald Trump is mounting the most serious challenge to the independence of the central bank since the 1950s, but the direction of government policy is largely dictated by the fiscal deficit of the U.S. Treasury. We commented earlier this month on the transfiguration of Treasury Secretary Scott Bessent from long-bond issuing bull into a meek advocate for funding the public debt short – via discount Treasury bills of varying maturities inside of 18 months. Naturally issuing more 10s and 30s would push LT interest rates higher and also inflate the cost of the public debt. E ditor's note: The next quarterly conference call with subscribers to the Premium Service of The Institutional Risk Analyst will be held on July 30, 2025. Please email us at info@rcwhalen.com for additional details. Republicans in Congress are desperately looking for budget savings. So this raises the question: Should Congress have given the Federal Reserve the power to pay interest on reserves (IOR), the cash that banks deposit with the central bank? The short answer is yes -- unless you want the U.S. Treasury to default next time the credit markets go sideways. Like March 2020, when President Donald Trump declared an emergency allowing millions of Americans to stop paying mortgages and rent . For about 60 days thereafter, nobody in the world of residential housing finance knew how they were going to pay interest on $12 trillion in mortgage debt and avoid default. The Trump White House did not ask. Until the Fed came to the rescue with massive purchases of securities, every commercial bank, mortgage lender, municipality and the United States itself would have defaulted a month later. Fact is, if we did not have $40 trillion in public debt, nobody would be worried about paying interest on reserves at the Fed. The authority for the Fed to pay IOR on deposits by banks was initially granted by the Financial Services Regulatory Relief Act of 2006 , with an effective date of 2011. The 2008 financial crisis prompted Congress to accelerate the implementation so as to enable the commencement of massive purchases of securities (aka "quantitative easing" or QE). Sec 201 of the Act states: ‘‘(A) IN GENERAL.—Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates.” The proposal was highlighted in an April 2004 letter from Fed Chairman Alan Greenspan to Senator Richard Shelby (R-AL) , who was then the Chairman of the Senate Banking Committee, and Senator Mike Crapo (D-ID) , in response to their request for the Board's top legislative priorities for regulatory relief . Two decades ago, Governor Donald Kohn , who was formerly Director of the Division of Monetary Affairs of the Board staff, testified before Congress on the operational and policy reasons for giving the Fed the authority to pay interest on reserve balances. Three factors were cited: Simplifying the market for reserves and eliminating incentives for arbitrage by banks, eliminating entirely the need for banks to keep required reserves at the Fed, and giving the Fed the ability to manage the rate for federal funds, the short-term market that has been effectively nationalized by the central bank over three decades.  This last factor, forseen by Chairman Greenspan, Governor Kohn and the Board staff two decades ago, was the chief reason for the proposal, but the true reason was still discussed in catious terms: the growing federal debt. In testimony before Congress in 2004, Kohn summarized precisely the situation facing the Fed today and the chief reason why the central bank must be able to pay interest on reserves to manage short-term dollar interest rates. Kohn: “While overnight interest rates have exhibited little volatility in recent years, even when the sum of required and contractual balances was considerably smaller than at present, volatility nevertheless could potentially become a problem at some future time if such balances fell to very low levels. Such a development might be possible if interest rates were to rise to high levels, which would reduce the demand for required and contractual balances and provide extra incentives for reserve avoidance. Paying interest on such balances is one way to ensure that they do not drop too low.” Even in 2004, when the party was starting to end in residential mortgages and the federal debt was just over $7 trillion, the Fed saw that the growth in the government debt markets would soon require new tools for monetary policy. Specifically, the Fed needed a way to finance the purchase of government debt without directly boosting inflation. Borrowing cash from banks was seen to be less damaging to the economy, but obviously the inflation from QE flowed into housing nevertheless. More than a decade before the Fed actually began to use massive open market purchases of Treasury debt as a policy tool, the central bank essentially anticipated the future need. In 2016 testimony, Dr. George Selgin of Cato Institute described how the rationale for paying IOR mutated from a general policy initiative to something far more specific a decade later: “The rationale behind the early deployment of the Fed’s authority to pay interest on reserves was entirely different from that behind the original, 2006 measure. Interest on reserves (henceforth IOR) was to be relied upon, not as a means for improving banks’ efficiency, but as a new Federal Reserve instrument of monetary control. Specifically, it was resorted to as a contractionary monetary measure, meant to prevent monetary expansion that would otherwise have taken place as a consequence of the Fed’s post-Lehman emergency lending operations.” As the size of the government debt has grown, the Fed anticipated that it would need to fund larger and larger open market operations. These operations flow through the financial statements of the largest banks in a dreadful arithmetic of inflation and deflation. When the Fed buys securities for its portfolio, it creates deposits in the banking system in the form of reserves and bank assets rise, but with little profitability. When it shrinks the portfolio, as it is doing now (“ Waller Wants Lower Reserves & Tighter Policy “), it destroys bank deposits as the Treasury deficits consume the available cash. Bill Nelson , Chief Economist of the Bank Policy Institute, said in an optimistic December 2019 talk entitled, " The Fed’s Balance Sheet Can and Should Get Much Smaller ": "The quantity of reserves that the Fed has judged to be necessary for reserves to be abundant has grown remarkably over time. In April 2008, when Federal Reservet considered the possibility of operating policy with an abundant-reserves framework, It estimated that the level of reserves that would be needed '…might be on the order of $35 billion but could be larger on some days.' The assumption rose to $100 billion in 2016, $500 billion in 2017, and $600 billion in 2018. It is not possible to know precisely what level the FOMC judged necessary at the beginning of this year when it made its decision to adopt a large-balance-sheet framework because the Fed decided to break with its own tradition and not disclose its forecast. However, available information suggests that at that time the FOMC judged about $1 trillion in reserves was abundant. I’d guess that their current estimate is about $1½ trillion." Notice that the minimum amount of reserves given by Governor Waller last week has exploded since 2019. The Fed needs to pay interest on reserves to balance demand for deposits at the Fed with the market rate on T-bills and money market funds. If the Fed could not pay interest on reserves, then it could no longer finance large open market purchases of Treasury securities.  If the Fed expanded its balance sheet by purchasing Treasury bills and paid for these earning assets with zero yield reserves, banks would sell reserves and buy bills and other earning securities, driving market interest rates to zero or below. If there were no federal deficit or massive debt, then reserves would be scarce. As a century ago, banks would have to hold municipal bonds, mortgage and agency securities, and corporate bonds for cash liquidity. Reflecting this 19th Century worldview, some conservatives in Congress think that ending QE is a good idea. No, eliminating the federal deficit is the solution. In the next credit market crisis, without QE, the Treasury market will just close. Quantitative easing and paying interest on reserves are two necessary evils when the US government has $40 trillion in debt and counting.   The Federal Reserve is now the banker of last resort to the US Treasury, inflating and deflating the economy with its balance sheet. Think of bank reserves held at the Fed as another form of T-bills that the government issues when it must repurchase its own debt, via its alter ego, the Federal Reserve Board. Paying interest on reserves and on reverse repurchase agreements (RRPs) is essentially the same activity. The Fed must pay interest on reserves for the same reason that the Treasury pays interest on its debt, because the ebb and flow of cash in and out of the financial markets must always balance.  The chart below shows total owned securities, mortgage backed securities and RRPs by the Fed. Contrary to what some economists and members of Congress believe, there is no bonanza here for commercial banks. QE has hurt bank profitability and paying interest on reserves is a modest compensation. Interest-bearing deposits with the Federal Reserve, non-U.S. central banks and other banks earned 4.15% for Bank of America (BAC)  in Q2 2025, but BAC’s cost of interest bearing liabilities was 3.43%. The risk free return on bank reserves for Bank America was around three-quarters of a point, as shown in the table below. Naturally, the Fed does create bank reserves out of thin air to pay for quantitative easing, a policy course that has caused the central bank to rack up hundreds of billions in losses but kept the market for Treasury debt open for a while longer.  Think of the losses incurred by the Fed from its sloppy handling of quantitative easing as part of the cost of the Treasury's massive debt. The worst asset allocation choice made by Chair Janet Yellen and Chairman Jerome Powell was purchasing trillions of dollars in mortgage backed securities, which boosted home prices and is the main cause of the operating losses at the Fed. Would ending Fed interest payments on bank reserves save the government money? Senator Ted Cruz (R-TX) says it would, but he is mistaken. Before Cruz and others in Congress go down this road they should understand the real world issues that drove Chairman Shelby to sponsor the legislation 20 years ago that allowed the Fed to pay IOR. Paying interest on reserves has nothing to do with whether banks lend in the private sector and everything to do with enabling the Fed to manage the Treasury market. If you don’t want the Treasury market to remain open, then take away the Fed’s power to pay interest on reserves.   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.

