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New York | At the end of last week, we featured an update from Michael Whalen about the latest developments in the world of new/old media, specifically television and streaming content. After a week of bank earnings, it seemed like a everybody might need a laugh, at least in relative terms. Like many other industries, in media fragmentation is the order of the day. As we predicted in the Q2 2020 IRA Bank Book , loss provisions for all US banks will be higher this quarter than last. The total level of loan-loss reserves for all US banks is now just shy of $200 billion, still well-short of the peak of $250 billion in 2009-2010. Our guess is that loan loss reserves could reach half a trillion dollars before we are close to the peak for COVID-19, but some in the banking industry are more constructive. Source: FDIC This week in The Institutional Risk Analyst , we are doing a little teach-in on bank loss accounting and earnings. As many of our readers know, when a bank puts aside provisions for future loss, this income is shifted to an off-balance sheet account where reserves, loan losses in the form of charge offs, and credits recognized in terms of recoveries, are reconciled. Let’s use Goldman Sachs (NYSE:GS) as an example. Loan loss reserves were $2.86 billion at the end of March, but jumped to $4.39 billion in Q2 2020, this after the addition of $1.59 billion in provisions in the second quarter. Goldman’s loss rate was 55bp vs an average of 26bp for the 123 banks in Peer Group 1 , which is all depositories above $10 billion in assets. In cash terms, GS had net charge-offs of $225 million in Q1 2020 and $260 million in Q2 2020. By comparison, GS had a $688 million accounting restatement in Q1 2020 that was disclosed to federal regulators. At GS, you see, nothing is extraordinary. Provisions for future losses at Goldman are up sharply, but actual realized losses net of recoveries are not yet elevated. Following the industry trend and guided by internal credit metrics, GS and other banks are likely to continue to build loan loss reserves for the next several quarters, a fact that will depress earnings and also the hopes of a lot of Buy Side managers for a rebound in financials. But it this right? Will the bank credit reserve build continue? The answer to that question will move a lot of money into or out of bank stocks in coming weeks. The calculus depends fundamentally on your view of the economy and in particular corporate credit. In the 2009-2010 period, loan loss reserves for all US banks rose to $250 billion, but actual losses net of recoveries tracked at 20% of that then astounding number. This is why we use the early version of Basle I to measure loss given default or “LGD” for bank loan analysis. It informs your perspective of net loss rates and thus the trajectory of future provisions and thus earnings. Source: FDIC/WGA LLC What does all of this mean? So far, the pace of bank credit loss reserve build in 2020 is larger than in 2009, twice as big to be precise. At the current loss rate, we expect to see the industry consume total operating earnings with credit expense in 2020 and some of 2021 as well. We also expect to see realized losses net of recovery jump sharply higher in Q3 and several quarters thereafter. Banks such as GS, Citigroup (NYSE:C) and JPMorgan (NYSE:JPM) that managed to ride the wave of volatility in Q2 2020 are unlikely to see that extraordinary gain repeated in Q3 2020. The record increase in revenue for Investment Banking and Global Markets at GS, for example, is extraordinary and again illustrates the volatility of the firm’s financial results. Also, the growth in deposits seen at GS depends greatly on whether the Federal Open Market Committee continues to monetize the national debt at the current pace. The Q2 2020 results for GS are shown below. Source: Goldman Sachs Estimating the actual source of the losses coming at banks is more difficult because of the breadth of the COVID-19 disruption and the efforts being used to obscure the actual credit situation facing many debtors. Many issuers, for example, are using financials adjusted for COVID19 losses on the theory that these losses are “extraordinary,” “unusual,” “infrequently occurring” or “non-recurring.” In the age of COVID19, nothing is extraordinary. Bank do not consistently break out provisions by loan category or sector. JPM, to its credit, does provide detail on business line provisions expense. The chart below shows the provisions by business line and particularly shows the big surge in loss provisions for consumer exposures. Source: JPMorgan When people ask us: How bad will it be for the banks? Our short answer is dreadful, yet the scope of the task still remains uncertain. Will loss provision builds be sufficient in Q2 2020? JPM held out the possibility that "worst case" reserve builds may have peaked in Q2 2020. JPM's Chief Financial Officer, Jennifer Piepszak, summed it up nicely: “In addition to the obvious impact on consumer, its protracted downturn is expected to have a much more broad-based impact across wholesale sectors that we’ve seen in the first quarter. Given the increased uncertainty of the macroeconomic outlook, how customer payment behavior will play out and the future of government stimulus and its ultimate effectiveness as it