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New York | The great sucking sound heard last week was the release of accumulated froth in the global equity markets. The FOMC’s decision to act with a 50bp cut in the target for Fed funds had little effect on real markets for real counterparties. Meanwhile, the panic in the media is having outsized effects on people, companies and society. Below we ponder the effects and consequences. The unfolding impact of COVID19 changed the effective ratings for dozens of corporate issuers, resulting in an increase in the effective cost of equity finance for everyone from American Airlines (NYSE:AAL) to Amazon (NASDAQ:AMZN) . And the fact that the Fed dropped the target for federal funds is nice, but does nothing really to help these and other companies. Assets move for ratings, a fact we learned long ago from Bob Salvaggio at AMBAC in the world of RMBS. John Dizard writes in the Financial Times on the topic of Fed interest rate announcements: “The actual rates at which even most institutions can borrow against Treasuries or government backed securities have not been cut by any 50bp. On Tuesday, the widely used DTCC GCF Repo index quickly rose from 1.6 per cent at the open to 1.85 per cent, and only came briefly down to 1.5 per cent before creeping up again. The index settled at a 1.72 percent average for the day. By that evening, “ease” or no ease, the Fed was turning down some of the record $111bn of bids for repo from within its own select circle of counterparties.” Because so much of the world of monetary policy is predicated upon maintaining consumer confidence, and since the availability of credit impacts same very directly, times of market stress are costly to the economy. The Fed now faces a sudden, twin crisis of both liquidity constraint and sharply discounted credit profiles for some major corporate and public sector names. The Fed’s 50bp was thought to be a way to reinforce confidence, but instead it signaled that the worst is yet to come. Treasury Secretary Hank Paulson’s suggestion that the government had to buy bad assets from Citigroup (NYSE:C) over a decade ago had a similar effect. Robert Eisenbeis at Cumberland Advisors asks whether the Fed wasted 50bps last week. Our thought is probably yes. Nobody in the mortgage industry is going to agree with you on that count, however, with secondary market spreads north of two and one half points and widening. He writes: “The Fed’s move was clearly intended as insurance designed to convince participants that the Fed will do what it takes to support the economy in the face of the coronavirus threat. As the day proceeded, however, the realization set in that rate cuts aren’t medicine when it comes to the threat of a pandemic. It can’t get consumers out of their homes to spend and it can’t fix supply chain bottlenecks.” The first question, of course, is whether the virus panic now being fanned in the global media and also in the political sphere is going to cause a global credit crisis and recession. Specifically, and to the questions about the efficacy of last week’s Fed rate cut, is merely adjusting the target for Fed funds sufficient to meet the growing demand for the volume of credit? Specifically, will the hit to the supply chain also cause crippled corporate credits to lean hard on bank lines and other sources of liquidity. “Just cutting funds and IOER without backstopping liquidity is going to make USD funding offshore a nightmare in coming days as the global supply chain (which is a payments chain in reverse, thanks Zoltan) clogs and backs up like bad plumbing,” says Ralph Delguidice of Pavilion Global Markets . “Companies not shipping high value-added goods (chips, etc) will draw down USDs to make payments to fill the gap (resulting in a temporary surfeit of liquidity). This will become a global scramble for dollars among those banks seeing deposits flee and credit lines drawn the longer the chain stays disrupted.” Source: FDIC/Whalen Global Advisors LLC As the chart above suggests, the FOMC has managed to throttle bank deposit growth since December 2018. Strangely, this is when the central bank stopped raising rates and started to become aware of ST liquidity risk. With the shock to the global supply chain will also come a shock to commercial banks, first in terms of increased volatility in once stable corporate deposits from longtime customers. Later these same customers may come under financial stress or even be forced into default and restructuring due to the disruption of COVID19. Liquidity, like confidence, is something that economists discuss endlessly but cannot define or measure. We constrain bank liquidity with rules and regulations, but then lament when funding is insufficient to meet market demand. And cash liquidity available to the broad market, not the target rate for Fed