July 14, 2025  | Last week, prices for silver surged to a new high, fulfilling a lot of long-standing predictions for the much abused metal. Silver is consumed in various industrial applications, but nobody uses the transition metal as money in the 21st century. We talk about the parallels between the silverites who nearly bankrupted the U.S. Treasury in the 1890s and crypto in our new book, Inflated: Money, Debt and the American Dream .”

January 8, 2024 | Sometime during the summer of 2016, the worst of the post 2008 asset price deflation arguably bottomed out. During that summer, Cumberland Advisors chief-investment officer David Kotok approached us during lunch on the shores of the Big Lake in Downeast Maine.  “Write the book,” said Kotok. He had a glass of white wine in one hand and a large chain pickerel on a stringer in the other. “Write the book.” Kotok then turned and went off to consult with Ray Sockabasin about the steaming of the pickerel.   Source: Missouri Department of Conservation After returning from Maine, we next heard from the folks at John Wiley & Sons . “We hear you are writing a book,” they exclaimed. We said yes. Soon a contract appeared. We then realized that a book need be written. And it was. In the intervening 15 years, we have discovered an awful lot more about the financial history of the US that makes us think about reissuing "Inflated," especially now that the US public debt has reached $35 trillion. In 2010, the US public debt was under $15 trillion, but today post-COVID we are at just shy of $35 trillion and counting.   Notice in the chart below showing the national debt that the relative increase in debt accumulation during COVID was minor, but the baseline of increase in indebtedness has been steady. Growing fiscal deficits reflect a national flight from reality that has occurred during and after the 2008 financial crisis. Nobody in Washington or on Wall Street seems to know or care. The growth in debt suggests that the psychic damage caused by 2008 may be more enduring than the COVID lockdown event. Source: US Treasury In the book "Inflated," we argued that understanding the development of the US financial evolution since colonial times is about layers of leverage. In the earliest days, Americans used gold and silver coins, and obligations drawn upon UK and Dutch banks. Later state chartered banks added to the money stock, issuing private paper IOUs against vault cash measured in precious metals. Money in those days was metal. By the Civil War, the government of Abraham Lincoln borrowed all of the available gold coin and then turned to issuing unbacked paper greenbacks to finance the war to end slavery.  The creation of national banks to buy Lincoln’s debt was a major addition of leverage in the American system and one that remained even after the Civil War era greenbacks were redeemed. The legal and financial expedients used to finance the civil war enshrined the special role of the dollar in the US economy. The creation of the Federal Reserve System on the eve of WWI represented yet another new layer of leverage, this to feed the demand for financing during and after the war. The Fed took the ball from JPMorgan and other US banks to finance the wartime trade needs of the Allied governments. After the 1929 market collapse a decade later, market capitalism in the US truly died. More publicly-backed parastatal entities led by the Reconstruction Finance Corporation and the Federal Deposit Insurance Corporation were created by Washington to restructure and finance housing, banks and many other parts of the economy. We wrote in "Inflated" in 2010: "It is often overlooked by popular accounts of the Great Depression that President Hoover, and not FDR, created the Reconstruction Finance Corporation (RFC) and the Federal Home Loan Banks, two of the most significant and interventionist initiatives ever taken by Washington up to that time. The RFC, operating under Jesse Jones, was empowered to make loans to banks, insurers, and industrial companies almost without limit. The RFC was initially set up with the idea of repaying the government and then some on its investment, and would serve as an important part of the government’s response to the Depression during the 1930s." In the 1970s Ginnie Mae and then the GSEs became issuers of securities, adding yet another layer of leverage. Nonbank finance blossomed in the 1990s, driving decades of economic growth despite the best efforts of prudential regulators to kill this key American phenomenon. In the most recent Fed proposal in Basel III Endgame ( see our comments here ), the regulatory attack on residential mortgage finance has reached a hysterical frenzy. Last week we reminded our readers on X to read a couple of important research papers coming from the economic community talking about the true reasons behind the Fed’s open market operations in 2008 and 2020. In both cases, the narrative tells us that the central bank rode to the rescue of the US economy. In fact, the Federal Reserve Board rescued the US Treasury and, indirectly, the national Congress. Menand and Younger (2023)  state in their excellent paper, “ Money and the Public Debt: Treasury Market Liquidity as a Legal et Liquidity as a Legal Phenomenon .” “This Article… argues that American public finance has long been closely intertwined with the American monetary framework and that deep and liquid Treasury markets are, in large part, a legal phenomenon. Treasury market liquidity, in other words, did not arise organically as a product primarily of private ordering. Instead, it was actively constructed by government officials. The high degree of convertibility between Treasury securities and cash—the market’s “liquidity”—depends upon entities that can create new, money-like claims to buy Treasuries. Sometimes the government’s central bank has issued these claims directly, as in March 2020; other times these claims were issued by central bank-backed instrumentalities, such as banks and select broker-dealers. Either way, it has taken extensible, money-financed balance sheet capacity to give Treasuries their cash-like properties.” Notice in the above passage that the market for Treasury debt was created by government and, of course, sold by private dealers. In 2008, as we’ve noted in The IRA  over the years, the primary dealer community was annihilated. The Fed forced many independent primary dealers to merge with or become commercial banks. Becoming banks destroyed the nonbank ecosystem for marketing US Treasury debt. This evolution took us backward to the period before WWII when large banks controlled US finance. Why is the decline of the nonbank dealer community important?  