relates to both, consumers and wholesale clients, we've put more meaningful weight on the downside scenario this quarter. And so therefore, we're prepared and have reserved for something worse than the base case. And given CECL covers life of loan, if our assumptions are realized, we wouldn't expect meaningful additional reserve builds going forward.” We are heartened to hear Piepszak’s optimism about the “base case” for credit losses at JPM. JPM CEO Jamie Dimon went further and suggested that an additional $20 billion in reserve build would leave him over-reserved for the base case scenario in the Fed’s latest stress test exercise. But the reality is that nobody in the industry yet knows what will happen with corporate exposures as the year grinds to a conclusion. We suspect strongly that provisions for commercial exposures at JPM and other major banks will be higher than reserves for consumer losses by year end. Piepszak notes in response to a question from John McDonald at Autonomous , the most heavily impacted COVID sectors are “Consumer and retail, oil and gas, real estate, retail and lodging, and sub-sectors, as you think about real estate.” That takes in a lot of the US and global economies. Summer Reading List The Need for a Federal Liquidity Facility for Government Loan Servicing Karan Kaul & Ted Tozer, Urban Institute Prepayments: Ginnie Mae vs. the big banks National Mortgage News Yes, the annual fishing trip to Leen’s Lodge in Grand Lake Stream Maine is on this year for the first week in August. For details, please contact Scott Weeks info@leenslodge.com or (800) 995-3367. David Kotok West Grand Lake (2019)

This week in The Institutional Risk Analyst, Emmy award winning composer and music executive Michael Whalen gives us the update on the slow and steady fragmentation of what we used to call television. Michael called this trend years ago and takes particular relish in describing the latest changes in the industry. By Michael Whalen Making predictions is dangerous and arrogant. Making predictions almost ensures that the future you see will never actually happen, right? I know. Maybe I have had one too many nights in “self-isolation” during this year’s pandemic staring at a huge screen in my living room… But, for those of you who are interested in the future of media here in America and you’re not afraid of outrageous statements — even after three and half years of President Donald Trump  — here comes one more outrageous statement. Prediction: The three “traditional” US television networks ( CBS, ABC, NBC ) will merge their enormous oceans of content to survive in a brutally tough video streaming environment. And, the merger will happen much sooner than you think: my prediction: 3–5 years. Let me be clear: I am not saying CBS, ABC and NBC will merge their companies, but I do believe that they will merge their content to compete in today’s vicious online streaming environment. Let that sink in for a minute… Given the recent launches of “Peacock” (NBC), HBO MAX , Disney+ and yes, YouTube Live into a crowded field of video streamers that include Netflix, Amazon Prime , Apple TV+ , Hulu , Crackle , Sling TV , Crunchy Roll and many others. You might have noticed that we here in the United States have a plethora of “choices” for our video content. Or… do we? Even though it’s (almost) 2021, we as a media culture are still dealing with a huge number of legacy video carriage agreements and licenses left over from the TV and cable days. Because of the bizarre eccentricities of these contracts, we TV streamers must manage and sidestep these prehistoric contracts even though we are “cord cutters”. You’re someone who has “cut the cord” with your cable company, right? No..? “Cord cutting” ( watching television via Internet only ) now accounts for 19.9% of US households in 2020, raising their numbers to a staggering total of 25.3 million. In 2018, there were 90.3 million US households subscribed to (Cable/Satellite) TV, with that number dropping by almost 4 million this year to 86.5 million. Here’s the basic problem: in the cable television era we had ONE place that provided hundreds of channels of content where the copyright issues and residuals were transparent to the masses who surfed channels the offerings of the moment. As of the end of 2019, seventy percent of U.S. households have at least one subscription to a streaming video platform, compared with just 40 percent of U.K. homes. The average American video subscriber watches 3.4 services. For each one, they pay an average $8.53 per month. If you annualize this average, it’s $102.36 a year. This total is less than the cost of most premium cable packages across the United States. The average cable bill in the United States is: $217.42. Now with these new streaming services coming on-line, Americans will be evaluating whether they are getting value for their streaming dollar. These first few years of video streaming demanded much of us early cord cutters. But now, streaming is all the “rage.” Now old fashioned TV networks scramble to be relevant in an environment that feels more like the Wild West of the 1800s rather than the streamlined technology-driven future utopias detailed on TV shows like “Star Trek”. Are Americans getting “value” from their streaming dollars? The answer so far is….. no. Like, really no This “no” response will force