May 7, 2018 | We were in the car last week heading to Washington for the gala celebration for The American Conservative’s 15 years in existence. During the trip, we heard former auto industry executive Bob Lutz take down Tesla’s (TSLA) economic model live on CNBC. Talking to Carl Quintanilla, Lutz – who worked in senior management for all three US automakers – basically made two interesting points: that Tesla spends too much for its larger batteries and that the company’s labor costs are six times the industry average. Lutz repeated his view that examination of the company’s financials by “anybody who knows anything about the automobile business” must lead to the conclusion that “this cannot possibly work” with reference to TSLA’s costs and revenues. He predicted bankruptcy for the company. “[Musk] doesn’t want to talk about the numbers, which are a disaster,” former GM Vice Chairman Lutz told CNBC (“Elon's costs are way higher than his revenues: Bob Lutz”). He says let’s talk about the future… He wants to talk about anything but the disastrous business.” Suffice to say that Lutz generates a LOT of controversy, both from the supporters of Tesla and its charismatic CEO Elon Musk and from auto industry aficionados, as we discovered on our twitter thread upon posting his interview. But Musk does not cut a very impressive figure as a corporate CEO, behaving like a cranky child a la Facebook’s (FB) Mark Zuckerberg. He either needs to play the role as CEO of a public company or stand down. Come to think of it, Musk reminds us a lot of Henry Ford, a difficult man who had a vision and largely kept his own counsel. Ford was not known for his patience with mere mortals, preferring the company of other visionaries like Thomas Edison, Harvey Firestone and Charles Lindbergh. In fact, Henry Ford was an appalling manager who was not even an officer when Ford Motor Co was started. He would have failed for a third time in business but for his partners like James Couzens, Horace Dodge and Charles Sorenson. What we can definitely say about autos having researched Ford Men: From Inspiration to Enterprise over many years is that manufacturing passenger vehicles in the 21st Century is a very tough, often times irrational business with modest and frequently negative equity returns. Watching Ford Motor (F) decide last week to stop making “cars” is a reflection of this economic reality. Ford and all the global automakers must follow the evolving preferences of consumers when it comes to product design and discard products that don’t fit that target. Green is good, but consumer preferences for SUVs are really about utility, a trend Ford itself helped shape by introducing truck-based passenger vehicles like the Bronco and Explorer several decades ago. When Toyota responded in 1998 with the Lexus RX300, that marked a key step in the evolution and feminization of luxury sports utility vehicles. The 2000 model year Ford Explorer was still a big, dangerous truck, but the Lexus RX was a round, beautifully finished, if underpowered, passenger vehicle that rode high, had a big cabin, rear hatch and great visibility. The Lexus also had good gas mileage. The fact that TSLA has embraced traditional sedans rather than some sleek kind of vision for the hybrid SUV is notable. As we discussed with Bloomberg Intelligence auto analyst Kevin Tynan in February in The IRA ("The Interview: Kevin Tynan on Autos and Mobility"), the global industry is headed towards a mix of SUVs and true trucks with traditional passenger cars getting a rapidly declining share of the production pie. Makers like Tesla and Audi, for example, are atypical in their continued focus on passenger cars vs SUVs of varying shades. Tynan said in February: “A decade ago most SUVs were being built on a truck platform, but that is not the case at all today. These were full frame vehicles. Today there are very few SUVs that are built on the same platform as the pickups.” Or to put it another way, Ford still makes “cars” that look like SUVs on the outside. And please don’t take your Audi Q-7 off-road in Maine or even off pavement during the June Camp Kotok fishing trip (there are a couple of spots left, BTW). Take the Ford F-250 Super Duty with the double cab and short bed to tow the grand lake canoe (see below). Toma Stream Tynan also noted that SUVs and trucks tend to be more profitable than cars, but here is where the problem comes for TSLA. According to Lutz, the delivered price for the Tesla Model 3 is in the $50k range as opposed to original price tag of $30k. That big delta in terms of the delivered price for a Tesla Model 3 will take out a lot of demand for the vehicle, Lutz concludes. More important, at that $50k price point, Tesla is up against Toyota, Audi, BMW and Daimler Benz, all of whom have full electric and hybrid offerings that can be reasonably profitable today. And the rest of the auto industry is right behind the premium marques in terms of features at lower price points. Elon Musk has achieved two huge goals: First, he validated the concept of electric cars in the public mind and with the auto industry. The entire global auto industry is desperately chasing Tesla’s vision of the electric future of personal transportation. Second, Musk has created a premium brand in Tesla, but this brand needs to be managed to be competitive. As Tynan noted: “Tesla is valued as a tech company, but as a car maker they are in precisely the wrong place in terms of consumer who want a higher ride and other attributes of a truck or crossover… Tesla could at least build a car that consumers want.” To us, Musk needs to declare victory and move on to his real passion, namely selling the future, space travel, shuttle to Neptune, whatever. Making cars of whichever propulsion type is about today and those few global designer/assembler/marketers that can compete for market share. Like Henry Ford, Musk’s considerable talent as a visionary and salesman may not be matched by his operating skills. He should just admit as much and put Tesla up for sale. Tesla ought to hold an auction among the top global automakers and pick a partner to build TSLA autos and especially small and mid-size hybrid Tesla SUVs. The continuing surfeit of global capital may still enable Musk to extract himself whole from the Tesla project and avoid facing the fate of some previous automotive entrepreneurs. We’re thinking not so much about the habitually conservative Henry Ford as much as William Durant of General Motors (GM) fame. One of the greatest speculators of a century ago, Durant built GM into the largest corporation in history during the first decade of the auto industry. Ford, GM and the Dodge Brothers were all fabulously successful and profitable businesses in the 1900s with returns to shareholders measured in the thousands of percent annually. Durant brought Buick, Oldsmobile, Pontiac, Cadillac, Champion ignition, AC spark plug and other companies into GM, sales soared, but earnings lagged. By 1910, however, Durant became over-extended and lost control of GM to the creditor banks led by JPMorgan (JPM). Durant was ousted by the bankers as his company sank into bankruptcy. By 1915, aided by the du Pont family and other investors, Durant regained control of GM and began “an enormous program of expansion,” to quote Earl Sparling’s 1930 classic, “Mystery Men of Wall Street.” The E.I du Pont Nemours Powder Company put $50 million of war profits into GM to support Durant. In the Spring of 1920, Durant tried to float $64 million in new stock to finance the excess of expenses over revenue at GM. The stock was trading at $38.50, but new investors were coming in at half that valuation – just $20 per share. The situation went from bad to disaster quickly, when several large stockholders, concerned about the misalignment of costs and revenue, threatened to sell, forcing Durant to personally support the stock. By June 1920, Durant had been buying GM stock through intermediaries for more than a month, but to no avail. The stock broke to $20 in public trading when a 100,000 share block was offered, Sparling reports. GM reached $12 per share by the end of the month. The value of GM continued to fall along with his fortune. Durant spent his entire cash reserve -- $90 million – to allow some of his personal friends and associates to exit the stock. By the end of 1920, JPMorgan stepped in once again and along with the du Ponts took charge of GM for the second time in two decades. They paid Durant $40 million for his stake, of note. More important, Du Pont controlled GM until the Administration of President Dwight D. Eisenhower forced the divestiture. It seems to us that Elon Musk has a choice. He can either magically cut the cash burn rate of TSLA down to nothing and start delivering cars on time or he can look for an exit strategy. Musk has created an awful lot of value in TSLA, but the better part of valor may be for this American icon to partner with a global automaker and move on to personal aircraft, for example. Otherwise TSLA will continue to burn cash and, eventually, must go back to the markets for more. And if TSLA is unsuccessful in raising new cash, then like GM in 1920 the great endeavor will be finished – unless Musk is prepared to fund the venture out of his own pocket. The bond holders and other creditors are, of course, ultimately the true owners of TSLA. Thus a sale may be the best outcome for this valuable brand, but how to get Musk to accept such an outcome? Trouble is, Musk may not be able to fund his project until it becomes at least as competitive as the rest of the industry. And between today and that operational goal, TSLA will be valued more and more as a car company as opposed to a technology play. Ponder Audi AG valued at $34 billion vs TSLA at $49 billion. The markets will resolve the question soon enough. One might apply the judgment of Sparling on the persistent Durant to the personality of Musk: “[I]t isn’t money nor even power that this man has striven for all his years, but achievement, a role in the play of life that might turn that comedy and farce into the kind of drama it would be had a surer playwright written it.” 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 3, 2018 | In this issue of The Institutional Risk Analyst, we talk with Dennis Santiago, co-founder of Institutional Risk Analytics and the author of the Bank Monitor safety and rating system. The Bank Monitor was acquired by Total Financial Solutions of Hackensack, NJ in 2014. Dennis is a rare analyst who combines a high-level understanding of operations analysis and business process with an equally sophisticated understanding of technology. He is an involved public citizen and political commentator published on platforms such as the Huffington Post and America Out Loud. His personal blog at www.pickingnits.com focuses on global risk and national policy. We spoke to Dennis at his office in Los Angeles. The IRA: Dennis thanks for taking the time to catch up. Let’s start off by talking a little about how you are using the Bank Monitor ratings engine and specifically the use case developed for the State of Ohio at TBS. How are they using the Bank Monitor to screen the risk of the banks that are participating in their state-level deposit insurance program for banks? Dennis: The Ohio case is a fascinating study in action and reaction dynamics of federal regulation. As the market has gone beyond the 2008 crisis, new business cases for safety and soundness testing have emerged. This one stems from how the increased capital requirements at the federal level have constrained capital flexibility for local markets, reducing the amount of credit available to these communities. As a result of capital and liquidity requirements imposed at the federal level, banks are compelled to over-collateralize loans. The driving rule behind public depositor overcollateralization was the implementation of the US version of Basel III’s Liquidity Coverage Rule (LCR). It was structured such that a bank gained no operational liquidity for taking municipal deposits. Roughly, every muni deposit dollar had to be collateralized with a low yield high quality liquid asset. The net net interest margin (NIM) for the silo is zero. The IRA: That’s very interesting and something we’ve never heard about in the financial industry media. What approach did Ohio take ultimately? Santiago: The regulatory answer was to allow the pooling of collateral by a guarantor so as to generate headroom to engage in higher yielding assets. This created conditions for generating economical NIM’s off these exposures. Ohio enacted a law that created a way for the state to pool the collateral. They created a vehicle to guarantee a portion of the collateralization requirement at the federal level for in-state banks are deemed to be safe and sound using acceptance criteria more strenuous than federal requirements. The collateral relief is significant thus enabling banking services to Ohio municipalities. To enable this, what Ohio did was use a customized version of the Bank Monitor safety and soundness monitoring solution that not only looked beyond FDIC insured deposits regime analysis but went further and assessed the overall quality of depository institutions at the uninsured deposits layer. Municipal deposits tend to be well above FDIC insurance limits. The IRA: We had no idea the State of Ohio was doing this. To be clear, the state is using public