The public debt is rising during a time when the functioning of the Treasury market is deteriorating. The Dodd-Frank legislation enshrined the Volcker Rule, for example, reducing liquidity in the bond markets. Independent primary dealers that once made markets in Treasury paper have been replaced with hedge funds running basis trades funded with credit lines provided by bank prime desks. Treasury Secretary Janet Yellen and others in the establishment fuss about the need for central clearing in the market for US government debt. Yet do these luminaries that populate the Biden Administration understand that limiting market liquidity via regulations like Basel III, the Volcker Rule and now centralized clearing of Treasury debt, actually hurts market function? These last remaining nonbank buyers of Treasury debt are seen as a problem by regulators, but they could not be more wrong. Ponder the bid-to-cover ratio of the 10-year Treasury note below. Notice that the ratio has steadily declined as the size of the auctions has increased. Source: Bloomberg The steady increase in calls for the Fed to end its balance sheet runoff (aka “QT” in Fed newspeak) is really not about interest rates or the economy, but all about poor execution in the US Treasury market. Dallas Fed President Lori “Repo” Logan , the intellectual author of the Fed's various liquidity facilities, has been among those officials saying that the Fed should maybe end its balance sheet contraction soon. That’s a hint. Notice in the chart above that the Fed's reverse repurchase agreement (RRP) facility has shrunk as money market funds moved into T-bills. Yet the overall system open market account (SOMA) is still over $7 trillion. That $2.5 trillion in low-coupon mortgage-backed securities is not moving at all. Those Fannie, Freddie and Ginnie Mae MBS with sub 4% coupons might as well be 15-year Treasury bonds in terms of effective maturity. The Fed’s balance sheet is still enormous, but the public debt is growing rapidly, the more important fact. Like most Fed officials, Logan never actually talks about the budget deficit. We never talk about why the Fed needed to erect all of these new liquidity facilities and repo programs in the process of keeping the Treasury market open. Here is an excerpt from Logan’s comments from November 2023. “In recent decades, central banks around the world have been shifting toward floor systems for monetary policy implementation. That shift has been motivated by the actions central banks had to take in response to the Global Financial Crisis (GFC) and subsequent stress episodes; by a growing appreciation of the benefits of floor systems across a wide range of economic and financial environments; and by post-GFC changes in bank regulations and banks’ own risk management, which increased the demand for liquidity and the costs of interbank transactions.” Logan, like most Fed officials, is able to deliver speeches rivaling the oratorial duration of Fidel Castro but say absolutely nothing. Logan describes a “liability driven floor” system for reserves as the US policy choice going forward, yet she neglects to tell us why the Fed needed to defend the zero bound at all. The Fed’s actions in Q1 2020 to catch the collapsing market for Treasury debt created huge market disruptions for banks and money-market funds. The Bank Term Funding Program then became necessary when the Fed shifted to “fighting inflation.” Notice at the end of her speech that Logan continues the idiotic messaging by Fed officials asking commercial banks to make regular use of the discount window. Not going to happen. Calls by Fed officials for banks to use the discount window for regular liquidity needs is revealing of the childlike naïveté that operates inside the central bank. Banks that are seen using the Fed discount window are presumed to be distressed and at risk of imminent failure. No amount of happy talk from President Logan or other Fed officials will change this perception. Fed officials would do well to come up with a new name for the bank liquidity facility. The effective nationalization of the US bond markets and banks is the unspoken truth that President Logan and Fed Chairman Jerome Powell will never address publicly. Since the FOMC began targeting fed funds as a policy mechanism decades ago, the short-term interest rate market has become a function of FOMC policy and ever more frequent open market operations. Equity market investors do not seem to understand what this creeping nationalization of the heretofore private credit markets implies. As the public debt of the US grows, after all, the implicit claim of the Treasury on all private US assets also expands apace. 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.

January 11, 2024 | Premium Service  | In this issue, we set up Q4 financials earnings for readers of our subscription service.  First and foremost, the biggest factor in the analysis remains the lack of visibility on interest rates and related volatility. If, for example, the FOMC ends the runoff of the balance sheet and begins to purchase new securities for the system open market account (SOMA), does this mean that rate cuts this year are off the table?

January 16, 2024 | Last week Citigroup (C)  CEO Jane Fraser  announced more losses and thousands of layoffs in coming years. Readers of The IRA   might think we did a victory lap. After years of investors and analysts calling for improvements in the bank’s operating efficiency, Citi is finally making significant changes. The prospect of thousands more people losing their livelihoods in finance does not make us happy. More, Citi cannot cut its way to profitability. Truth is that there are too many big banks in New York. Several ought to adopt a similar approach as Citi to enhancing shareholder valaue. But maybe more radical action is needed. There are numerous examples of large public companies that defy logic and their shareholders when it comes to managing expenses, especially personnel expenses. Yet when we look at Citi, personnel expenses are not the only problem. Citi’s operating results vs average assets, for example, shows that the bank is in line with Peer Group 1. But when we look at expenses vs net operating income, suddenly Citi’s operating profile shows a definite downward skew. Total operating expenses for Citi in the Q3 2023 Form Y-9 are actually below peer when measured against average assets, but jump up to the 76th percentile of Peer Group 1 vs adjusted operating income. In plain terms, Citi’s income is too low for its growing overhead expenses, thus Fraser is cutting people. Citi’s personnel expenses are four points higher than its peers measured against operating income, according to the Form Y-9.  