copyright holders to make some strange (read: desperate) decisions. Said another way, I won’t pay $9.99/month for the non-ad version of Peacock (NBC) so I can watch episodes of “Saturday Night Live” from 45 years ago. The data is only now starting to dribble in, but Americans have reached their limit with content subscriptions and feeling ripped-off because the video platform they signed up for has very finite amounts of content. Also, the COVID-19 pandemic has Americas very scared as for the first time since the 1980s consumer savings is going up and personal debt is going down. People are very wary of being “nibbled to death” by 10 or more small automatic subscriptions a month for music and video content. If you go to business school, day one they define “value” as: “in the absence of value; price matters.” In this very bizarre and unsettled environment, price matters. This is the impetus that will drive the “big three” to consider merging their catalogs, creating a pool of co-produced content and to do battle with: Apple, YouTube, Netflix and Amazon Prime. Let’s pause for a second and talk about the genius of Amazon Prime: tying a video streaming subscription with free shipping (and other stuff) from the biggest on-line market in the world is very, very smart. Bundling these services masks the sting that would occur if consumers were asked to pay for these items separately. Look to see bundling of services coming very soon from Apple, Google and others. Amazon also only produces a tiny percentage of original content versus the licensed content that they have online. Again, they’ve made a smart decision not to do battle with Netflix in the content wars. They pick their shows and they produce a surprising number of “hits” on their own ecosystem. Creating your own audience ecosystem versus trying to fight the fight of video streaming apps on consumer’s home systems will be THE reason that the TV networks will merge into one streaming platform. Netflix knew early on that if you had compelling content you could keep your audience in your ecosystem, market to them and you were more or less “protected” from the brutal winds of companies trying to create an audience of their own. Sadly, the analysts at UBS just downgraded Netflix stock because of fears of “tough subscriber comparisons”. In English, this means there is a ton of competition and Netflix is losing its grip on its once bulletproof subscriber ecosystem. Again, let me be clear: I am not saying CBS, ABC and NBC will merge their companies. Combining those three cultures, real estate, facilities, union agreements and complex infrastructures would be an Olympian effort. I believe that these three traditional broadcast media companies will merge their content, market it and even co-produce new content to help offset the spiraling cost of high end-television production (read: “Game of Thrones”). Remember that these networks own cable divisions that could contribute even more content. When CBS launched their “All-access” streaming service with every episode of every show they’ve produced they were sure that consumers would be amazed at their choices. It took about a weekend for America to look at their offerings and respond with a shrug and “so what?” For those of you reading carefully, you might ask: “ABC is owned by Disney and why wouldn’t Disney simply put ABC content on their own successfully launched streaming platform?” Consider that ABC is an outdated albatross in the Disney content world which also includes the Marvel franchise, Star Wars, Pixar and others. We are talking about the survival of ABC and Disney isn’t willing to be taken down with that ship. Placing ABC inside the Disney platform would be Disney and ABC surrendering to a not-so-obvious truth of television in 2020: network television content doesn’t age well on streaming platforms and it is very tough to market “older shows” (especially to a younger audience). This is to say nothing of the hidden costs associated with network shows that any producer working on a Netflix show would laugh at: mostly the reliance on only using union talent and production people. There were decades when the intellectual property of the “big three” television networks were some of the most valuable assets in all of entertainment. Those days are long gone. There are some network shows: “Friends”, “Seinfeld” “The Gilmore Girls” and about a dozen others that have aged better than most on streaming platforms. However, all of this is just furthering my argument that “birds of a feather flock together” and these three networks know each other and by and large have similar older audiences. Therefore, having them huddle together to survive a relentless race for audience share and relevance makes sense, right? Maybe my prediction isn’t so “outrageous”? Time will tell if I am right or even partially right. However, the streaming wars are far from over. We are just getting to the really brutal and bloody part of the streaming wars. Stay tuned…