funds guarantee mechanisms to provide collateral cover for uninsured deposits of municipalities at prime banks? And this is being done to give capital relief to banks in Ohio? Santiago: That is correct. Banks that operate within state lines can follow state law and are able to take advantage of this facility. The bank must have a physical branch in the state of Ohio. It’s a very innovative solution. More importantly from a fiscal policy perspective, it illustrates agency theory in action between federal and state actors. The IRA: Talk about this dynamic between state and federal regulation. How have the new capital and liquidity rules constrained credit? Santiago: The constraint is because of the need to put up additional capital and reserves against different types of risk exposures. The higher capital levels and the new risk weighting for different assets penalizes banks for selecting higher yielding asset types. We are essentially removing capital that the bank would use to lend from the business operating equation. The IRA: And less effective leverage? Santiago: Yes, yes. The banks look great and have lots of capital, but the business volumes are flat and down vs 2015-2016. The banks don’t have any capital allocation left to lend. Volume is constrained by the Dodd-Frank capital rules; that’s why investors are skittish about bank valuations today. The IRA: Agreed. In the great continuum of risk and public policy, where are we now? Are we too restrictive on banks? Santiago: We may have gone a bit too far in terms of restrictive policy on banks, thus causing new forms of behavior to emerge. You’re seeing regulations that are effectively encouraging the growth of non-bank companies, which are the customers of banks. The banks lend the marginal dollars out to non-bank firms at relatively high spreads compared to real estate lending, for example. If banks have to keep more funds sequestered in capital and reserves, then the growth in non-bank lending is a way to boost NIM. What you have is higher capital balanced by riskier operations to get to the same returns. It begs the question, is this really the center lane path we want to see our financial system following? The IRA: Probably not. The banks do look better, but the pre-tax asset and equity returns are clearly lower than prior to 2008. The after-tax results look better thanks to the tax legislation last year. Santiago: We have lots of money in the piggy bank and lots of risky stuff, creating a barbell of risk at most banks. It’s like the barbell on the cover of Nassim Taleb’s new book “Skin in the Game,” with one tiny end and one grotesquely large end. The banks look under-risked because of the huge reserves they are required to hold. And it causes problems and costs. What we are seeing years after Dodd-Frank is a reaction by proactive states like OH to adjust their own bank regulation to maintain economic activity in the face of restrictive federal regulations. States like OH eventually adapted and passed laws leading to new filtering methodologies for tracking the performance of prime banks. This was a reaction to the negative impact on the OH economy as a consequence and effect of federal regulation. The IRA: We have a banking system that is under-levered and over-reserved. But we also have a system where the Fed has manipulated credit spreads and risk pricing. How much risk is hidden under the comfortable blanket of Fed open market operations? Santiago: Loss rates are clearly headed higher. In order to achieve the returns that investors expect, banks have taken on increasingly more risk in terms of asset participations. NIM is not a forgiving number. You make it or you don’t. The IRA: And NIM is extremely unforgiving when the cost of funds for banks is rising 3x the rate of asset returns. In the most recent earnings cycle, Goldman Sachs (GS) was the only large bank that actually grew interest income faster than interest expense. The great rubber band has clearly snapped. But you won’t hear anybody in the economics profession talking about this on CNBC. The narrative still says higher rates are good for banks. Santiago: Correct. And in the world of bank balance sheets, we have a capital squeeze in addition to a NIM squeeze. The rate of adjustment in terms of NIM is going to depend upon the inflation rate and how fast the Fed adjusts. Banks are already being forced to stretch in terms of asset returns and credit risk. Basically the Fed has flooded the room with liquidity for the past eight years. Banks have to keep their head above water in terms of earning positive returns. But the abundance of liquidity makes finding acceptable returns very challenging. In order to survive, the banks move their asset allocation decisions to less safe, especially when volumes are constrained by capital rules. The IRA: Bankers want bonuses. Where is your big worry bead for the future of the US banking industry? Santiago: Clearly the big transition in the banking industry in terms of asset-liability management (ALM) is going to be managing the shift from liability sensitive strategies to asset focused strategies. One of the big aspects of the 2008 crisis and the recovery was liability management by banks… The IRA: And by the Federal Open Market Committee, which protected bank NIM from 2009 onward by killing depositors and bond holders. Santiago: Now the focus is going to shift over the managing asset returns and related risks. How do you manage yield? In an environment where prices are constrained by the Fed and volumes are constrained by capital regulation, how do you placate the Goddess of NIM? I repeat, NIM is a unforgiving goddess. She does not care how. So if you are short on price and volumes, you turn up the risk on credit participations. All NIM wants to know is that you made your nut last quarter. The IRA: Speaking of assorted nuts, you’ve had some prescient things to say about bitcoin and the so-called blockchain tech that enables it. Haven’t we seen this movie before?? Santiago: Crypto is a really interesting phenomenon. It’s not the tech, it’s how the tech affects the landscape of money. It has grayed the line between people who live on the network and people who don’t. The blending of the two worlds of barter and above board enterprises is like oil and water. As a rule, they do not mix. The way a barter community exchanges value is totally antithetical to the tax paying world. The world of “Hawala” with two sets of books allows for the transfer of value without money actually changing hands. We note the exchanges in a “cross-ledger.” This stuff has been going on for hundred of years in parallel with other forms of finance. The IRA: So crypto has enabled the ancient barter system and outside of the established network. The barter participants don’t pay taxes. OK, we get it. Is that all there is, to paraphrase Peggy Lee? Santiago: We have not really thought through the implications of enabling barter via electronic multiple ledger bookkeeping on a global scale. The IRA: The true participants in the barter world would never trade bitcoin via an exchange. They exchange the numbers and report the transaction to the collective. Our friends in places like Russia and Lebanon use crypto to live, pay bills, outside of the formal system. It is a binary choice. Santiago: Exactly. Trading cryptos via electronic means defeats the point of trust in the barter world. The compact in the barter world is that your net value trade is zero. There’s no taxes or excise or fees. It’s currency-free economics. Crypto imposes itself upon this barter market. The thing about this is that taxes, excise and fees attempting to extract their due won’t be far behind. That’s just the way of things. The IRA: Fair enough on cryptos, but how about blockchain? This is definitely a movie we’ve seen before. It was an electric KoolAid XML taxonomy building party hosted by Chairman Chris Cox at the Securities and Exchange Commission. Eventually led to public companies filing their financials in a dialect of XML. Is there anything here with blockchain? Santiago: As a technologist, I have to admit that there are moments when blockchain bemuses me. If you listen to the pundits, about half say it is a solution in search of a problem and the other half says it’s the greatest thing since sliced bread. I’m a bit more pragmatic about tech having been around since before people started calling it FinTech. To me, the shared ledger technology that seems to get everybody exited is just the latest version of SOAP XML, which is also the basis of a ledgering system. This technology was designed about 30 years ago and eventually trickled down into areas like financial reporting at the SEC as you noted. The FDIC CALL Report data warehouse is another massive implementation of XML based technology to gather, screen and publish bank financial statement data. The transfer of data between banks and other financial institutions is based upon APIs that sit atop XML constructs that are ancient in technology terms. The growth of global trade, manufacturing and logistics is a massive and universal example of XML-based ledgering technology. The IRA: So there is nothing really new here in terms of basic functionality? Santiago: Blockchain is an alternative ledgering system architecture. It is replacing something that is working well. More non-ICO solutions are presently deployed than blockchain ones. Don’t get me wrong. For some use cases, it’s the perfect fit. As with all tools, knowing when and where it’s the best option, and when it’s not, is the key. But people also confuse blockchain as a ledgering system with blockchain as a cyber security system, which it is not. The cases of theft of bitcoin and derivative cryptos have shown the technology still has vulnerability as manifested by incidents of cyber theft poking holes in the tech. We have nerds stealing money from the other nerds in scenarios lifted right out of movies and novels, which is pretty funny. The IRA: Ha. How does this end up? Santiago: What I think is going to happen with blockchain is that people will eventually realize that it is first a foremost a ledgering system that competes with existing systems, some of which are technical, others structural. The question becomes, why is a blockchain-based solution the more efficient solution? When is cost and latency attractive because it provides improved trust or transparency? In a flat internet where everyone is a stranger and are trying to hack you all the time the answer may go one way. In closed universes of known senders where per message mechanistic send/receive confirmation is mitigated, the most efficient transmission and ledgering systems will win out. The pragmatic odds probably favor innovative hybrids still hatching in laboratories. In the end, once we are done with falling in love with the toys, then we will wake up. And people are already starting to wake up to the reality that there’s more than one use-case and implementation design solution in this phenomenon. It’s not a one size fits all discovery. These are savvy folks. They are asking the obvious questions. Stay tuned. The IRA: Thanks Dennis 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 30, 2018 | Sometimes simple images are the most powerful. The chart below from FRED shows US real GDP change vs. the effective rate for Federal funds over the past five years. Just imagine around Election Day in the US this November, if the Fed funds rate is above the last print in real GDP and the gap between two year Treasury notes and ten year T-bonds is just about nada. Bad for stocks, yeah. But then maybe we see a bond market bull rally because the Street remains so painfully short quality duration. As major central banks turn off the Electric Kool Aid drip, we’ll find out soon enough whether the promise of growth is real in a world with equally real interest rates. This question of just how fast the US economy can grow without near-zero short term rates is really the first order of business when assessing macro market risk. If you believe the dot-plots from the Federal Open Market Committee, we are almost assured to see the convergence of GDP growth rates and Fed funds. Question to Chairman Powell: Are you prepared to start explicit sales of securities from the System portfolio? The chart below shows the painfully slow decline in the amount of Treasury bonds and mortgage backed securities behind the Fed’s $4 trillion in excess reserves. The consensus on the Street seems to be lower growth and higher inflation, but with little upward pressure on interest rates. The Mortgage Bankers Association, for example, has projected real GDP change slowly trending below 2 percent by 2020. If we do two more quarter point increases in Fed funds this year, then we get perfect stagnation with rising inflation, right? Fact is, global growth is not particularly strong, as witnessed by the slow attrition of Sell Side firms over the past decade. UBS, HSBC, BNP, Merrill Lynch, Morgan Stanley (MS) and other second tier transactional players fled to the safety of wealth management after the 2008 crisis, but folks like Deutsche Bank (DB) pretended that 2008 did not happen. This lack of response by management eventually crippled Deutsche financially and led to the current situation, where one of the biggest banks in Europe may require state aid. Last week, we saw Deutsche Bank retreat from the world of deal making and derivatives