But cost cutting alone is not going to fix the problems at Citi. A big part of the challenge facing Citi is in the business model. The decision to sell Smith Barney to Morgan Stanley (MS) in 2009 may have made sense in the depths of the financial crisis, but the sale of the asset management business left Citi crippled in terms of future business prospects. The chart below shows Citi (blue) vs JPMorgan (JPM) in gold. Source: Google Finance The lack of an asset manager deprives Citi of significant non-interest revenue that would make the business more stable. The table below from the FFIEC illustrates some of the key operating and financial differences between Citi and industry leader JPMorgan .   Source: FFIEC Q3 2023 Note in the table above that JPM had $1.5 trillion in mutual funds and annuities in Q3 2023 vs zero for Citi. JPM’s cost per employee is significantly higher than Citi but so is the assets per employee at $12 million vs $9.8 million. Citi’s efficiency ratio is 16 points higher than JPM, which still benefits from the acquisition of First Republic Bank. Non-interest income is only one third of operating income at Citi vs almost half for JPM. And overhead expenses less non-interest income is just 5% of operating income at JPM vs a third for Citi and Peer Group 1. In a serious economic downturn, Jamie Dimon could literally run his bank on fee income alone and devote all of net interest income to loss mitigation. Kinda makes you wonder why the Fed and other regulators want to make JPM raise capital. Keep in mind that Fraser and her team actually grew topline revenue 4% in 2023, but expenses rose twice as fast. Even though Citi’s occupancy expenses are half of its peers, the bank loses ground on other operating expenses, which again are four points higher than its peers.  Thus Citi's net income remains well-below the top-five banks by assets. Source: FFIEC We congratulate Jane Fraser for tackling Citi's poor financial performance, but think that mere cost cutting is not enough. Citi has some very valuable businesses, including a global payments platform, a high-yielding consumer lending business and a global banking franchise. What is missing is a large asset management business to add non-interest income to the bank. The $2.3 trillion asset bank needs to merge with an qually large asset manager, but many of the properties are already taken. If Jane Fraser and her team are not able to combine with a large asset manager, then the only alternative that makes sense to us is to break up the bank and sell the pieces to other institutions. At 0.53x book at the close on Friday, the various pieces of Citi are clearly more valuable individually than the whole business is valued by the market today. The global payments platform alone should be worth more than the market value of the whole bank today as a going concern. Yet the fact is that Cit has been destroying shareholder value for several decades. In that regard, a little context is important in any discussion of Citi and long-term shareholder value. Pam & Russ Martens wrote last November in Wall Street on Parade : "Citigroup did a 1-for-10 reverse stock split on May 9, 2011. That means that investors holding 100 shares of Citigroup back in January 2007 saw their position shrink to 10 shares after May 9, 2011. So yesterday’s closing price of $42.04 for Citigroup is effectively $4.20 for long-term shareholders, adjusting it for the reverse stock split. To put that in even starker terms, investors who have held onto this dog for almost 17 years have watched 92 percent of its share price vanish." The real question, of course, is why is Citi even around in 2024. The bank that first introduced no-doc subrime mortgage lending to banks in the early 1980s lost its reason to exist after the rescue by the Treasury in 2008. But the Fed is particularly incapable of allowing large banks to fail as businesses and be broken up. The prefered pathway of the Fed and other regulators is to merge good banks with bad and thereby create overall mediocrity. We've been following Citi since we worked in Bank Supervision at the FRBNY in the 1980s. In those days, anything with the "foreign" label was considered fair game by US intelligence operatives. US banks, multinationals and even the Fed itself often housed American officials engaged in covert work for Uncle Sam. Indeed, several of our colleagues from that era worked for the OSS in WWII and later for the CIA. During the Cold War, Citi was a very convenient bank indeed. Citibank had offices in all of the right cities that might support US strategic interests, whether that was Lagos or Vienna or Beijing or Tel Aviv or especially Mexico City. But the business model that kinda made sense during the Cold War is irrelevant 50 years later. The fact that Citi is unable to sell or IPO its Banamex unit in Mexico speaks volumes about the real book value of this corporation. One day, we'll have to tell the story of Citibank Private Banking during the term of Mexican President Carlos Salinas de Gortari . The scandal involving Raul Salinas de Gortari led to the exit of CEO John Reed in 2000. Cost cutting is fine and long overdue, but we think that Jane Fraser and the board still needs to articulate a vision for Citigroup going forward. Why does this bank still exist in 2024?? What communities does this bank serve and why? Is a voluntary combination with another organization the best alternative for C shareholders? Or should Fraser seek a mandate from the board to sell the company? Fact is, were it not for the protection afforded by the Bank Holding Company Act, Citi would already have been broken up years ago. Source: FFIEC Our rough, back of the envelope guess is that Citi is worth at least 1.5 book in a breakup. The payments platform alone should be worth multiples of the current market value of equity at $100 billion. The gross yield on the bank's $2.1 trillion in earning assets is north of 9%. Black Rock and Santander attempted to buy Citi's consumer book back in 2011 . With interest rates likely to fall, maybe it's time for Citi's board to take another look at asset sales. Even if we assume that the investment bank and Banamex are a zero, we think a breakup strategy ought to be actively considered by Fraser and the Citi board. If the objective is to recover value for the long-suffering Citi shareholders, how else would Fraser and the board of Citi proceed other than selling the company? If Fraser cannot articulate a coherent reason to keep the business together, a breakup may be the most sensible strategy. 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.

January 22, 2024 | In this edition of The Institutional Risk Analyst , we take a look at Q4 2023 results for U.S. Bancorp (USB) , one of the bellwethers in our commercial bank group. Would it surprise you to know that the term “commercial real estate” was not mentioned once during the USB investor conference call?

January 30, 2024 | Premium Service  | In response to reader requests, we look at three banks – Bank of America (BAC) , American Express (AXP)  and SoFi Technologies (SOFI) . We’ll start with the smallest, $27 billion asset SOFI, and work our way up the proverbial value chain in terms of asset size.