funds, is what gets stuff to happen in the economy such as loan growth. In fact, the volume of liquidity flowing through GCF repo for Treasury collateral has been falling for the past year even as interest rates have fallen – or rather have been pushed down by the Fed. GCF RMBS repo volumes have been strong, of note, even as new loan origination volumes climbed 20% year-over-year. As with this past September and December 2018, when we took large cap stocks off by a third in value, the forward concern seems to be liquidity risk resulting from numerous examples of falling corporate cash balances and deteriorating credit conditions. We cannot see whole industries such as airlines, lodging and hospitality grappling with sharp cuts in revenue and not expect a substantial reaction in terms of reducing costs and raising liquidity in those sectors. Another worry when it comes to liquidity is the new issue market, which was going great guns in January but may have slowed significantly in February with the notable exception of mortgage securities. At $158 billion in January, RMBS volumes were up 25% YOY according to SIFMA. But more worrisome is the fact that corporate and ABS bond issuance has fallen dramatically since September of 2019. This may have been the early sell signal from the world of credit in this cycle. We’re struck by the fact that corporate debt issuance started to dive five months ago, but the equity markets did not respond until the arrival of COVID19. In fact, after a small pop in high yield (HY) spreads in the September 2019 time frame, HY credit spreads actually rallied 50bp in yield down to the mid-300s over the curve by early 2020. With the arrival of COVID19, however, HY spreads have widened to plus 500bp over, dangerous territory that can be a predictor of an impending credit risk reset event. Fred Feldkamp’s First Rule states simply that when HY spreads go much about 400bp over the swaps curve, financing activity on the fringes of the consumer economy slows as counterparties start to demand wider spreads on risk transactions. Get to plus 500bp as we are today and the economy is in danger of an outright stall. An economy is an airplane that never actually takes off but must always be at least at sufficient autorotation speed necessary for flight. Falling volumes in the GCF repo market, stagnant bank deposit growth and a sharp drop in corporate bond and ABS issuance don’t sound like a particularly positive combination to us. Add a likely spike in cash demands by a range of public and private obligors whose effective credit ratings changed over the past week and we see a variety of immediate and long-term problems facing the Fed and the Trump Administration. For starts, we think the Fed should worry less about targeting interest rate price and more about understanding, intimately, what is happening in terms of apparent and real liquidity in the credit markets. Like we said, assets move for ratings. There is a huge, sudden and somewhat hysterical asset allocation shift underway out of equities and into safe assets due to uncertainty arising from COVID19. At some point, however, the lack of yield in bonds will drive investors back into equities.

New York | Is the Federal Reserve Board killing America’s banks, pension funds and anybody else that saves with low interest rates? The answer we provide in the latest issue of The IRA Bank Book Q1 2020 is a resounding yes! Points: * Bank interest expenses fell in Q4 as lower market interest rates and ample liquidity provided by the Fed ended the steady increase in bank funding costs since 2016. The drop in yields, however, hurt asset returns as well. Earnings are down several quarters in a row. As bank earnings fell in Q4, revenue decreased faster than funding costs. * Despite increasing credit provisions at most banks, overall credit continues to be a distant worry. Banks are preparing for another very strong year in residential mortgage lending, a notable bright spot in terms of volume growth. * In particular, Q4 2019 actually saw sales of mortgage notes into RMBS with servicing retained rise for the first time in almost a decade, again signaling a renewed interest in correspondent lending on the part of several large mortgage banks including JPMorganChase (NYSEJPM) , Quicken Loans, Freedom Mortgage, Amerihome, a unit of Athene (NYSE:ATH) and Mr. Cooper (NYSE:COOP) . Copies of The IRA Bank Book Q1 2020 may be purchased at The IRA online store. To say thank you to readers of The Institutional Risk Analyst , copies of The IRA Bank Book Q1 2020 are on sale, 50% off through COB Friday, March 6, 2020 . Just how is the @federalreserve killing America's banks? Read and learn about the true cost of Financial Repression. Source: FDIC/Whalen Global Advisors LLC