trading, and going back to an imaginary European commercial banking business. We saw former Goldman Sachs banker and now European Central Bank chief Mario “Whatever it Takes” Draghi make noises about possibly continuing with the ECBs disastrous experiment in “quantitative easing.” Then we ended the week with German Chancellor Angela Merkel holding hands with Donald Trump at the White House. One observer commented to The IRA last week that perhaps Merkel was at the White House to discuss “Plan B” for Deutsche Bank, but this of course assumes that there was Plan A. It seems pretty clear that there has never been a real design for dealing with Deutsche at the corporate level. Years of QE in Europe has decimated DB and other European universal banks. Just as in the US, the ECB’s bond purchases have suppressed bank earnings and loan pricing, and basically killed secondary market trading. Each day we hear further doubts raised about the prospects of synchronized global growth, if for no other reason than the level of indebtedness globally is growing faster than the underlying economy. Global debt is now at $164 trillion, or 225% of GDP, the International Monetary Fund warns. The world is now 12% of GDP deeper in debt than it was at a peak debt cycle during the financial crisis in 2009, hitting a whopping $164 trillion, according to the International Monetary Fund. Our friend David Rosenberg from Gluskin Sheff + Associates in Toronto likes to remind us that the growth of the past five years – both in terms of stock prices and GDP – has come to us c/o the Fed, ECB and Bank of Japan. Why this fact is not obvious to more people working in the equity markets is a source of wonderment to us. Our collective inner neo-Keynesian cheers for the impact of low rates on debtors, but forgets that banks and pensions and even individuals are savers as well. It is pretty clear that the much anticipated surge in cash from tax cuts has not caused an upward surge in corporate investment. The Street has been trimming GDP estimates since January, which in turn “trickle down” into earnings models. And the economic prognostication chorus has certainly turned bearish in the last few weeks. Indeed, Rosenberg told the gathered audience at the most recent Grant’s Interest Rate Observer conference that upcoming market adjustments would lead to a resurgence of religious faith. One place we can assure you there is no lack of tearful prayers is the world of financial institution treasury, where the prospect of a flat yield curve is seen as truly dreadful. Look at the US bank unit of DB, for example, and the gross spread on the half of the lending book deployed in real estate loans is a whole 311 basis points (bp). The same measure at JPMorgan (JPM) is 361 bp. Wells Fargo (WFC) real estate loans? 391 bp. Bank of America (BAC)? 364 bp. Do you want to even hear Citigroup? A whole 263 bp gross spread on real estate loans according to the FDIC. With inflation currently at 2 percent, less funding costs, these banks are giving money away for nothing. If you look at the real estate loan book at US Bancorp (USB), suddenly we are near 5 percent gross yield. How about Bank of the Ozarks (OZRK) at 554 bp? BBT Corporation at 432 bp? Get the idea ? The smaller banks have more pricing power for originating assets, but net loan yields overall are still constrained and barely positive in inflation-adjusted terms. So here’s the big question we face: Has the FOMC effectively capped financial asset returns for the foreseeable future? That is, do all savers face years ahead where yields on securities are better than say the lows of 2012-2015, but not much higher than today? And do banks now face competition from the bond market even as pricing for loans and securities show little real upward pressure? Our best guess is that the attempt by the Fed, ECB and BOJ to stoke inflation by stealing duration from the markets via QE has had the reverse impact, namely constrained asset returns and income – that is, carry – from the global investment book. We’ve discussed the impact of curve flattening on net-interest margins previously in The IRA ("Bank Earnings and Financial Repression"). If GDP slows as the FOMC continues to literally force short-term rates higher, market sentiment toward the weaker financials such as DB could become very dicey indeed. But the more important concern is how global equity investors react to the idea that inflation may be higher than GDP in the years ahead -- the classic definition of stagflation. 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 25, 2018 | Watching the related financial dramas of China’s HNA Group and Germany’s Deutsche Bank AG (DB), we are reminded of Timothy Dickinson, who reminded us that the image of purposeful design and order imposed from above by experts and regulators is largely an illusion. The world is filled with ill-considered people and strategies, and no realm more than the intersection of public policy and corporate governance. The Federal Open Market Committee is raising short-term interest rates as though it matters, yet in fact Fed policy remains relatively easy in terms of the cost of credit -- the duration. The problem comes because of the scarcity of assets, one reason why high-yield credit spreads have been tightening even as short term funding rates have risen. And the fat part of the Fed’s passive portfolio runoff is in the mid-2020s and thereafter. The chart below shows "AAA," "BBB" and high yield bond spreads. Of course, everybody is so excited by the move of the 10 year Treasury bond to a three percent yield. The move of the short end has been even more pronounced, however, one reason why so many banks are reporting shrinkage in net margins even as shareholder payouts of capital surge. The FRED chart below shows Federal funds, Treasury 2s and 10s. Imagine Fed funds at 2% and Treasury 10s still shy of 3.5 percent yields. The alarm bells in Washington will be ringing. As we note in an upcoming conversation with Dennis Santiago, banks are constrained by the dual impact of restrictions on lending due to regulation and a dearth of duration due to the Fed, ECB, BOJ and “quantitative easing.” In an already difficult market environment, the less well managed institutions get into trouble more readily. We’ve already described the comic behavior of HNA in previous comments, but needless to say there is always more grist for the mill. Most recently, Lucy Hornby in Beijing and Hudson Lockett of the Financial Times described some of the structural aspects of the HNA investment in DB, including a suggestion of a rather complex leverage structure above the investment in the bank. “The sharp fall in the bank’s share price has forced HNA either to sell part of its stake, or pay cash to cover a derivatives arrangement that was used to acquire the shares,” they report. Although it is very common for financial investors to apply leverage high up the capital stack, bank regulators tend to frown on double leverage – especially when it is not adequately disclosed. Double digit ownership of voting shares certainly is a threshold most competent regulators set as requiring active assent for any bank investment. Ultimately, diligent bank regulators generally need to know who is investing in a bank in a significant way. And a key requirement in that approval process is the ability to be a stable investor and potentially a source of strength to the bank should more capital be required. Readers of The IRA will recall that DB searched for years and in vain for a new shareholder prior to the arrival of HNA. When the shadowy Chinese group started to accumulate DB shares in February 2017, the situation at the bank was grave – and had been for years. The board and management of DB has been unable to articulate a strategy for the business going back a decade. While much attention has been focused on the procession of CEOs that have moved through the DB CSUITE, the blame ultimately rests with the board and chairman Paul Achleitner. Like most supervisory bodies in Europe, the board of DB has proven remarkably inert in recent years, basically a reflection of the lax governance of banks more generally in the EU. For example, the FT reported on April 19, 2018, “Deutsche Bank, HNA, and the GAR chase” that their investigation into the provenance of the HNA investment in DB suggests the possibility “of an additional undisclosed shareholder behind one of the HNA entities.” This is a remarkable revelation (kudos to Cynthia O'Murchu and Robert Smith at FT), yet note that prudential regulators on both sides of the Atlantic have taken no action – at least in public – for fear or toppling over the sagging Deutsche Bank. Normally when you hide the identity of the beneficial owner of a US bank, the primary regulator begins an enforcement action and sends out cheery referrals to the US Attorney and other law enforcement agencies. The parties involved start thinking about jail time. Yet in the strange case of DB and HNA, exactly nothing is happening. The regulatory community has been caught completely off base over the past year and more, but can do nothing for fear of ragin contagion. Indeed, the festering mess at DB shows that “took big to fail” is alive and well and global regulators are powerless. The key issue for investors is to understand that precisely no one is in charge when it comes to the twin systemic risks posed by DB and HNA. If as seems likely HNA is forced to unwind its leveraged investment in DB, then the German bank will be worse off than before. DB will have wasted more than a year engaged with a surreal investor who has disappeared into the mist like a character in a bad Chinese martial arts film. Who then will step forward to rescue DB? After a $50 billion deal spree, much of it fueled with leverage, HNA has cut a wide swath of value destruction through the world of banking, aviation, lodging, real estate and other sectors. Just how did HNA get the approval of EU regulators for this investment? Nobody knows and nobody is talking. But the aftermath of this celebration of global incompetence could create significant dangers for the financial markets. When the government of New Zealand shot-down an HNA Group investment in a bank, this provided an indication of big problems. The Overseas Investment Office (OIO) blocked an attempt by China’s HNA Group to buy a vehicle finance firm in part due to doubts about the debt-saddled conglomerate’s financial stability, Reuters reports. The OIO apparently disliked the HNA practice of pledging equity investments in group companies as collateral on loans. “The information provided about ownership and control interests was not sufficient or adequate for the OIO to determine who the relevant overseas persons are for [HNA’s] application to acquire UDC,” said Lisa Barrett, the office’s deputy chief executive for policy and overseas investment. “We were therefore not satisfied that the investor test in section 18 of the Overseas Investment Act 2005 was met.” Were US regulators consulted or even aware of the HNA share purchases in DB last year? DB operates a mostly securities business in the US, but the German bank does have a $55 billion trust company in New York. Deutsche Bank Trust Corporation is regulated by the Fed and the State of New York, and is a significant player in the market for commercial mortgage backed securities (CMBS). Of note, one possible permutation of the DB saga back in Germany is the sale of the US banking business. JP Morgan weighed in on the DB debate several weeks back with the publication of a research report for clients that said Deutsche should shrink its U.S. business “to create shareholder value.” But since German Chancellor Angela Merkel threw the German bank under the bus several years ago, the remaining value of DB is questionable. Reports that former Merrill Lynch CEO John Thain is being nominated to the supervisory board of DB is certainly good news. Thain is a veteran operator, but sadly he is not CEO. More than anything else, DB needs to tell investors and regulators why this bank should continue to exist. If in fact DB moves forward with the sale of its US unit, then the entire business could be in play. But should the bank stumble in a way that surprises Europe’s distracted politicians, look for a very hastily planned merger. Our candidate for the first zombie merger of the 21st Century: DB plus Citigroup (C). Neither bank has a particularly strong domestic banking business or funding base, but there are some interesting asymmetries. Financially it would be a disaster for shareholders, but politically it makes all the sense in the world -- especially if you are Angela Merkel or Donald Trump. 