In the darkest hole, you'd be well advised Not to plan my funeral 'fore the body dies, yeah "Grind"/Alice in Chains February 5, 2024 | Premium Service | In this issue of The Institutional Risk Analyst , we ponder the broader repercussions of the abortive earnings release by New York Community Bank (NYCB) . We then take a look at the earnings from PennyMac Financial Services (PFSI)  and Western Alliance Bancorp (WAL) .  First let’s review the tragedy of errors at NYCB. When you make it to the front page of most global financial newspapers, you have achieved something and not necessarily something good. No doubt the officers and directors of NYCB are surprised at the market’s reaction to their clumsy disclosure last week. That is precisely the problem. First, the managers of NYCB apparently failed to recognize that going over $100 billion in assets is an enormously big deal for a community bank. The dreaded $100 billion demarcation line is well-known in the industry and especially for National Banks. Going big means that all aspects of the institution are now under additional scrutiny and that minimum levels for financial, systems and controls, and operational requirements have been raised.  Moreover, ever since NYCB jumped to an OCC charter in order to get the purchase of Flagstar approved in 2022, they have been living in a very different world than was the case under the NY Department of Financial Services. With the DFS, banks can negotiate, checkbook in hand. Tammany Hall with a Progressive Face. With the OCC, banks just get down on their knees and beg for forgiveness. The fact of a $300 billion residential loan servicing business at NYCB adds to the misery of dealing with the OCC. Just ask the folks at Cenlar FSB ( Cenlar FSB, COOP, BLND and the Great MSR Migration ). NYCB did not speak to shareholders nearly enough about what it means to be a large bank, including the need for additional capital and risk management resources. Dividend cut? Yeah. The bank needed to talk about capital, systems and controls, and what this would cost going forward. Pre-release the bad news next time. That's what big banks do. This leads to the second point, which applies to NYCB and all banks with commercial real estate and multifamily exposures. Loss Given Default on urban progressive multifamily assets is now assumed by regulators to be > 100%. And just by coincidence, the data has been telling us this for more than a year. Source: FDIC/WGA LLC You’ll notice in the financials for NYCB that capital leverage ratio is below 8% capital to assets. In the old days pre-Flagstar and Signature Bank, NYCB could run a fully loaned out book and even add additional exposure via brokered deposits. This worked because losses on multifamily real estate were low or zero. The value of commercial and multifamily assets in NYC had mostly gone up for a century. Loans were often interest only and owners could take out cash at refinancing every seven years or so. Happy days. But no more. Times Square | January 2024 When we rated banks at KBRA, many of the community banks in NYC had gone years without any measurable defaults on commercial mortgages or financings for multifamily apartments. But in today’s commercial real estate market, regulators are now hypersensitive to changes in commercial risk exposures at legacy urban banks. We spoke to several lenders who confirm that Fed, OCC and FDIC officials have been working the phones to check whether other NY banks are planning public disclosure of large commercial defaults. The operative assumption by regulators today is that the valuations and loan-to-value ratios of commercial property financed by banks are suspect. Historical loss data for these same commercial loan portfolios is now irrelevant. What really annoys us about NYCB and other banks with commercial exposures is that they knew months ago that the OCC was demanding pre-emptive increases in capital and loan loss reserves. Why? On the assumption that some commercial property valuations in the $20 trillion market are in a free fall and that, accordingly, defaults will spike in 2024. Several banks we contacted said that last year OCC examiners began demanding higher reserve levels, setting up a showdown with the external auditors. These are the same auditors who approved lower loan loss reserve levels in Q3 2023! Love that volatility. Loss given default for bank C&I loans is running over 80% so a boost in reserves makes sense. Q: What do Silicon Valley Bank, First Republic Bank, Signature Bank and New York Community Bank have in common? Same auditor, KPMG. Meanwhile in the credit markets, the Fed’s pivot is not yet resulting in higher lending volumes. While falling LT interest rates in the Treasury market helped stocks for a time, the downward move of the 10-year Treasury note has not really helped the housing markets, specifically mortgage-backed securities (MBS) and mortgage servicing rights (MSRs). Investors, looking at the still wide spreads between Treasury paper and MBS are not biting, in part because of uncertainty about interest rates. And banks continue to be net sellers of Treasury debt, MBS and whole loans. Source: FDIC Last week, several Democratic senators urged the Federal Reserve to cut interest rates, which they argue have “aggravated the country’s persistent crisis of housing access and affordability,” reports The Hill . In a letter to Fed Chair Jerome Powell , Senator Elizabeth Warren (D-Mass.), John Hickenlooper (D-Colo.), Jacky Rosen (D-Nev.) and Sheldon Whitehouse (D-R.I.) said the central bank’s decision to rapidly raise rates “has resulted in higher costs for homebuyers and renters, as well as a lack of new construction.”  Senator Warren and her colleagues are totally wrong about interest rates and home prices. The Fed’s decision to drop interest rates to zero in response to the COVID lockdown in 2020-21 drove up home prices dramatically and semi-permanently. Mortgage interest rates then rose for almost two years up to 8% in the third week of October 2023, but home prices continued to rise due to low supply. Since then, advertised residential mortgage rates have fallen a point or more. But despite the mini-rally, three quarters of all mortgages remain deeply out of the money for refinance. And home prices continue to rise, as shown by the chart from FRED. Notice that average home prices in San Francisco have begun to fall. If Senator Warren and her Democratic colleagues in the Senate want to address rising home prices, then they should ask Chair Powell to raise  interest rates up into double digits and keep them elevated until we crater residential home prices. A lot of banks and nonbank mortgage lenders will fail in the process, but we can just add this to the economic tab for COVID. The lack of supply of homes, not just volatile interest rates, is the true culprit when it comes to inflated home prices. Chairman Powell and his colleagues on the FOMC made a short market worse, and permanently inflated home prices by playing God with interest rates and markets starting in 2019. Get used to it.  At least until the maxi home price reset later this decade. The chart below shows the fair value of MSRs owned by all US banks. Notice as you read the discussion below that the modeled fair value of MSR reported by banks was rising through Q3 2023, but our calculation of implied value (red line) was not. Hmm. Source: FDIC/WGA LLC Meanwhile in the world of mortgage finance and MSRs, JPMorgan, the largest US residential loan servicer, took down the valuation of its $7 billion servicing asset by 7% in Q4. Guess what the down mark will look like in Q1 2024 unless the 10-year Treasury retraces back to say 5%.  Wells Fargo (WFC)  took down the fair value of its MSR 12% or $1 billion to $7.4 billion.  Gabriel Poggi at BTIG wrote this note last weekend: “ Do we care about negative MSR marks yet? After seeing the marks that both JP Morgan (JPM – Not Rated) and  Wells Fargo (WFC – Not Rated)  took in 4Q’23, and the common belief that rates are headed lower over the coming quarters, what do we think about being levered long MSRs right now? Balanced business models, in theory, should be able to offset marks with some origination, but I’m not convinced that origination cash flows will be all that sufficient unless mortgage rates head south in a material way. I know I am a broken record here, but isn’t this where really parsing the difference between GAAP and cash earnings at the servicers/originators is critical. Aka, when mortgage rates (and MSR marks) start to decline? Yes, there is hedging in place, but as we have all learned from years of hearing about ‘mortgage hedging’…nothing is fully hedged.” The table below shows the fair value of MSRs for JPM, WFC, U.S. Bancorp (USB) and PennyMac Financial (PFSI) . Notice that the changes are double-digits and reflect the modeled estimate for fair value for our favorite intangible asset. Gain-on-sale accounting is purely aspirational, no matter how many jobs it creates. Sad to say, new mortgage lending volumes are not up double digits, no matter what the model may say. As a result, we expect to see net runoff in MSRs and lower servicing income going into Q1 2024.  