New York | Last week, financial markets wiped out about a quarter of the market value of large US banks and nonbank companies. One of our core holdings, U.S. Bancorp (NYSE:USB) , closed Friday just shy of 1.6x book vs over 2x only a couple of weeks back. When USB goes below 1.5x book, we’ll be nibbling again. In a funny way, as we said on Twitter last week , the coronavirus or COVID19, took some excess air out of the obvious bubble in US equities. This market wanted to go down, but did not know how. Thanks to Uncle Xi Jinping and COVID19, Federal Reserve Board Chairman Jay Powell’s problem is fixed for now. Yet the low level of interest rates remain both an immediate opportunity and also the most important long-term problem facing the US banks and the broader financial sector. First the good news. Last year, thanks to lower interest rates, was the best year in mortgage lending and secondary market sales in half a decade with over $2 trillion in production. Refinance volumes actually exceeded purchase loans in Q4 2019. And 2020 is looking to be another record year in terms of both volumes and profitability, this even as loan loss rates continue to be muted due to low interest rates. JPMorganChase (NYSE:JPM) , for example, reported strong results in mortgage banking for the past several quarters. But with the rising volumes comes risk in terms of home price appreciation. The chart below shows loss given default (LGD) skewing sharply negative for bank owned multifamily loans, a pattern that is shared with LGDs for residential loans, construction and development loans, and home equity loans (HELOCS). These outlier indications of negative credit costs harken back to 2005. Then as now, negative LGDs for residential real estate suggest that monetary policy is too accommodative and that home price inflation is actually quite high. Source: FDIC/Whalen Global Advisors LLC “JPMorgan Chase & Co. is shifting workers to handle an expected surge in demand for home loans as the American housing market looks forward to its strongest spring in at least a decade and the coronavirus sends mortgage rates lower,” reports National Mortgage News . Indeed, the entire industry is gearing up for a big year in terms of both purchase and refinance transactions, with a bumper crop of new mortgage servicing assets awaiting financial investors. Indeed, as we reported earlier in The Institutional Risk Analyst , both JPM and Citigroup (NYSE:C) are said to be keen on re-entering the correspondent channel in a serious way, part of a larger trend that is seeing commercial banks regaining market share in residential mortgage aggregation and servicing. As we prepare The IRA Bank Book Q1 2020 for publication later this week, there are a couple of key takeaways regarding the mortgage sector from the Q4 2019 data from the FDIC. In particular, Q4 2019 actually saw bank sales of mortgage notes with servicing retained rise above $6 trillion for the first time in almost a decade, again signaling a renewed interest in correspondent lending and servicing on the part of several large banks including JPM, C and others . Of note, the unlevered yield on the $38 billion in bank owned mortgage servicing assets in Q4 2019 was over 9%, as shown in the chart below. Source: FDIC/Whalen Global Advisors LLC Another positive data point for bank mortgage banking: The nonbank share in mortgage servicing actually grew modestly as well in Q4 2019, this as bank sales of residential mortgage backed securities (RMBS) surged. In particular, Q4 2019 actually saw sales of mortgage notes with servicing retained rise $20 billion, the first time in almost a decade bank RMBS securitization volumes have risen . Source: FDIC While the banks are re-entering the market as aggregators and sellers of correspondent loans into the agency and government RMBS market, the nonbanks remain the predominant originators of loans. And with the surge in lending volume driven by falling interest rates will also come a surge in loan prepayments on existing mortgage securities. Last month, our friends at SitusAMC had capitalization rates for new production conventional 3.5% coupons indicated at 5x annual cash flow, a valuation that now is rendered stale by February’s frantic equity selloff and interest rate rally. Maybe 3-4x? As with the MBA production volume estimates for 2020 and beyond, we expect to see significant revisions to prepayment rates for premium coupons in coming days. Now the bad news, of sorts. Even as volumes for residential mortgage loans surge in 2020 and beyond, the rest of the bank loan book is being squeezed. Yes, the wild rise in bank interest expense has stopped and reversed down below $40 billion per quarter. The trouble is, interest earnings are falling faster, and thus net income for US banks fell again in Q4 2019. Returns on earning assets, one of the most basic measures of aggregate bank profitability, are again falling under the dead weight