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 16, 2018 | There are a number of factors that have led to the historic gains seen in equity markets since the election of Donald Trump and the subsequent tax cuts, especially when it comes to financials. Some of these assumptions were never realized, others no longer pertain. Number one was the idea that tax cuts would drive an increase in economic growth, and thus add more borrowing volumes for banks. Overall, the promise of tax cuts has yet to arrive for the banking industry when it comes to credit volumes. JPMorgan Chase (JPM) did manage to turn in some impressive lending growth, mostly in credit cards. But the overall financial performance of JPM came due to some one-time events, benefits on the legal expense line and a big pop in principal transactions. Lending fees and loan volumes overall rose a whole 2% year-over-year (YOY). The Trump tax cuts added four hundred basis points to bank equity returns this quarter, but the top line remains constrained. With EPS of $2.38, JPM’s basic earnings per share rose 40% YOY. Return on equity rose to 15% according to the JPM IR supplement. Notable for readers of The IRA Bank Book, JPM’s interest expense rose 47% in Q1 2018 vs the same period a year before. Meanwhile, interest income increased just 18% year-over-year, resulting in a substantial reduction in net interest margin (NIM). In many parts of the financial media, you still hear happy talk from economists about expanding net interest margins for banks as the Federal Open Market Committee takes the Treasury yield curve negative. But that clearly is not the case. Economists are often wrong, especially when they wander into the world of finance. Pay attention to this relationship between interest income and expense as 2018 continues and the yield curve flattens, as shown in the FRED chart below. At Citigroup (C), which like JPM is more market sensitive in terms of liabilities than the industry norm, interest expense rose 44% YOY in Q1 2018. Interest income was up a mere 12% YOY. Other than shrinking NIM, what this suggests, at least for JPM and C – some $4 trillion in assets and the two biggest OTC derivatives shops on the planet – is less return from float going forward. Interest earnings, lest we forget, account for the lion’s share of equity returns in both cases. But we digress. Aside from the lack of a demand-pull surge from the Trump tax cuts, banks have not seen the increase in corporate investment predicted by so many economists as a result of cash repatriation. In fact, most companies have paid their tax bill w/o moving the cash concerned. As we noted in January of this year ("Tax Cuts, Offshore Cash & Jobs"), this is known as “deemed repatriation” at the Internal Revenue Service. Another, third, big factor that helped drive the maniac bull rush in financials during 2017 and into February of 2018 was the prospect of deregulation. There have been a number of meaningful changes made since 2016 under administrative rules, in particular the appointment of OMB head Mick Mulvaney to run the Consumer Financial Protection Bureau. But the Trump Administration has been slow to fill regulatory positions, like Fed governors and FDIC directors. The much awaited financial reform “reform” legislation started with the Choice Act (Versions 1&2) sponsored by House Financial Services Committee Chairman Jeb Hensarling (R-TX) but was quickly narrowed down to what could garner a majority in the Senate. The original Choice Act had a broad reform of the CFPB, which is now totally gone. Senate Banking Committee Chair Mike Crapo knew that Hensarling’s Choice Act was a non-starter in the Senate. He got together with members of both parties and focused on reform for small banks, which has bipartisan support. The regulatory reform legislation that has passed the Senate is very modest indeed. The Crapo Senate bill is not a strong, broad reform proposal, but it was supported by 16 Democrats. The result is a very narrow bill which is now pending in the House but has so far not moved from the House Financial Services Committee. The IRA hears from several well-placed sources that any attempt to modify S. 2155 will doom any chances of regulatory reform this year. For example, the legislation passed by the House to streamline the Volcker Rule is the top priority of the large banks. It may be added to S. 2155 by Chairman Hensarling, but this will likely kill the legislation. So far Hensarling is not "backing down," whatever that means. Just what constituency Hensarling is serving by taking an intransigent position on S. 2155 is debatable, but the fact is that he is one of the least productive House FSC Chairs in recent memory. Hensarling could be noble and get something done as his tenure ends, but few are betting on that outcome. There are a number of Democratic Senators who signed onto S. 2155 who took a good amount of heat from Senator Elizabeth Warren (D-MA) and other far-left Democrats. And keep in mind that this is really not a Dodd-Frank reform bill as much as relief for small banks and mortgage companies. There is very little if any lift contained in the Senate legislation to help large banks. And changes to the Volcker Rule are DOA in the Senate. Bottom line: S. 2155 must get passed as is or it will die when it comes back to the Senate with amendments. The bill would get no Democratic support. We do not expect S. 2155 to get out of committee in the House. Even if Dodd-Frank reform is dead this year, that does not mean that there is no deregulation in Washington. The tenure of Mick Mulvaney as acting director of the CFPB is perhaps the most significant. Mulvaney put a stake in the heart of regulation by enforcement, a key issue for the mortgage industry. Mulvaney says he is not going to use Section 5 of the Federal Trade Commission Act (FTC Act), 15 USC 45(a)(1) (a/k/a “UDAP”), which prohibits "unfair or deceptive acts or practices in or affecting commerce." The impending $1 billion fine against Wells Fargo (WFC) by the CFPB and the OCC is an example of how Mulvaney will use the power of the CFPB when actual harm is done to consumers. But it needs to be said that the past regime of regulation via enforcement, with no due process or public guidelines for compliance, was outrageous, even by the usually irrational standards used by most progressives. Most people in the mortgage or consumer finance business, if they make a mistake and a consumer is harmed, they will make good. They don’t need to be sued. By bringing the CFPB into alignment with the FTC and other agencies when it comes to UDAP, Mulvaney has restored some modicum of fairness and balance to an agency that was run more like the Spanish Inquisition, with Richard Cordray as Torquemada. While having Mick Mulvaney at CFPB is certainly not a bad thing for banks, it is far from the wave of deregulation that was one of the original drivers of the bull market in financials. Indeed, as time slowly runs off the legislative clock, it is increasingly clear that there may be no significant financial reform legislation passed this year. This represents yet another failed promise for financials at a time when sources of support for current market valuations are dwindling. 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, 2018 | This week The Institutional Risk Analyst is travelling to San Francisco for the Mortgage Executive Roundtable, a conclave of mortgage professionals that meets twice a year to discuss issues facing the housing finance industry. We’ll be reporting to the group on the progress – or lack thereof – in adopting the technology known as “blockchain.” Some of our findings follow below. A “block-chain” is the transaction validation technology behind bitcoin and other crypto currencies. It has a very high price in terms of per unit transaction cost, but has some promising qualitative possibilities. The technology combines industrial strength encryption with a public ledger that allows market participants to validate transactions collectively. Blockchain by design is extremely inefficient in order to achieve its primary purpose, namely security, but has the advantage of a public transaction record In a survey of the mortgage industry and other domains, to date we are not able to find any commercially successful adoptions of the blockchain technology. Despite an enormous amount of hype and billions of dollars in funds invested, the combination of 1) encryption and 2) public ledgers has yet to find a viable use case – other than crypto currencies such as bitcoin. Ironically, the strong cryptography of blockchain has failed to protect the network from hacking and fraud, raising basic issues about the cost-benefit tradeoff of this type of approach. And the high cost and other operational considerations has so far thwarted efforts to drive adoption. Consider some recent developments: “Decisions by Depository Trust & Clearing Corp., BNP Paribas and SIX Group to stop working on blockchain projects reflect Wall Street's concerns about industry readiness and cost” – Rob Chrisman “Wall Street has been much more excited about the system underpinning bitcoin than the cryptocurrency itself, but the global financial industry has not yet been able to do much with the technology known as blockchain” Reuters "Basically, [blockchain has become] a solution in search of a problem" – Murray Pozmanter, MD, DTCC As initial enthusiasm for the blockchain technology ebbs, party due to the hype and chicanery surrounding the multiplying crypto currencies, some observers are starting to argue in favor of using a distributed ledger technology (DLT) without the costly encryption component of crypto currency schemes. One possible use case for the mortgage industry is the documentation of title transfers for residential mortgages, an area that is rife with fraud and inaccuracy. “Since the financial crisis of 2008, there has been a certain level of distrust with respect to residential mortgages. This distrust is rooted in the secondary mortgage market, in which thousands of residential mortgage loans were originated and then sold and assigned to successor lenders and/or trustees, sometimes multiple times,” notes Michael Reyen, writing in American Banker. But hope springs eternal. Last week, Ranieri Solutions, a financial services technology investment firm founded by Lewis S. Ranieri, father of the securitized mortgage market, announced a partnership with Symbiont, to explore opportunities to use Symbiont’s blockchain platform to improve all aspects of the mortgage industry. “The mortgage market, despite significant efforts, continues to lag behind from a technological standpoint creating inefficiencies that impact mortgage loans throughout their life cycle,” say Ranieri. “By partnering with Symbiont, a proven blockchain pioneer, Ranieri Solutions believes that together we can implement this transformative technology to bring necessary efficiencies, transparency, and security to the mortgage markets.” While improving the system for conveying and documenting ownership of residential homes is clearly a valid goal, it is far from clear that blockchain is the right technology solution for the problem. Property records are the unique province of the various states. Although there is obviously a need to improve the property sale and title recordation process, the chief obstacles to change are political and bureaucratic. Amendments to the Uniform Commercial Code and the Blue Sky laws for the securities industry provide a political roadmap for such an adoption process, but blockchain may not be the right solution for this task. Coming out of the 2008 financial crisis, the states, Congress and the mortgage industry fashioned a national standard for the foreclosure process via legislation, litigation and enforcement actions. In the case of property records, there is no immediate political catalyst to bring the states together and have them voluntarily adopt a treaty mandating a consistent recordation and disclosure system for real property transfers. And, again, it is far from evident that a DLT type approach is the best way to address the need for better property records. “The Deloitte Center for Government Insights found last March that land registration was the second most popular area of focus for public-sector experiments being conducted with blockchain, behind digital payments and currency,” reports Rob Chrisman. And Bert Ely, writing in The Hill, starts to suggest a practical roadmap to make such an enhanced property recordation system a reality: “A real-world application of DLT will occur only if it makes economic sense. An application that minimizes the potential for fraud, is highly accurate and very fast in executing transactions will not be implemented if it is more costly to operate than an alternative, less sophisticated technology. The pursuit of accuracy strongly suggests a central authority or governing body must oversee a specific application of DLT in a ‘permissioned’ environment, with pre-agreed rules and procedures to ensure the accurate entry of transaction data into the DTL ledger, the prompt correction of data-entry errors and overall data integrity.” Of course anything is possible given enough time and expenditure, but we continue to believe that the blockchain is a solution in search of a use case. The qualitative benefits of a DLT, for example, impressive as they may be, do not offset the additional cost of using this technology. In that regard, blockchain seems to violate the Three Laws of Silicon Valley – cheaper, better, faster – for the adoption of a new technology. In the case of the mortgage industry, improving the way in which property records are updated and maintained is clearly a desirable objective. But we think that before such a system is considered, the various states need to agree on a consistent national data template for property records. This all sounds great in theory. The tough part is doing the heavy lifting to make it a reality. Until then, blockchain will remain a clunky, very expensive solution looking for a relevant problem. 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.