Source: EDGAR PennyMac Financial Services In 2023, PFSI was the #2 aggregator of conventional loans in the US, but the total market last year was just $1.4 trillion and most of these were expensive purchase mortgage loans.  The chart below shows the forward estimates used by PFSI in their disclosure, but analysts are backing away from the rate cut narrative.  If the FOMC slow walks rate cuts this year, we’ll see another year of sub-$2 trillion volumes.  Source: PFSI How is PFSI making money in a low volume market? Servicing. The servicing book of over $600 billion in unpaid principal balance (UPM) of loans has supported PFSI and, indeed, allowed the firm to de-lever its balance sheet. The value of escrow balances has also grown. The critics calling for PFSI to roll over in 2022 were very wrong. Yet even in a falling interest rate environment, the firm’s servicing book may runoff faster than expected. We suspect that lending revenue will be at the low end of estimates for 2024. Source: PFSI The trouble facing all mortgage lenders is that the average loan coupon in the $14 trillion UPB market is still below 4%.  The FOMC would need to push MBS yields down 300bp into the 3s to really move the needle on home refinance volumes. As a result and opposite to the 2020-21 period, lenders may face net runoff of MSR portfolios but weak origination volumes comprised largely of purchase mortgages. The cost of originating a conventional purchase loan is over $10,000, according to the MBA survey. A refinance loan, by comparison, is a quarter of that cost. All of that said, PFSI has cut back on operating costs and is now positioned to wait for lower interest rates as smaller issuers exit the industry.  Fact is that investors in PFSI have done very well over the past five years compared to either NYCB or WAL or indeed most other commercial banks. Along with Mr. Cooper (COOP) , PFSI remains the market leader in correspondent lending and has one of the best total market returns in the financial services industry. The chart below shows PFSI, COOP and WAL. Source: Google Finance (1/3/2024) Our chief concern is what possible interest rate volatility will do to the GAAP results for PFSI and other mortgage lenders. In an environment where actual lending volumes are low and credit costs are rising after a long period of muted default servicing expenses, runoff of MSRs will be painful. Remember, most private mortgage issuers do not hedge their MSRs.  PFSI spent $300 million in Q4 2023 on hedging in order to manage appearances for investors and also lenders. If that consumer recession ever materializes, hedging the MSR will become a luxury. Western Alliance Bancorporation We exited our position in WAL in 2023 after the market kerfuffle due to the failure of Silicon Valley Bank. Readers of The IRA  will recall that WAL was the best performing bank in the US in 2021, riding the massive wave of mortgage volumes and the purchase of AmeriHome Mortgage from Apollo Global (APO) portfolio company Athene Holdings (ATH) . Since 2023, WAL has continued to perform well, growing deposits and equity in a decidedly quiet market for mortgages and MSRs, two favorite assets of WAL. Like NYCB, WAL is a play on a rising residential mortgage market.  When loan purchase volumes go up, WAL makes more money. AmeriHome is a large correspondent lender that competes with PFSI, is strong in conventionals and also plays in Ginnie Mae MBS. The government MBS exposures are of a very pedestrian flavor in terms of credit. WAL actually grew net interest income and deposits in 2023 vs 2022, as shown in the table below. Source: WAL Q4 2023 WAL’s provisions for credit losses were up in Q4 2023 as the bank continued to normalize from the very low level of defaults during the Fed’s QE and the national loan forbearance program that was in effect during COVID. Provisions were actually down 8% YOY 2023 vs 2022, but none of that matters in an equity market where a single headline loss event can brand your bank as commercial real estate roadkill in a matter of minutes. WAL has a well-diversified loan book and, more important, a management team used to running a national lending and warehouse financing business. The bank's default activity on C&I, commercial real estate and development lending has been well-below peer for years. Also, WAL has very little multifamily exposure. WAL had net charge offs of $8 million in 2023, roughly 4x 2022 and above pre-COVID levels. Net charge offs were $1.2 million in 2018 and $3.4 million in 2018, but all very low compared to the $50 billion loan portfolio. The WAL $70 billion asset bank has been in the bottom quartile of Peer Group 1 in terms of net loss for the past five years. Like NYCB, the fundamentals of WAL are strong, but the bank remains vulnerable to headline risk and other hazards that are more pressing for smaller banks and companies. The larger banks that are included in passive investment portfolios benefit from the long-bias of Exchange Traded Funds and other passive strategies. This is one reason why short-sellers will target a smaller issuer like NYCB or WAL, but not go after larger underperformers such as Citigroup (C) or Bank of America (BAC) as readily. WAL was under attack a year ago and today is stable, profitable and out of the woods -- for now. 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.

February 9, 2024 | Premium Service | Is that sudden peak in consumer credit costs about to begin? In this issue of The Institutional Risk Analyst , we hear from Bill Moreland  at BankRegData  about the credit outlook for New York Community Bank (NYCB)  and the banking industry more broadly. We then dive into the results from PayPal Holdings (PYPL) .  Next week, we’ll take readers on a trip down memory lane and talk about why President Joe Biden needs to channel President Herbert Hoover  of a century ago and resurrect the Reconstruction Finance Corporation to clean up the black hole of moribund urban commercial real estate.  As we noted the other day, NAREIT says the value of commercial real estate in the US was over $20 trillion in 2021. A lot of this supposed value was aspirational and assumed an inflating market. Today, we'd probably haircut the entire industry by 20% or $4 trillion. Maybe Barry Sternlicht's estimate of a $1 trillion loss is a little bit light? But hold that thought. First the good news from Bill Moreland , the banking industry actually grew in Q4 after a year of shrinkage in assets and income.  “The $258.60B Q4 increase is the largest in 8 quarters since the go-go printing days of 2020-2021,” he writes. “The reason, as always, is the Federal Reserve: 1) About $90B of the asset increase was from AFS Securities valuation gains from Powell's conveniently timed beneficial December verbal pivot, and 2) Approximate $33B quarterly increase in the BTFP the majority of which was most likely a Cash arbitrage play.” Moreland notes that cash deposits with the Fed held by JPMorgan Chase (JPM)  and Wells Fargo (WFC)  have soared. “ Either the Fed is paying too high a rate and the largest banks would rather take the no risk 5.40% IORB, or the largest banks aren't comfortable lending in the current environment.”   