New York | We go into Q2 2020 earnings season with a combination of expectation and dread. On the one hand, we are getting more data on the state of credit inside banks and nonbanks alike, a process of revelation that will make a lot of investors and risk professionals queasy. The discovery process must continue even as many cities remain effectively closed, with plywood covering the windows of businesses. Spray Paint on Plywood, Broadway & Houston Street | 07/12/20 For now, the reversal of progress on COVID19 in many states throws any calculus of two weeks ago regarding future credit losses into the waste bin. The longer the US economy remains in lock-down, the more horrific will be the financial and economic cost. This cost will soar into the tens and hundreds of billions, and will be spread across banks and institutional investors. Tom Michaud , KBW CEO, told CNBC’s “Squawk on the Street” last week he expected to see higher credit loss provisions in Q2 2020 earnings, something we have flagged as an indicator of the degree of comfort inside banks as to the credit outlook for 2020. Michaud also bravely predicted that Q2 would be the worst quarter in terms of big provision numbers, but that actual losses would remain muted in Q2, a point with which The Institutional Risk Analyst concurs. Note that loss rates were already starting to lift in Q1 2020, an unfortunate trend that we can see going hockey stick in the current quarter due to commercial losses. Source: FFIEC In the past couple of weeks, US bank stocks have given up most of the “rebound” from April and May, and are now again in the red for the year – with the notable and ironic example of Deutsche Bank AG (NYSE:DB) , the quintessential example of the too big to fail bank. Despite its latest faux pas regarding transactions for deceased sexual predator Jeffrey Epstein, DB is up 29% this year as of the close on Friday. Morgan Stanley (NYSE:MS), which looked left for dead two months ago, is also up double digits in the past month. The YTD results are less promising for the large bank group. On CNBC's “Fast Money” last week, we opined that there is still a lack of visibility on credit and earnings for financials, except in residential mortgages, where a record year for volumes and profit per loan is in prospect. A heavy calendar of corporate bond issuance, surging residential loan volumes and fees from risk free government loans may be the bright spots for US banks this quarter. Also, kudos to the folks on the Federal Open Market Committee for moderating intervention in the REPO and the mortgage backed securities (MBS) markets last week. GNMA 2.5s for August are off from the June highs, this even as the Treasury benchmarks fell in yield last week due to COVID concerns. We note, however, that the VIX has not been much below 30 for long since March. The flip side of bull markets in residential mortgages is prepayments. The asset shrinkage due to consumer mortgage refinance activity on higher coupon MBS is pronounced and accelerating, which will force the Fed to continue MBS purchases merely to keep the portfolio size stable. But the macro picture of stability remains dependent upon near total monetization of Treasury emissions by the independent central bank. “The biggest question is whether the Fed will continue to buy enough Treasury and MBS paper to fully fund the issuance of US Treasury debt," writes Lee Adler of The Liquidity Trader . “In other words, will the Fed continue to do enough to monetize the entire Federal Debt? So far, the answer is yes. That could change, but it hasn’t yet.” The constant prepayment rate (CPR) for the $1.2 trillion in FNMA 4s were running around 40% in June and speeds on GNMA 3.5% MBS were equally high, accordingly to MIAC . With coupon spreads at 2% and the current MBS coupons headed for 2%, this means consumers can get a 3% mortgage or better. At the present rate of prepayments, on-the-run MBS (which are, in theory, comprised of 30-year mortgages) will basically disappear within a year or so. Properly understood, we think that 30-year mortgages are really 30-day instruments that renew if the home owner/debtor does nothing. The owner of the mortgage note is short a put option, which is given to the debtor at no cost. Is this a great country or what? The wave of prepayments in June and beyond will likely come as bad news for owners of mortgage assets such as REITs and MBS funds that are not able to lend and create new assets at reasonable cost. The June prepayment numbers on MBS were so high, in fact, that the FOMC can expect the system open market account (SOMA) to take some pretty hefty losses on redemption on its MBS holdings, but that is the point is it not? Through its various emergency lending activities, the Federal Reserve is taking direct credit risk in ways never anticipated by Congress but mandated, if you’ll forgive the pun, by circumstances. And as we have said before, the circumstances in terms of credit are quite dreadful. Just as the Fed takes a cash loss on a loan prepayment at par in an MBS, a default on a loan made via any of these emergency credit programs may eventually cause a loss to the central bank. This loss is subtracted from the earnings on the Fed’s portfolio, including the interest earned on MBS and private securities. The Fed is, in fact, operating as a fiscal agency of the US government. Nobody in Congress seems to know or care. Meanwhile across the world in China, the Chinese Communist Party led by dictator Xi Jinping has apparently mandated an economic reflation of huge proportions. This includes a bubble in stocks fueled by higher margin lending, the Financial Times reports. The mandate from on high is that China is