August 13, 2026 | In this issue of The Institutional Risk Analyst, we return to the troubled world of private credit. People in the private credit trade will tell you that raising new money today is almost impossible. Why? Because there are growing signs of contagion in the insurance sector after years of dubious business practices by insurers controlled by private equity and credit firms. As details of some of these situations emerge, we suspect that the mainstream financial media will become more engaged. Earlier this week, Alicia McElhaney at the Wall Street Journal wrote an important piece about the bankruptcy of 777 Partners, a default that has repercussions across many asset classes, including insurance. She writes: “The Miami-based firm filed for bankruptcy Sunday in the U.S. Bankruptcy Court in Dallas, seeking an orderly liquidation of its remaining assets. The voluntary filing follows an effort by creditors in mid-July to force 777 into an involuntary chapter 7 liquidation. The firm has been selling off assets and winding down operations under independent management since 2024, following lender lawsuits and federal probes.” But the visible financial problems of 777 Partners are just the tip of the proverbial iceberg. After collapsing several years ago, efforts to restructure the fund were not successful and criminal charges were even brought against at least one former principal of the firm. Concerns about 777 Partners go back to late 2023, when the Bermuda Monetary Authority (BMA) officially canceled the insurance registration of 777 Re Ltd, Reinsurance Business reported last year. The financial problems of 777 Partners caused the Utah Department of Insurance to suspend new business activity by Advantage Capital or “A-Cap” as it is known in the industry. Earlier this year, Oaktree Capital Management, a unit of Brookfield Asset Management (BAM), acquired a controlling stake in one A-Cap unit, Atlantic Coast Life Insurance Co., while also providing capital to Sentinel Security Life Insurance Co. Oaktree is the grim reaper of Wall Street and delights in making money from other people's misery. “777 Partners had attracted attention for deploying capital into a range of high-risk assets, including football clubs. The firm’s co-founder Josh Wander pursued a failed takeover of Everton FC after earlier investments in teams such as Genoa CFC and CR Vasco da Gama,” HedgeWeek reported in March. “Federal prosecutors in New York charged Wander in October with allegedly defrauding lenders and investors of about $500m.” Wander denied wrongdoing. The scale of the financial collapse of 777 Partners is truly epic, yet very little notice to this massive default has been paid outside of the specialty media. Yet the Miami-based private equity and alternative investment firm has actually received intense, sustained coverage across global financial, investigative, and sports media outlets—particularly regarding its multi-club soccer network, the failed takeover of Everton FC, and subsequent collapse. “777 Partners and 600 Partners, the two parent holding companies, held businesses and investments across structured finance and private credit, insurance and reinsurance, financial technology, litigation finance, aviation, professional sports, media and entertainment, and sustainability,” reports bankruptcy specialist Bondoro.com. “Those businesses were conducted through numerous operating subsidiaries, special-purpose entities, and portfolio holding companies.” The scale of the 777 Partners default is quite vast, as described in the First Day Declaration by Mark Shapiro regarding one bankrupt affiliate known as Signal National LLC: “777 Partners was formed as a Delaware limited liability company in 2015 by Wander and Pasko. Its original business was underwriting and financing the purchase of structured-settlement portfolios and other non-traditional receivables, including medical-lien receivables, structured-settlement payment streams, and annuity-backed receivables. Beginning around 2018, and accelerating from 2021, 777 Partners expanded well beyond that base into consumer and commercial finance, insurance distribution, aviation and airlines, media and entertainment, and ownership interests in professional sports clubs and leagues across the United States, Europe, South America, Australia, and the Caribbean. Pasko formed 600 Partners as a Delaware limited liability company in 2017 as an affiliated investment holding company. Its portfolio overlapped with a number of 777 Partners’ business lines, including structured settlements, aviation, media and entertainment, and professional sports.” We believe that the unwind of 777 Partners and the literally hundreds of affiliates involved in this fiasco provides a picture of how the private credit trade is going to end. Millions of retirees who depend on life insurance and annuities could be affected by unsound management practices by private credit and equity managers who care only about profits. The First Day motion for Signal National LLC from the US Bankruptcy Court for the Northern District of Texas (Case 26-90190-elm11) is below for your reading pleasure. 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.