of quantitative easing (QE) and panic buying of risk-free assets. We’ll discuss this troubling trend in detail in the new edition of The IRA Bank Book . The forward scenario for residential mortgage risk kinda looks like this. Falling rates cause a surge in residential mortgage production in 2020, but the disruption due to COVID19 is so pronounced that the US economy slips into recession. The FOMC responds with even lower interest rates, causing yet another manic surge in mortgage refinance and purchase loan production in 2021-22. RMBS coupons will fall into the low 2s, but then comes the punch line after 2022: a larger than expected upsurge in credit costs. After almost a decade of FOMC-suppressed credit default activity, the LGDs in the $11 trillion portfolio of residential mortgages will skew in the other direction. We suspect the rate of change in visible default rates will be considerably faster than in past cycles. Defaults will occur at both ends of the mortgage credit stack, including the high-end, prime jumbo production that is now trading well through the TBA curve. And with the industry and many large institutional investors in the residential asset class leveraged to the rafters, the cost of distressed servicing will come as a very unpleasant surprise to some investors. Large Buy Side players who think that they own cash flows attributable to specific mortgage servicing assets via participations may also be surprised, in the event of servicer default or forced sales. Read the fine print. And the mortgage industry will see another wrenching process of distressed loan resolution and also consolidation among nonbank mortgage companies and REITs. The nonbank servicers will clean up the mess as the commercial banks happily provide the financing. And life will go on. But the next couple of years in residential mortgage lending and servicing could be a very profitable and also quite volatile ride indeed.

New York | The rally in risk-free bonds is quickly rendering irrelevant the policy direction of the Federal Open Market Committee . We’ve talked in past comments in The Institutional Risk Analyst about the structural shortage of risk-free collateral, even with bond yields down 50% from the November 2018 peak. As fear of the economic effects of the COVID-19 virus grow, investors are seeking liquidity and high-grade credit. Many of the financial and risk decisions that were made even six months ago now look questionable in view of the unfolding flu epidemic from China. But as we noted earlier, the risk to the US markets was always meant to come from offshore. At present the forward risk is that the combination of QE by central banks and fear driven purchases of US Treasury paper may drive US interest rates to zero, further inflating the US bubbles in housing and financial assets. The chart below shows the now negative cost of default for 1-4 family loans held by US banks, another way of saying home prices have risen strongly. Source: FDIC Some analysts continue to point to a future increase in unemployment or an economic slowdown as the likely pretext for lower interest rates. But the market already has discounted a slowdown. And lower market rates provide the impetus for another spasmodic surge in valuations for stocks, bonds and real estate – and all at the same time. Traditional correlations are dead and gone, thus the question is only the timing of the next upward surge in dollar asset prices. A sustained drop in interest rates may actually forestall an economic slowdown, again dashing the hope and expectations of many forecasting economists. Even as the fear trade drives dollar interest rates down, estimates for forward loan origination volumes are rising. Indications of growing froth in the housing markets such as the LGD chart above go largely unheeded by investors, but regulators are concerned. Such is the level of consternation among regulators over the visible level of inflation in housing assets that lenders are being told to step back from certain housing markets, particularly in overheated coastal cities. Worries that a sharp decline in home prices will occur as and when the next recession begins are driving the increasingly frantic directives coming from the Federal Housing Administration and the Federal Housing Finance Agency regarding capital levels in a stressed economic scenario. Across the mall in Washington, however, no less a luminary than Fed Governor Lael Brainard is pushing for an even higher inflation target. Why? The Fed Board does not really say. Perhaps to goose asset prices ever higher? Referring to the policy as “flexible inflation averaging,” Governor Brainard believes that the US central bank needs to set temporary inflation targets above its current goal of 2 per cent, to make up for periods when inflation runs below “target.” But what exactly is the