We think that the latter is increasingly the case. Indeed, the Fed’s radical and really clumsy approach to managing reserves continues to offer banks a risk free alternative to private lending. How is this helpful? Bill Nelson  at Bank Policy Institute wrote in his latest paper  entitled “How the Fed Got So Huge”: “Following the collapse of Lehman Brothers in September 2008, the Federal Reserve underwent a significant shift in how it implemented monetary policy, transitioning to an excessive-reserves framework that it had deemed too radical and rejected just months prior. This shift involved borrowing excessive reserves from banks, deviating from its traditional method of borrowing only the amount banks needed to meet reserve requirements and address clearing needs. Despite initial intentions to revert to the necessary-reserves framework, subsequent developments, including three rounds of quantitative easing, led to the permanent adoption of the excessive-reserves approach in January 2019 by the Federal Open Market Committee (FOMC). This decision was a mistake. The framework has not yielded the purported benefits, such as simpler policy implementation, and has required the Fed to be vastly larger than originally anticipated. Advocates of the excessive-reserves approach argue it aligns with the Friedman rule, but alternatives like a voluntary-reserve-requirement regime could achieve similar outcomes without the drawbacks.” In terms of NYCB, the bank just elevated former Flagstar CEO Alessandro (Sandro) DiNello as Executive Chairman, but he and his team have a lot of work to do. Selling participations in credit exposures or outright asset sales is the first task. Moreland notes that charge-offs have been increasing across the bank’s portfolios. He reports on the latest CALL data from FDIC: “Flagstar (NYCB) is not just a 'couple' of loans charging off, but rather increasing 30-89 Days Past Due (up $61.16 Million), NPLs (up $240.68 Million) and Performing TDR (up $122.46 Million). An argument can be made that even with the large Provision in Q4 NYCB is still under-reserved.” We think that most bank portfolios are under-reserved because of the strange movement in loss provisions and, more, the volatility of loss statistics. As we note below regarding PYPL, the firm was reducing loss provisions in Q4. Moreland notes that non-performing loans, performing troubled debt restructurings and charge-offs on multifamily loans are growing at NYCB and across the industry. He writes in a note to clients:  “A number of other large Multifamily lenders are also having delinquency issues including Citibank , Merchants Bancorp , F irst Interstate , Citizens Bank and Peapack-Gladstone . We're also seeing Multifamily lenders restructure large chunks of their portfolio. Huntington has $144.62 Million of Multifamily TDR (4.58% of portfolio), First-Citizens is at $109.86 Million (3.48%) and M&T has $125.59 Million (2.05%).” Notice the part about restructuring multifamily? That is going to continue for years to come. Many properties will see lender concessions to borrowers (aka a loan "modification"), hurting bank net interest margins. The alternative is for the bank to foreclose on a property that they cannot sell and do not want to own. One issue Moreland notes that has been troubling us for a while is the impact of the Fed’s manipulation of credit markets and COVID loan forbearance on consumer credit scores and future credit loss rates. Two years of loan forbearance ℅ progressive politicians made subprime consumers seem to be prime and enticed banks to lend to these same faux prime consumers, who are now likely to revert to pre-COVID subprime behavior patterns. “ I see the fundamentals crumbling, but the market just sees rate cuts,” Moreland writes. “Sadly, the Fed's never ending war on savers has led us to raising a whole generation who believe that 0% interest rates makes things 'affordable'. As if the whole economy has become a used car dealership pushing 'low' financing.” To those members of the financial media who keep telling us that the credit problems are in the smaller banks, we respectfully disagree. How about Bank of America (BAC) ? Moreland notes: “BAC reported a delinquency rate of 5.32%  on Non Owner CRE when we really should be tracking their Delq+Performing TDR rate which jumped to 8.09%  of their portfolio. Yes, a full 8% of Bank of America's Non Owner CRE portfolio is either delinquent or had their payments lowered.” Meanwhile in Washington, Federal Reserve Chairman Jerome Powell  and Treasury Secretary Janet Yellen  continue to predict the failure of banks and nonbanks, almost as though they want to get ahead of an inevitable meltdown. Yellen continued to prattle about the potential risk from failing nonbank mortgage lenders in her Senate Banking Committee testimony, this as commercial banks sink under the weight of accumulating credit losses.  Somebody should remind Secretary Yellen that liquidity was last year’s problem. This year and, indeed, the next five years is going to be about credit risk, as we’ve been predicting for some time. We think that banks and the whole industry could be driven into multiple periods of loss as they divert income to loss provisions.  This is the risk that deserves, nay, demands the attention of Yellen and Powell. Nonbank mortgage firms don’t retain a lot of credit risk on their books and tend to be net negative in terms of duration. As we noted in our last note, large forward issuers like PennyMac (PFSI)  and Mr. Cooper (COOP)  are actually paying off debt and deleveraging, and outperform most bank stocks even in a rising rate environment. Most mortgage issuers are shrinking their balance sheets and preparing for the rate cut cycle to begin. Where we do see risk of systemic contagion is the reverse mortgage space, where several issuers of home equity conversion mortgages or HECMs are struggling to stay afloat. The Treasury had to seize the bankrupt Reverse Mortgage Investment Trust at the end of 2022. We think Janet Yellen may need to size at least one more Ginnie Mae HECM portfolio before very long, at a cost of billions more losses to the taxpayer.  PayPay Holdings Like many financials that we follow, PYPL had decent Q4 2023 earnings, but is getting no love from the equity markets. Margins were flat and only expanded because of expense control. Membership and active account metrics were basically flat. The market has shown little interest in PYPL as a result. The stock price fell after the earnings release. Source: Google Finance Payment volumes are growing in the mid-teens internationally and about 10% in the US, again hardly a poor performance. Transaction expenses are growing 17% in the latest quarter, however, focusing the future on whether PYPL can grow faster and scale expenses lower at the same time. Source: PYPL Credit expenses are very low, two digits to the right of the decimal point. Again to the point above about loss provisions, PYPL was taking credit reserves back into income in Q4 2023 because actual losses were so low. Of note, PYPL took a $1.6 billion hit on the sale of buy-now-pay-later (BNPL) receivables originated as held for sale and subsequently sold. PYPL had taken gains on this paper in previous quarters. It may be that the market for consumer IOUs is weakening. CEO James Chriss noted that "In Q4, we delivered 9% revenue growth on $410 billion in total payment volume. Transaction margin dollar performance was better than expected in the fourth quarter, and we continued strong expense discipline, reducing non-transaction-related expenses by 9% year-over-year." In other words, transaction costs are rising faster than revenue, so we cut operating expenses -- aka people -- by 9 percent. Bottom line is that PYPL has lost its lustre as a fintech stock and, compared to some of its comps such as Affirm Holdings (AFRM) , is really getting no love from the equity markets. Non-GAAP earnings per share were $1.48 in the quarter, representing 19% year-over-year growth. Higher earnings per share in the quarter were driven by ongoing expense reductions. While some of our colleagues continue to publish aspirational comments about PYPL, we see more stable and boring financial performance ahead. 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.

February 15, 2024 | Premium Service  | In this issue of The Institutional Risk Analyst  we delve into the world of interest rates and residential mortgage credit as Q4 2023 earnings conclude. The largest residential mortgage issuers had decent quarters, though mostly due to servicing income and falling leverage. Treasury Secretary Janet Yellen  frets about the systemic risk from nonbank servicers, but the chief challenge for the industry is a lack of new loan origination volumes, high financing costs and a dwindling group of bank lenders.

February 21, 2024 | Premium Service  | Readers of The Institutional Risk Analyst  will be interested to hear that we’ve been working on several bank indices for the past little while with our partners at Thematic in Menlo Park. The WGA Bank Index is a census of superior banks which draws upon our work at Institutional Risk Analytics .