August 07, 2026 | Updated | This week in The Institutional Risk Analyst, we start with the latest edition of Mortgage Notes, one of our regular features. Don't forget to watch “The Wrap with Chris Whalen” on The Julia LaRoche Show every Saturday on YouTube to catch our discussion of what’s hot and what’s not in Washington and on Wall Street. Julia LaRoche Interest Rates As we noted in our last missive, it is pretty clear that the Federal Reserve is not going to be raising short-term interest rates in September or anytime soon. Did people really believe that Kevin Warsh was going to betray President Trump in his first year as Fed Chairman? Shall we talk about Fed independence with $40 trillion in debt? The following passage from CNBC’S “Squawk Box” earlier this week illustrates the point: "JOE KERNEN: You know what wouldn’t help the yen is if Warsh and Co raised rates in September.” "SCOTT BESSENT: Well, I think we have to look and think, what does an increase in the short-term rate actually do?" "KERNEN: Because one thing we definitely don’t want is Japan selling treasuries to do this. So, you have encouraged the Federal Reserve to upsize. Can we call it a FIMARF? Is there an acronym for this? The Foreign and International Monetary Authorities Repo Facility. Have you ever called it a FIMARF? I, can I coin that? Can I trademark that? BESSENT: Sorry, Joe, a day late and a yen short. It’s called the FIMA facility and the -- we’ll give you something. We’ll come up with something for you next time. And look, the -- what the facilities that the Federal Reserve has, whether it’s the FIMA facility or the swap lines, the purpose is to protect the U.S. economy and to keep any volatility offshore, prevent it from happening before it reaches our U.S. shores. And the FIMA facility was done in 2020, size of the bond market was much smaller then. So, I think it would be reasonable for the Fed to consider upsizing the facility. I’m happy that the Japanese government wants to use it and draw on it, and it’s a completely secure lending facility. One of the odd things about the Federal Reserve’s repo transaction with the Bank of Japan is that the latter could have called a Japanese bank or Nomura and financed US Treasury debt. Why bother with a repo with the Fed? And for the record, the WSJ is wrong to suggest that the BOJ repo impacts the US economy. QE with a dealer grows bank deposits 1:1, but central bank repo trades not at all. Meanwhile, we got some well informed pushback on our suggestion this week that the Treasury and/or the Fed may be encouraging the primary dealers to lean into a short-volatility trade. After all, if you give forward guidance to the dealers, they’ll go along, right? But we suspect that the Fed's repo transaction with the Bank of Japan may be just the beginning of financial problems for the Trump Administration. Our fellow scribe Adam Josephson notes that foreign central bank holdings of US Treasury debt are falling fast, meaning that long-term rates are headed higher even if the Bessent Treasury engineers a squeeze on the short end. Source: Federal Reserve Housing Finance Blues “Back in the first quarter of 2026, most mortgage lenders were anticipating lower interest rates and rising volumes,” we wrote in our latest column in National Mortgage News. Sadly, even just a couple weeks ago, we did know just how right that message turns out to be among mortgage lenders in Q2 2026. “The reversal in the bond market now confronts mortgage firms with some difficult choices. Many firms that had maintained excess capacity and headcount in anticipation of another down interest rate cycle are now forced to cut expenses in order to survive. The release of second quarter earnings for mortgage firms over the next several weeks will be a must-read for global investors. Look for some truly shocking results.” As it has turned out this week's crucial results for the mortgage industry are shocking and very institution specific, with some industry leaders faltering while others are consolidating positions of strength or monetizing assets to generate liquidity and reduce leverage. Of the four issuers discussed below, two are in strong positions and two are in varying degrees of operating crisis and even financial distress. PennyMac Financial Services PennyMac Financial Services (PFSI) reported weaker-than-expected Q2 2026 results on July 29, 2026, missing both top and bottom-line Wall Street consensus estimates. The miss was said to be due to rising interest rates and lower refinance demand. GAAP net income was just $22 million ($0.41 per diluted share), while adjusted net income reached $74 million ($1.39 per adjusted diluted share) on net revenues of $497 million. PennyMac Financial | Q2 2026 Little Orphan Annie would say "Yikes!" You see, PennyMac reports first among mortgage firms in the mortgage sector. So when they drop the ball again, for the second time in six months, the whole sector gets pasted in the equity and especially the debt markets. The institutional investors who want to own PFSI just look at earnings and volumes, that’s it. They don’t have the time or the desire to evolve an intimate understanding of mortgage finance. They just look at the earnings number and $22 million in Q2 2026 income does not cut it. If you go through the numbers in the income statement, just about every line item is moving the wrong direction, expenses up, volumes down, hedge costs up, gain-on-sale down large. Keep in mind that PFSI is the leading correspondent lender in the US and #2 behind United Wholesale Mortgage Corp (UWMC), yet somehow they lost two points of market share since 2025? Their share of broker direct is up, but we are not sure that’s a good thing. Total expense were up 5% sequentially, but now we have a strategic cost cutting strategy underway. PFSI fell 10% following the earnings announcement. After a long and successful run at PennyMac, is it time for a leadership change? loanDepot Not only did loanDepot (LDI) grow volumes in Q2, but they have reportedly been selling MSRs at a premium and repurchasing corporate debt at a 20 point discount. Smart. Founder & CEO Anthony Hsieh apparently wants to survive the coming nuclear winter of 7% plus mortgage rates. Some details: Originations: $8.0 billion in funded volume, unit volume increased 25% from first quarter 2026. Total Revenue: increased 18% to $337.3 million on $6.6 billion of pull-through weighted lock volume; Adjusted revenue(1) of $307.6 million Total Expenses: increased from $341.5 million in the first quarter of 2026 to $343.9 million primarily reflecting higher commission and direct origination expenses in line with higher origination volume. Despite the MSR sales to retire debt, LDI actually increased the value of its servicing assets to $123 billion in UPB in Q2 2026 or ~ 142bp of fair value. The leverage on the MSR is up to 5.3x total equity but still very manageable. LDI’s stock has been cut in half over the past year. This volatile low-priced stock trades over a 3x beta and is often a bellwether for the mortgage group, both up and down. Careful. United Wholesale Mortgage Corp When we read the earnings disclosure from UWMC, at first we were speechless, a rare occurance. For the past few weeks, the mortgage market has been rife with rumours about some dreadful financial event at UWMC in the wake of the loss of the auction for the mREIT Two Harbors (TWO). We can just hear our Russian grandma in her kitchen in Queens: "Jesus, Mary and Joseph." The release of the Q2 earnings, however, goes far beyond the whispers and revealed a truly horrific management lapse that cost the company $600 million in losses and its independence. Yet as one industry maven told The IRA, the change in value of the TWO MSR in Q2 was less than $10 million. From where does the rest of the loss arise? Operations. The UWMC presentation begins with an absurd statement: “Abandonment of Two Harbors transaction provides optionality to deploy capital into alternative initiatives as they arise,” something that is manifestly untrue. Mat has handed the company to the Oaktree unit of Brookfield Asset Management (BAM), a private credit firm. Is he is trying to hide the true reason for the fiasco, namely another half billion operating loss? The story about hedging the MSR is simply a canard in our view. Then the IR firm of UWMC goes on to reveal that “UWM recognized a $603M Q2’26 derivative loss tied to exposure it expected to assume [emphasis added] in connection with the TWO transaction…” There is indeed a $500 million swing in "capitalization of mortgage servicing rights" the the cash flow table of the most recent 10-K. But was Mat hedging or merely trying to inflate his assets to impress lenders? Keep in mind that UWMC netted $800 million in proceeds from the sale of MSRs in the quarter. United Wholesale Mortgage Corp | 2Q 2026 What that sentence in the cash flow table means is that UWMC decided to speculate on the hedge for the TWO MSR before they actually owned the asset. UWMC will tell you that they were proactively hedging the servicing, but you don’t hedge something you don’t own. Indeed, even before the second quarter began, it was obvious to the observant that CEO Mat Ishbia had lost Two Harbors. This latest fiasco at UWMC forced the company to seek a lifeline from Oaktree Capital Management, a firm well known to mortgage companies in need of new capital support. UWMC announced a $2.05 billion strategic capital partnership with Oaktree and the Ishbia Family. Oaktree received 165 million warrants in return for $1.6 billion in new funds. And UWMC still really does not have sufficient cash to support its current level of volume. Recall that Oaktree Capital Management initially invested up to $250 million in equity capital for a joint venture with then-Ocwen Financial (now Onity Group) on May 3, 2021. CEO Glenn Messina has valiantly rebuild the stock, but ONIT remains a subservicer with little owned MSR and a perfect partner of a predatory credit shop like Oaktree. In exchange for the capital infusion, UWM issued $1.65 billion in preferred equity and arranged a $400 million rights offering, alongside issuing long-term business warrants and granting Oaktree seats on the UWM Board of Directors. UWM suspended its quarterly dividend “to prioritize liquidity and pay down the preferred equity.” But the reality is that Oaktree now effectively controls UWMC and the company arguably should be sold. Compared to Ishbia's astute investment in the Phoenix Suns, the mortgage company is an embarrassment. Rocket Companies Rocket Companies (RKT) reported very strong earnings in Q2 2026, doubling revenue from YTD 2025 and generating half a billion in net income. Compared to some of the other issuers in the mortgage sector, the comparison is stark. The combination of Rocket Mortgage, RedFin realty and Mr. Cooper loan servicing has proven to be a significant island of stability and growth. “Rocket reached record levels of purchase and refinance market share in one of the toughest spring housing markets in years, while delivering our most profitable quarter in four years,” said Varun Krishna, CEO and Director of Rocket Companies. “We've spent the last several years building a fundamentally different company. Home search, origination and servicing now reinforce one another, with AI making every interaction smarter. Markets change. Systems endure.” RKT’s total servicing portfolio unpaid principal balance was $2.0 trillion or 9.1 million loans serviced as of June 30, 2026, reinforcing the potential to drive significant recapture opportunity from the industry's largest portfolio. During Q2'26, mortgage servicing rights sales totaled $53 billion of UPB, generating $795 million of cash proceeds. Significantly, RKT retained subservicing and recapture services on nearly 80% of the MSRs sold during Q2 2026. Overall, we are delighted to see the progress at loanDepot and unsurprised by the results for our friends are Rocket. Systems endure, but Mr. Cooper lives, and the proof is the continued acreation of book value for RKT. The results at PennyMac are disappointing, but the disaster at United Wholesale Mortgage Corp is almost beyond belief. We think the board of UWMC has a duty to ask for the resignation of the current CEO Mat Ishbia, should ask Howard Marks, Chairman of Oaktree, to chair the board, and should commence a search for a replacement CEO or pursue a sale. The magnificent loan funnel created years ago by some refugees from Flagstar Bank for Mat Ishbia has enormous value, but the current management instead seems intent upon destroying value at every turn. Recent Posts David Kotok: Gold & US Credit Default Swaps in Euro https://www.theinstitutionalriskanalyst.com/post/theira875 Rethink capacity: 7% rates end near-term volume hopes https://www.nationalmortgagenews.com/opinion/rethink-capacity-7-rates-end-near-term-volume-hopes 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 4, 2018 | Why are financials selling off as earnings season starts next week? Large cap banks such as JPMorgan (NYSE:JPM) led the markets higher earlier in the year, but have since underperformed the markets. What gives? First and foremost, when the markets are looking for a reason to sell, large cap financial names usually catch more that their share of attention. Remember that Wall Street only ever cares about the top 10-names in financials by market cap. When the thundering herd sells, banks usually get a disproportionate share of the short volume. The sector accounts for about 15% of the S&P 500. When a broad selloff is underway, look for financials to participate and then some, both in terms of cash and the highly liquid derivatives. Second, financials are overvalued – still. When JPM peaked at just shy of $120 per share on February 26th of this year, the market leader was trading just shy of 2x book value. The stock is still up 15% over the past six months vs single digits for the S&P 500. JPM has single digit equity returns and no real growth in terms of revenue. Hit the bid. Third and most important is the question of net interest margins and financial repression. In the inaugural edition of The IRA Bank Book, we discuss why the banking industry is facing a squeeze on margins thanks to the Federal Open Market Committee. Few analysts on the Street know or care about this looming threat to bank profits. At present, the US banking industry is earning about $130 billion per quarter in net interest income from loans and investments, but is paying depositors and bond holders a mere $20 billion per quarter for funding. This skew in favor of bank equity holders has been extreme since 2008, but the issue of financial repression goes back to the 1990s. Ponder the chart below. Source: FDIC In Q4 2007, when US banks grossed $180 billion from loans and other earning assets, they paid depositors and bond investors almost $100 billion. In 2015, the total cost of funds for the US banking industry was just $11 billion per quarter, but the industry booked $110 billion in net interest income. Get the joke?? Bank depositors and bond holders should be earning more like $40-50 billion per quarter. Today yields on deposits and fixed income securities are rising faster than the yields on bank loans. Just as the FOMC suppressed the cost of credit for banks after 2008, now the financial engineering of former Fed Chair Janet Yellen has created an interest rate trap for banks a la the 1980s. For those of you who missed that party, in the 1980s funding costs for S&Ls rose faster than asset earnings, gutting the capital of the entire housing finance sector. The unfortunate demise of the S&Ls also created the opportunity for banks to get into mortgage lending a decade later with similarly disastrous results. We look for the cost of bank funding to rise faster than the yield on earning assets over the next two years, a situation that is likely to put an effective cap on bank earnings and public market valuations. The kicker in the analysis is that credit costs are also likely to rise faster than either revenue or pre-tax earnings, adding an additional headwind to financials as 2018 unfolds. See you on CNBC Squawk Box tomorrow ~ 8:00 ET. 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.