recovering, thus all of the proverbial levers of stimulus are being pulled. The renminbi has rebounded to a three-month high, reflecting the strong government intervention that began around the end of June. The iShares China Index (FXI) is ahead of the S&P 500 over the past 30 days and for the year. But the recovery of the real Chinese economy lags far behind the manufactured reality visible in the financial markets. The stampeded of Chinese investors into shares, in many cases using illegal margin loans, is the latest evolution of economic thinking by Beijing, a development that does not exactly instill great confidence about the future. Recall 2015. Securities margin lending is the exclusive business of licensed brokerages, Caixin reminds us. Margin lending is illegal for other institutions or individuals, yet the activity is grows rapidly as available liquidity overwhelms the regulatory constraints. While there are many examples of resurgent financial markets, we remain concerned that the predominant global tendency is and will be deflation, one reason why a number of policy makers believe that additional credit support for the economy will be required in coming months. We agree. Look for a surge of equity issuance in coming months as financials look to maximize liquidity and capital. For Q2 2020 earnings of banks and financials, we can say that the process of data gathering and disclosure will be ongoing and intensive. We are still trying to understand the scope of a problem that is outside of recent experience and the silly media narrative of a “V” shaped recovery. Our friend Professor Edward Kane at Boston College sums up the approaching loss horizon for commercial real estate and related corporate risk exposures: “When payments are not made as due, delinquencies are not immediately registered. Often, the grace period is 60 days. But when grace periods expire, lenders and landlords have only two options: taking possession of the property (or collateral) or easing contract terms. Exercising these options generates uncertainty, takes additional time, and reduces the cash flows that existing contracts and properties can generate going forward.” “In the wake of the indelible economic damage the pandemic is causing, a lasting contracting equilibrium in the real-estate sector requires the rents and mortgage payments implied by pre-existing contracts to be renegotiated sharply downward. The long-lasting effects of the virus on opportunities to travel and work from home will eventually make it clear that the equilibrium value and size of various commercial real-estate holdings have been permanently reduced. The glut of commercial properties (especially hotels and shopping centers) will reduce land values all around. Agreeing to tear down commercial buildings and repurposing the land on which they sit is a time-consuming business. Far from undergoing a V-shaped recovery, travel, real estate and real-estate finance will remain depressed sectors for whatever time the recontracting and loss-allocation processes take.” “Sooner or later, direct and indirect mortgage lenders and tax collectors at every level of government must face the pain of these adjustments. State and local governments are deeply vulnerable. Targeting an increased flow of liquidity from the taxpayer-owned Federal Reserve System to benefit selected firms and investors in the travel, real-estate and state-and-local sector can delay and redistribute some of this pain across the population. But the pain can be postponed for only so long. We should not kid ourselves. It is going to take a good deal of time for the pain to go away.” To Melissa Lee's question last week on CNBC , bank stocks are a value trap for now. Look for markets to sell into the news on earnings for financials as a combination of frightful credit provisions and commensurately low earnings will kill the party that has kept even some blue-chip names well above book value since March end. And remember Lee Adler’s point, namely that we got effective MMT right now through FOMC monetization of the US fiscal deficit. The bank group we track actually closed up mid-single digits on Friday because, stated frankly, the Street wants to own these stocks, plain and simple. JPMorgan (NYSE:JPM) and U.S. Bancorp (NYSE:USB) led the way, but neither of these stocks is especially cheap at 1.3x book or so and given the magnitude of credit losses in prospect. Even as the banks take a licking on their CRE and commercial exposures in coming quarters, look for the nonbank residential mortgage sector to remain buoyant as swelling volumes and earnings contrast with the carnage elsewhere. The impending IPO by Rocket Companies , owner of Quicken Loans, will be cause for joyful fascination by long suffering mortgage folk even if the big media barely cares. The first version of the Rocket Companies S-1 was filed last week. The Street is hoping for a multiple on earnings in the teens or better for the IPO, which is led by Goldman Sachs (NYSE:GS) . In the event Quicken founder Dan Gilbert gets such a rousing reception from investors, the members of the mortgage finance ghetto all will be very pleased indeed. The annual fishing trip to Leen’s Lodge in Grand Lake Stream, Maine, is on this year for the first week in August. For details, please contact Scott Weeks info@leenslodge.com or (800) 995-3367.