February 29, 2024 | Premium Service  | Happy Leap Year. Now almost 60 days since the end of 2023, the earnings continue to roll in from the less attractive parts of the reporting group. The mortgage sector is still led by Fannie Mae and Freddie Mac , both up more than 140% over the past year, but the odds of a release of the GSEs from conservatorship are very long indeed. One of our favorite examples of outlier business models is United Wholesale Mortgage Corp (UWMC) , a leading aggregator of residential loans. UWMC is presently locked in a life and death struggle with Rocket Mortgage (RKT)  for ownership of the wholesale mortgage channel.  And despite a lot of bluff and bravado from UWMC, RKT may be winning. While UWMC had the biggest market share in conventional conforming loans in 2023, that just means that they are losing more money per loan than everyone else. UWMC reported a net loss of $461.0 million in 4Q 2023 compared to net income of $301.0 million in 3Q23 and net loss of $62.5 million 4Q 2022. This was inclusive of a $634.4 million decline in fair value of mortgage servicing rights (MSRs).  UWMC blamed its Q4 loss on the markdown for servicing assets, but in fact UWMC has been selling MSRs to subsidize a price war.  The battle for control of the wholesale mortgage channel is one reason why both firms reported significant losses in Q4 2023.  RKT reported Q4 2023 GAAP net loss of $233 million, but delivered "adjusted EBITDA profitability" for the full year and in Q4 2023, for the third quarter in a row. In the world of mortgage finance, all of the disclosure metrics are “adjusted” but that does not mean that the metrics are meaningful. What is significant is that RKT can essentially fund its war of attrition with UWMC indefinitely. Below are two snippets from the UWMC earnings that illustrate the current scene and also suggests why the mortgage sector is so poorly followed by institutional investors. First we see the balance sheet summary below showing assets, cash and FV of MSR all down. Equity is down $500m from the previous quarter. The picture from UWMC shows the company's first full-year GAAP loss and declining liquidity. But then we arrive at "adjusted" EBITDA and we see, viola, a $500m up mark for the remaining MSR due to a change in "valuation assumptions." The table below comes from the UWMC earnings release. During the conference call, CEO Mat Ishbia bragged about the impact of his notional $507 million increase in the value of the remaining MSR to window dress his negative financials: "We closed $24.4 billion in production for the quarter at the higher end of the guidance, with $20.7 billion of that coming from just purchased. Gain margin was 92 basis points, also well within guidance. And after adjusting for changes in the fair value of MSRs due to valuation inputs or assumptions, we generated pre-tax earnings of $39.2 million in the fourth quarter and $253.7 million for the year, both significant increases from 2022." Ishbia's adjustment of the valuation of his MSR is a fiction IOHO, especially given that interest rates fell in Q4 2023. Keep in mind that in Q4 2023, most issuers in the mortgage industry reported down marks on MSR other than COOP, which was up due to net purchases. Since UWMC models its MSR internally, changing the assumptions is an easy matter. Our assumption is that UWMC is continuing to sell MSR to finance its price war with RKT et al in wholesale. We see two big problems with this strategy.  First, as soon as UWMC CEO Matt Ishbia stops overpaying for new mortgages, RKT and the other players in the wholesale channel will return in force. Ishbia apparently thinks that his monopolistic behavior in the wholesale loan channel will permanently drive away the competition. We disagree.  Many of the biggest players in wholesale are also large Ginnie Mae issuers and servicers. They will just wait for Mat to run out of cash buying expensive conventional purchase loans. Second, UWMC, RKT and other large issuers of conventional mortgages are creating what is potentially a larger problem than short-term profitability. If you inspect the league tables for different loan types published by Inside Mortgage Finance , you’ll notice that some shops that were originating a lot of conventional loans two years ago have fallen far down in terms of new production. Why? Because they do not like the risk of underwriting conventional loans that may be underwater in the next housing correction. "The Federal Housing Finance Agency last week issued its 2024 “scorecard” for Fannie Mae and Freddie Mac, urging the two government-sponsored enterprises to “harmonize” their single-family representations-and-warranties framework," Inside Mortgage Finance reported earlier this month . "That included defect identification, remedies and repurchase alternatives." Industry leaders believe that the FHFA wants the GSEs to offer issuers like UWMC and RKT "repurchase insurance" to the tune of 25bps per loan. If the industry sees an increase in loan delinquency without a decrease in mortgage rates, firms that are stretched for capital and liquidity could be put into a very difficult situation. Either you pay FHFA Director Sandra Thompson 25bp for "repurchase insurance" or she hits you with a loan repurchase demand. Laurie Goodman , Jun Zhu and Michael Neal of Urban Institute wrote last year: "The government-sponsored enterprises (GSEs) have required that mortgage originators repurchase more loans in recent years as compared with earlier periods; the adverse impact of these actions on mortgage originators is magnified in a high-interest-rate environment. These repurchases can have an outsize effect on access to credit, and originators become less inclined to originate the types of loans that account for a disproportionate share of repurchase requests." The table below shows The IRA Mortgage Equity group and some key performance metrics sorted by tangible book value (TBV) per share. Notice the disparity between RKT and UWMC, on the one hand, and Mr. Cooper (COOP) and PennyMac Financial (PFSI) , in terms of TBV per share. There is a huge gulf in terms of valuation between firms that are building book value for investors and those that are bleeding cash into a very difficult secondary market for loans. Source: Bloomberg Our view of the mortgage world is that the gain-on-sale model typified by RKT and UWMC is fine in a falling rate environment, but in a rising or stable interest rate environment, the firms that acquire and hold MSRs have an advantage. We have always viewed UWMC as a redux of Countrywide Financial, but with the added consideration of Mat Ishbia's hyper-aggressive market strategy and the loan quality issues found in the wholesale channel. But ultimately, the performance of PFSI and COOP makes the case for value. Source: Google Finance Rate Cut Dreams Fade Watching the Street firms backpedal away from predictions of an interest rate cut by the FOMC this year is becoming more and more amusing. The Fed's favorite gauge of inflation rose in January by the most in a year. The Fed's heavily limited core CPI, which excludes food and energy costs, increased 0.4% vs December. The majority of investors are still banking on a rate cut by the Fed later this year, but we worry that markets and issuers are totally wrong-footed if inflation numbers continue climb and a rate cut is push backed into 2025. Jeremy Siegel at the Wharton School, for example, warns that a June rate cut is not "in the bag." Look for more analysts to retreat from the rate cut creed. "If fortune favors the prepared, then no market is going to have much luck," writes Simon White of Bloomberg . "A re-acceleration in inflation is increasingly on the cards, an eventuality that is materially underpriced across asset classes. That means portfolios are cheap to hedge, as well as leaving markets subject to outsized moves when they do price in inflation’s return." We think that the Street's pricing for interest rate cuts this year will slowly shift to a more neutral posture by Easter. Any indication that inflation measures are accelerating will speed this process. The fact is that Wall Street still cannot come to terms with the idea that ultra-low interest rates in 2020-2021 were an anomaly. These low rates are not likely to be repeated baring a complete meltdown of the economy and/or the financial markets. And looming in the background of all of these discussions is the massive federal budget deficit. 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. 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