In this issue of The Institutional Risk Analyst, we feature a comment from our fellow fisherman David Kotok, Chairman & Chief Investment Officer of Cumberland Advisors (www.cumber.com), which was published earlier this week. A number of people have asked about the widening spread between LIBOR and the comparable rate in the US. The short answer is that, yes, it is a structural problem and may be a warning of future contagion ahead. Questions? Join us Thursday at the University of South Florida in Sarasota when we'll be talking about the state of the US banking industry and signing copies of "Ford Men: From Inspiration to Enterprise." April 2, 2018 | Today we look at the warning that the widening spread between the LIBOR rate and the OIS rate may be sounding about what lies ahead, given a two-pronged Fed tightening policy. Whether investors realize it or not, this spread (LOIS) impacts what strategies make for successful investing. This five-minute read will bring readers up to speed. We will start with Daniel Kurt's Investopedia post, "What is the OIS LIBOR Spread and What Is It For?," from Feb. 21 of this year (https://www.investopedia.com/articles/active-trading/061114/what-ois-libor-spread-and-what-it.asp): "A decade ago, most traders didn't pay much attention to the difference between two important interest rates, the London Interbank Offered Rate (LIBOR) and the Overnight Indexed Swap (OIS) rate. That's because, until 2008, the gap, or 'spread,' between the two was minimal. But when LIBOR briefly skyrocketed in relation to OIS during the financial crisis beginning in 2007, the financial sector took note. Today, the LIBOR-OIS spread is considered a key measure of credit risk within the banking sector. (For a glimpse into the possible evolution of these two rates, read 'Will OIS Replace LIBOR?')" The LIBOR-OIS spread (or LOIS) has widened by twice the amount that the Federal Reserve has hiked rates. There are reasons for that, and we will discuss them below. But the impact of the LOIS's widening is at hand today. Think of it this way. The Fed sets the OIS as it determines the short-term policy rate. If the Fed wants to tighten policy by raising the short-term rate a quarter point, it has the complete power to do so. But the Fed cannot control those market forces that react to the Fed and to other factors. So if the Fed hikes a quarter point but market forces actually translate that hike into a half point, is the impact of the Fed's quarter point magnified and, in this case, doubled? We think the answer is yes. There are structural reasons why this magnification is occurring, and they are still in play. Hence the Fed is actually tighter than it would appear to be if we look only at the fed funds target rate and, by implication, at OIS. Three-month LOIS increased over a half point in the first quarter of 2018, while the Fed's policy target rate went up only a quarter point. And US Treasury debt management added to this mix. US Treasury bill yields are at their widest levels to OIS in fifteen years. They have widened in spread by a quarter point since the beginning of the year. At the end of the first quarter, three-month LIBOR was 2.30%. A year ago it was 1.15%. Thus the private sector has seen a 1.15% increase in this key interest rate. Note that about $200 trillion in global debt and derivatives prices daily from LIBOR. FRA (forward rates) used in foreign exchange derivatives are up 1% in the same period. So are US T-bill rates. And the new money market rules exacerbate these spreads. Meanwhile, the TED spread (eurodollar vs. T-bill) is wider than it was a year ago. I could go on, but the key point here is that the system is tighter by more than the Fed has tightened. There are at least six reasons: 1. Banks are reluctant to shift their liquidity pools out of the Fed (source: Joe Abate at Barclays). 2. Congress insists on perpetrating political shenanigans with the federal debt ceiling (BCA Research opinion). 3. Repatriation flows are adjusting cash balances worldwide, and the direct impact falls on the short-term money market end of the yield curve. 4. The Fed is shrinking its balance sheet at the same time it is raising the policy-setting, short-term target rate. (We think this approach is a potential double whammy for the markets. The Fed is playing with fire by trying to do two things at once.) 5. The new "base erosion and anti-abuse tax" (BEAT) was part of the 2017 tax code changes. It is causing dislocation in funding markets and driving some firms to use commercial paper (CP) as a way around the tax problem. But the CP traditional buyer was a money market fund that is now in the non-government group and can "break the buck." Using cross-currency swaps is an alternative, but banks "that used to be sources of structural demand for dollar funding (widening the basis swap) will require less dollar funding in the future. As a result, basis swap spreads tighten" (Deutsche Bank AG/London). 6. LIBOR is being phased out by 2021. The Alternative Reference Rate Committee (ARRC) wants to replace LIBOR with a new Secured Overnight Futures Rate (trading), or SOFR. Some banks are now leaving the LIBOR-setting pool in anticipation. There will be new SOFR futures contracts launched and trading. For the average investor this is a bewildering array of technical factors. We plod through all these factors ourselves in our daily work as we do the analysis on so many moving parts. Most investors have never heard of ARRC or SOFR, yet both impact their daily lives. Our issue concerns the businessmen and women who borrow using LIBOR as a reference rate. Their costs of funds are going up fast. And they are uncertain about future commitments since they know LIBOR is going away and they don't know what the market will do to replace it. And they are the ultimate target of Fed policy, for better or worse. For us there is a different question. We are puzzled by the Fed's silence on these impacts. The dot plots don't capture it. This issue is not about a GDP forecast. We are not talking about higher inflation expectations. No, this is about structural change and its impacts are broad. We worry that the Fed is setting things up for a slowing of the economy by being too doctrinaire and neglecting to acknowledge these structural changes. We worry that QT (quantitative tightening) is a dangerous force to combine with traditional interest rate normalization. We worry that the Fed has undertaken too much and is sailing the monetary policy boat into waters where the charts are incomplete. We think this policy error could be one of the reasons that the yield curve is flattening. At Cumberland our emphasis is on the higher-grade credits, whether muni or corporate or government. We are watching the distribution of credit and note Jim Bianco's observation that about half of the investment-grade debt is now Baa-rated. Jim points out that this percentage has nearly doubled from 25% in 1989. For Cumberland, that means about half the debt aggregate is off the table for our clients. We want to be sure our clients get paid. Bottom line: LOIS is screaming a message of warning. We know that members of the Fed are looking at this, but we wish there were more observations about it in their public statements. We don't expect the Fed to change its strategy. It is on a dual course of QT and rate hiking and will probably stay that course unless and until some shock occurs. So our professional stance is to worry. And we continue to search out and focus on high-grade credits. We think investors are poorly paid for chasing lower-grade or junk. 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.