New York | The summer of 2020 is all about picking winners and losers in the COVID19 lottery. This is especially of concern since government agencies such as the Federal Open Market Committee and US Treasury get to do the picking, a classic example of crony capitalism in practice. Counting and sizing the winners and losers will inform the macro perspective in the weeks and months ahead. The Treasury just released a list of the largest participants in the PPP program, but the market is no longer the biggest factor in selecting winners and losers. We can recall a decade ago going to see one of the bigger lawyers in the New York commercial real estate community. A young graduate who had worked for a small developer fixing and flipping homes in the Hamptons wanted to get into big time commercial real estate development. He sought guidance. The lawyer viewed his resume and advised the young man to stop seeking a position in development, but rather look for work in restructuring. "We're not doing development any more kid," he advised. "It's about restructuring now." Then as now. Many observers are predicting a November victory for Presidential candidate Joe Biden (D-DE) , a phenomenon strangely similar to the predictions made about Hillary Clinton four years ago. Recall that both democrat candidates were largely invisible, then and now. Meanwhile, the frequently overexposed President Donald Trump is doing the sort of things that incumbent presidents do to win re-election, namely being nice to Teamsters. “The US Treasury department has reached a deal to bail out YRC, a struggling US trucking company, with a $700m loan using funds from the $2.2tn stimulus legislation passed in March,” reports The Financial Times . The loan gives the Treasury a 29% equity stake in YRC, which Treasury Secretary Stephen Mnuchin describes as a key Pentagon vendor. Now YRC is a key vendor for just about everybody, right? And did we mention the loan saves 30,000 jobs including the jobs of 24,000 Teamsters? Moving from the sublime to the tragic, appraiser Miller Samuel says that purchases of co-ops and condos in Manhattan tumbled 54% from a year earlier to 1,357. In a report published last week with brokerage Douglas Elliman Real Estate , Miller Samuel says this was the biggest annual decline since the two firms started keeping the data three decades ago. While the world of high-end Manhattan residential real estate is certainly not looking very promising, the outlook for employment continues to be a big bone of contention. Recent strong gains in jobs have caused some analysts to claim that the headline unemployment rate is at best distorted to show an overly optimistic picture of the labor market, and at worst a downright lie perpetrated by President Trump to manipulate public perceptions. Bryce Gil of First Trust Advisors retorts: “It’s crucial to point out that even though the level of the unemployment rate would have been higher in June, its decline would have been larger. The official rate fell 2.2% in June, from 13.3% to 11.1%. With reclassification, the decline would have been nearly twice as large, falling 4.2% in June, from 16.3% to 12.1%. Given that it's the change in the unemployment rate that matters for financial markets when gauging the strength of the economic recovery, reclassification reinforces the optimistic outlook.” Good news on employment would be really great right about now, but we continue to worry about anecdotal reports that suggest a second wave of job losses impends in 2H 2020 and that this wave could be a significant obstacle to economic recovery. Those parts of the economy that are reopening are not nearly sufficient to provide jobs and livelihood to millions of people who worked in the services sector. And many employers who did protect workers for the past few months are running out of cash. We won't mention the names out of compassion for the losers. Another positive is that corporate bond issuance is likely to hit records in Q2 2020, however, the leverage loan market is headed in the opposite direction. Issuance across the U.S. syndicated loan market plummeted in the second quarter, Thompson Reuters reports, this “as the asset class navigated a slow recovery from the novel coronavirus that left borrowers scrambling for cash to keep their businesses alive while economies around the world gradually reopen.” The chart below shows SIFMA issuance data through May, seemingly affirming the concerns we’ve discussed in past weeks with Ralph Delguidice and others about the damage done to asset-backed securities (ABS) markets. While straight corporate bond issuance is up and mortgage related offerings are also surging to over $300 billion per month, ABS and other issuance is down. Th purple series showing ABS issuance is essentially a zero. Anecdotal reports suggest that corporate bond issuance in June was above May levels. Residential mortgage issuance also hit new volume records, suggesting a record $3 trillion annual run rate for new residential mortgage production in 2020 . Of note, the residential mortgage sector will be a big bright spot in Q2 earnings for some banks and financials, but players such as JPMorgan Chase (NYSE:JPM) may benefit less because the larger banks have stepped back from retail home lending. The latest changes made by Ginnie Mae with respect to loan eligibility (“ The problem with Ginnie Mae's new restrictions ”) may further hurt the appetite of larger banks to finance distressed government-insured loans. Follow-on equity offerings and even convertibles were strong in June, again suggesting that the flow of secondary equity and debt offerings from banks and corporate issuers will continue. A proliferation of IPOs and even special purpose acquisition corps (SPACs) suggests a “V” shaped equity market is forming, but will the economy follow suit? We are a seller of Vs, Us or anything normal in the way of economic bounce, a large seller. Torsten Slok at Deutsche Bank (NYSE:DB) argues that COVID19 peaked two months ago and that the number of news cases continues to fall along with the VIX. He notes, however, that “the speed of progress is slowing.” Slok also observes that despite record corporate bond issuance, dealer inventories of corporate debt remain low. And high yield credit spreads are stable, as shown in the chart below. As we suggest in the National Mortgage News comment above, maybe the Fed can stop buying MBS now? Indeed, while we continue to worry about an increase in unemployment as the credit default process ripples through the corporate world, market indicators are relatively strong – even if earnings are unlikely to meet the challenge. Thus, there is multiple expansion for stocks, but no earnings growth -- or earnings at all. The good news is that the credit markets continue to function. The bad news is that the cost of credit is rising dramatically and is already at highs seen a decade ago. We expect the June data to be horrendous in commercial real estate and corporate credit, but we also note again that credit spreads remain tight and markets are functioning for deals that make sense. Yet the tenor of things is decidedly deflationary. “Is the corporate money now sitting on the sidelines available to stimulate the economy; grow the value of financial assets; or to eliminate debt?” ask Dick Bove of Odeon Capital Group . “If the answer is the last option of the three, this would not be good for either the economy or the financial markets.” We kind of agree with Dick when it comes to the credit situation. We stand at an Irving Fisher moment, when our leaders either take collective action to fight deflation, as we did in the 1930s, or we stand back and watch as “market forces” led by the private equity industry do the work. The candidate that wants to win in November needs to start talking about restructuring and renewal, the twin national priorities that will assert themselves in coming months to the exclusion of aught else. It’s fine to buy time with PPP and other measures, but much of America’s economy needs to be restructured and made productive again. Reauthorizing the Hoover-era Reconstruction Finance Corp with receivership powers and a mandate to work with the Federal Courts and the Federal Deposit Insurance Corp to resolve insolvencies and fund new, restructured companies and banks is the obvious first step. Which of the two candidates, Trump or Biden, will first figure out this looming economic and political reality? Yes, the annual fishing trip to Leen’s Lodge in Grand Lake Stream Maine is on this year for the first week in August. For details, please contact Scott Weeks info@leenslodge.com or (800) 995-3367.

New York | Last week the Federal Reserve Board made public the annual stress test results, a financial media circus that celebrates the bank stress test popularized by former New York Fed President Timothy Geithner. The Fed essentially confirms what we already know, namely that banks have largely suspended share repurchases and at some institutions are looking at limits on dividend payouts. Banks had been conducting stress scenario analysis since the 1990s, of course, as part of the Basle process. The Geithner stress test of a decade ago was about perception, that is, confidence. It worked and the Fed tests went far to restoring confidence in banks. The subsequent iterations, however, have achieved little measured by clarity on risks taken by banks and the resulting Fed bank supervisory policy. All together share repurchases and common dividends were worth over $300 billion in 2019, but it is likely that many years will pass before investors see such cash returns on capital. To remind one and all what 2007-2015 looked line in terms of earnings, see the chart below. Source: FDIC Indeed, we’d not be surprised to see most of banking industry income in 2020 consumed by credit provisions (as opposed to actual losses). Fed Chairman Jerome Powell said back in April that he saw no need to put limits on bank dividends, but that position is evolving rapidly. Meanwhile, the cacophony of nonsensical double speak from the FOMC drones on and on. Several Fed governors have taken to referring to banks as a “source of strength” to the US economy, a uniquely Neoclassical-Keynesian synthesis. Governor Lael Brainard commented in her dissent to the stress test results : "This is a time for large banks to preserve capital, so they can be a source of strength in a robust recovery." In fact, it is the shareholders of banks that are supposed to be the source of strength to the insured depository institution. In the 19th Century, bank shareholders often had double liability and, upon call, could be required to provide new money equal to their original investment in the bank. Cutting dividends is the modern-day equivalent of double liability bank shares circa 1880, for the simple reason that the Fed dares do no more. But as we've noted before, loss absorption is about