First we’ve launched the first volume of The IRA Bank Book, a review of the operating and credit performance of the US banking industry written for institutional investors. US banks have the best financial disclosure in the world, down to the portfolio level, a fact that allows analysts to dig deep if they care to spend the time. They don't. We’ve done the digging for you and present a macro level view of key industry trends. And best of all, you get to pay us for our work. Watching the continuing trials of HNA Group, we are reminded that the side effect of years of central bank largess will be an arithmetic reckoning when it comes to credit. The massive liabilities accumulated by the likes of HNA, Anbang Insurance and even Softbank will eventually come back to haunt these ambitious Asian debtors. And behind them stands the world’s most indebted state, namely China, governed by the paramount leader Xi Jinping. “And so castles made of sand, fall in the sea, eventually.” So wrote Jimi Hendrix in 1967, but he was talking about love not global investing, right? Our friends at Grant’s Interest Rate Observer recently cataloged China’s debt overhang in a comment appropriately titled for the Easter season: “Xi Jinping’s poisoned chalice.” They noted with typical understatement: “The whole world lives at the end of the whip of China’s credit growth.” Ditto. Especially when that growth is driven by an authoritarian state and makes no sense in economic terms. And yes the size of China’s financial pyramid is extraordinary, as befits a system where political concerns trump all other questions. The Chinese communists have taken the progressive model of money creation from the US and doubled down several times over! Everyone expressed surprise when the Trump Administration announced the imposition of tariffs on China. But readers of The Institutional Risk Analyst know that last November Leland Miller of China Beige Book pretty much called the start of the trade war down to the day. We asked author and intelligence analyst Jim Rickards what he thought of the timing and substance of the trade actions by Washington. "Many observers are shocked by the new trade wars. They shouldn’t be,” Rickards notes. “Trump has been talking about unfair trade and lost jobs for decades; long before he launched his political career. Unfair trade was a pillar of his speech announcing his presidential candidacy in June 2015 along with immigration and 'The Wall.' “Trump continued hitting the unfair trade issue hard throughout the campaign in 2016, and during the transition after he won the presidential election on November 8, 2016. He intended to make trade his first order of business upon being sworn in as president on January 20, 2017. But then the trade agenda was put on hold. Trump refrained from imposing tariffs in 2017, his first year in office, based on the advice of his national security team including National Security Advisor General H. R. McMaster, Secretary of State Rex Tillerson, and Secretary of Defense James Mattis.” “The national security team urged President Trump not to start a trade war because the U.S. needed Chinese help to avoid a war in North Korea. However, China did not do all it could to apply pressure on North Korea. Once China’s lack of cooperation on North Korea became clear by late 2017, Trump saw no harm in confronting China on trade. Now the gloves are off.” But even with the astounding numbers on China’s bad debt pile assembled by Grant’s and the sage political judgment of Jim Rickards, we remain unsatisfied in our search for an explanation of the behavior of Chinese dictator Xi Jinping. Sure, the country’s debt (aka the entire banking system) is enormous, the biggest of any industrial nation on earth. And yes, the political stars seem aligned for a trade war with the Trump Administration. But that still does no explain the level of disarray and haste seemingly driving the consolidation of political power in China. Uncle Xi is a man in a hurry. His moves to eliminate rivals in the Chinese Communist Party have come swiftly, as have belated moves to seize insurer Anbang and extend credit to the apparently insolvent HNA. But more to the point, the CCP’s tolerance for and even encouragement of the debt fueled spending spree of the past decade is unseemly. It evidences a degree of sloppiness and financial naiveté on the part of the CCP party leadership that raises questions about their chances of survival. Viewed in this light, Xi’s moves to consolidate power may be seen as defensive and reactionary. The thing western analysts have trouble accepting is that the Chinese economy is actually far weaker that the state-approved statistics suggest. Unemployment and massive bad debts are just part of an increasingly unstable situation in some Chinese provinces. China’s "One Belt, One Road" plan, for example, is a bad copy of the New Deal that is doomed to fail in terms of generating real, sustainable growth. But it will certainly add to China's debt. A trade war with the US will only exacerbate an already bad situation, where the CCP tries to manufacture internal economic demand via subsidies for dead companies and infrastructure projects that produce little or no return. The failure of Xi and the CCP to build a stable, sustainable economic system is the root of the political fear evidenced by Xi and his cronies. James Palmer wrote in Foreign Affairs in February ’18: “[T]he most recent change signals something far deeper than the party’s primacy over the law; it spotlights the essential instability of the entire political system… During Lunar New Year this month, traditional fireworks were banned from Beijing — even down to the firecrackers thrown joyfully by small children. By itself, that could be passed off as a legitimate health and safety measure. But such was the worry about public gatherings that there were not even any organized displays of fireworks. For the first time in decades, the sky over China’s capital as spring arrived was dead, black, and silent.” Thus the trade war moves by the Trump Administration, to position for the 2018 and 2020 elections by focusing outward in the daily search for new antagonists, comes at a bad time for China and the financial markets. With Mike Pompeo at the State Department, John Bolton as National Security chief and Peter Navarro as trade czar, you have an almost Reagan era formulation that may try to use trade disputes to provoke a political crisis in China. Yes, the Trump White house may even think regime change in Beijing is possible given sufficient pressure. Ponder the effect of a 21st Century version of the Taiping Rebellion with nuclear weapons in the mix. China's version of the US Civil War lasted for some 14 years (1850–64), decimated 17 provinces, took an estimated 20 million lives. And this type of unrest is precisely what Xi and China's communist rulers fear. Financial markets need to anticipate that the tariffs announced by the White House are only the first steps in a much broader retaliation against China for decades of theft and deceptive trade practices. Again, Rickards: “What the market is missing is that all of the tariffs on steel, aluminum, solar panels and the rest are small beer compared to the mother of all trade sanctions coming soon in the form of a “Section 301” report that will land on the President’s desk any day. Section 301 of the Trade Act of 1974 is the “nuclear option” when it comes to trade wars. It does not involve tariffs and subsidies by trading partners. It involves the theft of intellectual property. The damages from Chinese theft of U.S. intellectual property will add up to trillions of dollars.” He continues: “The remedies available to President Trump are much broader than those permitted by other provisions of the trade act. Trump does not have to retaliate against a specific good or industry. He can impose penalties on any part of the Chinese economy that arguably benefited from the theft of intellectual property. When it comes to electronics, computer code, and the 'internet of things,' that can be almost anything. When the Section 301 report reaches Trump’s desk he has 90 days to make decisions on penalties on Chinese goods. But, those decisions have already been made. Trump is just waiting for the report. When he gets it, he won’t wait 90 days to respond. He’ll respond almost immediately. So, these opening salvos are just the beginning. There's a lot more trade war damage to come." As the markets react to the moves by Xi Jinping and Donald Trump, it is important to remember that there is a wonderful co-dependence between the governments in Beijing and Washington. Both leaders need a new enemy to distract their restive populations from other issues. In the case of President Donald Trump, he needs enemies to distract attention from the increasingly erratic and scandal prone nature of his government. We note, in this regard, that our colleagues at Kroll Bond Rating Agency just assigned a "AAA" rating to the United States even as we stare at $1 trillion plus annual fiscal deficits. Really? For Uncle Xi, he seeks to focus attention away from the growing tyranny and insecurity evidenced by China’s return to 1950s style authoritarianism. With growing concerns about the political stability of China, including unflattering comparisons of Xi with Romanian dictator Nicolae Ceaușescu (1918-1989), it will be increasingly difficult for corporate cheerleaders in the West to sell the China growth story. In the case of both Uncle Xi and President Trump, we should remember the words of George Orwell in his 1944 classic, “Animal Farm: A fairy story.” “Twelve voices were shouting in anger, and they were all alike. No question now, what had happened to the faces of the pigs. The creatures outside looked from pig to man, and from man to pig, and from pig to man again; but already it was impossible to say which was which.” Happy Easter. 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.

March 20, 2018 | Next week we launch the first paid product for The Institutional Risk Analyst, "The IRA Bank Book," which will feature our concise thoughts on the US banking industry and credit markets, along with some pretty charts to illuminate the discussion. More on this soon. This week the markets await the first press conference of Federal Reserve Board Chairman Jerome Powell, a tribal ritual that brings together the media, investors and policy makers in a shared experience of confusion, accidental misstatement and deliberate obfuscation. The question we all ask is whether the Federal Open Market Committee will raise targets for short-term interest rates a quarter of a percentage point? Or More? How soon? But the question that we ought to ask is this: How long will it take for the narcotic effect of central bank market intervention to wear off? And what happens to market volatility as the end of official suppression of rates and credit spreads slowly plays out. Will there be lumps in the proverbial gravy train on Wall Street? Yeah… "We make linear forecasts but in reality, interest rates, corporate profits and exchange rates—all crucial measures of return in their markets—are actually nonlinear series,” writes our friend John Silvia, Chief Economist of Wells Fargo & Co (NYSE:WFC). “This is an important challenge to how we think.” Indeed, the biggest challenge facing market analysts is to ignore the linear data that overwhelms our senses and focus on the random nature of markets. Consider the idea of record bank profitability, a theme repeated over and over again by the financial media. But is this true? One of the things we focus on in the inaugural issue of "The IRA Bank Book" is whether the US banking industry is really profitable given the huge disparity between the rising interest earnings of banks and the still tiny, heavily subsidized cost of funds for the industry. One of the costs for consumers of central bank intervention has been the transfer of trillions of dollars in income from savers to debtors such as banks over the past decade. In Q4 2017, the total interest expense of all US banks was just $21 billion, but banks made $150 billion on total earning assets at the end of 2017. A decade ago, the interest expense of a smaller US banking industry was $100 billion vs $180 billion in income. Today adjusted for the 33% growth in total bank assets, US banks should be paying well more than $100 billion on various sources of funding, from deposits to short-term borrowing from other banks to bond investors. With the net interest income of banks at $107 billion last quarter, how much of bank earnings disappears in a rising rate environment? (Q: Do you think investors or journalists can get their minds around the idea of shrinking NIM in a rising interest rate world?) If we simply return to the net interest income spreads of a decade ago, that implies a shrinkage of $25 billion in net interest income for US banks as rates rise. Much depends on how fast deposit rates rise. Just saying. Source: FDIC Meanwhile, away from the relatively blissful world of banks, bonds and borrowed money, the world of global equities and perceived volatility is starting to evidence increased stress. After years of a 100% correlation between stocks and bonds, rate movements are beginning to impact the direction and magnitude of stock price moves. How this process of “normalization” proceeds and at what pace are the imponderable questions. But to John Silvia’s earlier observation, neither equity markets nor bonds follow a linear pattern. Instead, global markets tend to follow a change pattern closer to entropy, where the inefficiency of market understanding and reaction in terms of asset allocation tends to make investors lag events as a matter of course. Even with massive amounts of data, the gap to understanding and then action is considerable and largely random. And this random quality is present both for policy makers and investors, raising interesting questions as to systemic risk events. “The main problem with entropy uncertainty models is that they are used to justify the notion that there’s room to push agendas to the limit line of the outer edge of the envelope that supports the policy maker’s cognitive bias,” opines Dennis Santiago, Senior Managing Director for Compliance and Analytics at Total Bank Solutions. “It’s a rubber band. It’ll snap.” Even with the sharp rise in equity market volatility in early February, many market participants are still groggy after years on maintenance medication c/o the FOMC. An important indicator of changing market perception is corporate credit spreads, which are starting to widen as uncertainty regarding interest rates and the economy grow, as shown in the chart below. The smarter money is already rolling out of equities into the safety of short duration credit, but the broad market still underestimates the possible rate of acceleration in volatility. “Active equities investors were slower to react to last week’s ‘signal’ in momentum ‘reversals’ and defensive / ‘duration-sensitive’ leadership—as such, much more ‘deer in headlights’ yesterday than rest with Long-Short Beta to Nasdaq at the 86th percentile,” writes Charlie McElliott at Nomura. Note to readers: You don’t want to be the deer in the headlights. There are some analysts who believe that Chairman Powell and his colleagues on the FOMC may try to get ahead of the curve and increase rates by more than 25 basis points when the Fed next moves. Powell is in the difficult position of having to remedy the slow pace of FOMC decision making under his predecessor. Although a rise of 50bp is certainly justified by the available employment and inflation indicators, not to mention toppy stock and real estate prices, accelerating the normalization process via Fed action may have a very unpleasant impact on investor perceptions, volatility and most important, credit spreads. Our biggest worry heading into the end of Q1 2018 is that the artificial stability engineered by the Fed is going to snap again, but on a larger scale and more lasting basis than we saw in February. In the event, credit spreads will widen, loss rates on loans and credit products will accelerate, and the US economy may slowly slip into a stall. Fed Chairmen tend to start their terms with a financial crisis and the migration back to normal may be very rough indeed. 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. 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