earnings more than capital. Recall that much of the loss provisions put aside in 2009 and 2010 were recovered back to income in subsequent years. Ian Katz of CapitalAlpha Parners in Washington writes that the Powell pirouette on bank dividends is not just about share repurchases. “In fact, the more common view among sell-side analysts is that at least one or two banks will cut their dividends, with Wells Fargo (NYSE:WFS) and Capital One (NYSE:COF) the most frequently cited.” Remember, though, that the folks at the Fed are making this up as we go merrily along. In today’s market, we see The Federal Open Market Committee (FOMC) brazenly manipulating market rates as though they could determine the economic outcome. By turning market prices such as federal funds into government targets for policy goals like employment, the central bank's sole effective mandate, the Fed destroyed the ability of markets to correctly price risk. The sad truth is that the Fed is completely reactive at this point, unable to fashion an exit from years of massive open market operations. The greater good, from the FOMC’s perspective, is maintaining the access of the US Treasury to the debt markets. Ludwig von Mises wrote, “Once society abandons free pricing of production goods rational production becomes impossible. Every step that leads away from private ownership of the means of production…is a step away from rational economic activity.” Of course, the Fed should provide guidance on share repurchases and dividends, but banks have already figured this out for themselves. Indeed, banks are going to be issuing new equity for a while and in large quantities. But with the Fed, OCC and FDIC busily issuing regulatory guidance to counteract the impact of the FOMC adding almost $3 trillion to the banking system’s liquidity in mere weeks, the investment situation in the banking market does seem a bit surreal. Think of the spectacle. Banks and corporate issuers are now forced to raise capital at distressed valuations, this after spending much of the past decade repurchasing shares at higher and ever more ridiculous price levels. Investment advisors and analysts must fashion some reasonable explanation of why this is good. Shareholder value will be diluted more and then some more. And who do we thank for this blessing? The FOMC. By manipulating the price of credit, the FOMC set the stage for the dilution of bank shareholders. In fact, last Monday we kicked out our remaining bank common in U.S. Bank (NYSE:USB) and moved higher up the capital structure into some preferred. As we told Melissa Lee & Co on CNBC's Fast Money , we don’t want to get our feet wet. But, of note, USB is still trading above book value as of Friday's close. Just as COVID19 is surging in the South, the credit loss picture facing US banks is also showing signs of monstrous growth. We are already at 2009-2012 levels of delinquency in commercial real estate and the proverbial flood waters are continuing to rise. Intex had delinquencies in commercial mortgage backed securities (CMBS) at 7.5% at the end of May. Try double digits in June easy? In May, the top-ten delinquent CMBS issues totaled $7 billion in loans on retail and hotel properties including Mall of America ($1.3 billion), Courtyard by Marriott Portfolio ($415 million) and Innkeepers Portfolio ($755 million). As we note in the new edition of The IRA Bank Book for Q2 2020: “The chief risk to the system, as it was in the 1990s, comes from commercial real estate and corporate exposures rather than residential mortgages. A sharp decline in rental collections in commercial office space and retail locations is hurting asset valuations. Existential changes in business usage and consumer behavior are likely to impair evaluations for many commercial buildings.” So ask not whether bank dividends are safe, especially with 2009-2012 in mind. The answer to that question is less and less likely. Better instead to think about the mid-1930s, which resulted from a decade of financial boom. A lot of very real losses in coming years will be caused by the period of easy money engineered by the FOMC and the Fed’s staff, magical people who truly think that they control the US economy. The New York Review of Books recalls in a wonderful review of “ The Marginal Revolutionaries: How Austrian Economists Fought the War of Ideas ” by Janek Wasserman: Hayek likewise rejected the idea that society could be planned. He saw the economy as a spontaneous order. In his 1937 essay “Economics and Knowledge,” Hayek argued that central planning was bound to fail because planners lacked necessary objective knowledge. Only the market, which Hayek later called a “subtle communication system,” could solve the problem of resource allocation, since it reflected “the spontaneous interaction of a number of people, each possessing only bits of knowledge.” Happy July 4th holiday. And yes, the annual fishing trip to Leen’s Lodge in Grand Lake Stream Maine is on this year for the first week in August. For details, please contact Scott Weeks info@leenslodge.com or (800) 995-3367 .

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

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

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

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

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

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

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