target? The fact that the Fed’s governing statute refers to “price stability” as the Fed’s policy target does not seem to bother Governor Brainard. Neither the former MD bank regulator nor the rest of the FOMC seem to have noticed that asset inflation in housing, stocks and bonds and other asset classes are presently running at low- to mid-double-digit rates of increase. Another surge in the value of housing assets impends. Were US home prices rising at say 25 or even 50 percent annually, do you think Governor Brainard and other FOMC members would take notice? Would such a circumstance constitute inflation or at least a rise in consumer living expenses that warranted recognition? That depends. The Debt Avalanche The fixation of the FOMC and other world central banks with statistical “inflation” stems less from a concern about weak employment, consumer price inflation and economic activity than from the growing pile of debt held by public sector obligors. Unless global central banks lean against the potential debt deflation by monetizing a certain amount of public obligations each year via QE, the situation will very soon become problematic. The new update of the IMF’s Global Debt Database shows that total global debt (public plus private) reached US$188 trillion at the end of 2018, up by US$3 trillion when compared to 2017. Ponder how these figures will look at the end of 2020 after a year of dealing with the coronavirus. “The global average debt-to-GDP ratio (weighted by each country’s GDP) edged up to 226 percent in 2018, 1½ percentage points above the previous year,” the IMF notes. “Although this was the smallest annual increase in the global debt ratio since 2004, a closer look at the country-by-country data reveals rising vulnerabilities, suggesting that many countries may be ill-prepared for the next downturn.” China, of note, has seen the fastest growth in its debt load, this as the Chinese Communist Party has turned to ever larger and more ridiculous types of public spending to keep the nation’s 1.4 billion citizens cowed and under control. We are now into year five of the great debt deflation in China, which was signaled by the collapse of HNA Group and Anbang Insurance and the growing red ink in China’s overall payment flows. Again, ponder China's debt numbers in 2020. Source: IMF We wrote in The American Conservative last week that much of China’s pile of debt is really just deficit spending in disguise: “The collapse of heavily indebted Chinese companies such as HNA and Anbang Insurance Group several years ago illustrated the growing pressure on the Chinese economy caused by hundreds of billions of dollars in subsidies to state companies and local governments that are treated as ‘debt.’” Yet even with the consternation over China, any correction in equity markets as a result of reduced expectations for growth due to COVID-19 will be quickly overwhelmed by the rising demand for dollar assets. The world already had a propensity to hold dollar assets before the start of the year, but as 2020 progresses, the downward pressure on US interest rates will become intense. Should the US central bank, as well as the European Central Bank and Bank of Japan , be buying dollar assets via QE when the rest of the world is piling into risk free securities as well? You can be sure that Governor Lael Brainard and the rest of the FOMC will never ask that question – at least not in public. That would involve an open admission of policy error, something that Federal Reserve is unable to accept. But to be fair, the concept of delegated infallibility is well established in Washington agencies, most notably Defense, Treasury and particularly FiNCEN. We have long maintained that the decision first by the BOJ, then the Fed and ECB, to force interest rates negative via public asset purchases was inevitably deflationary. The diversion of interest payments from private investors to governments, and the reduction in carry on assets generally, reduces private leverage on capital and also current income. We suspect that the deflationary effects of QE cause consumers and investors alike to become ever more cautious. The good news, of sorts, is that inhabitants of the dollar zone will continue to benefit from the spreading deflation in China and the rest of the world as the dollar soars. So long as the dollar remains the global means of exchange, the US under Donald Trump can seemingly issue infinite amounts of debt in competition with profligate communist China, which of course will hyperinflate endlessly to forestall political unrest. The bad news, again in relative terms, is that real inflation on a personal level in the US will remain brisk, with prices for housing and financial assets continuing to rise and with it the true cost of living in dollars. Even in the event of a global debt crisis and restructuring, perhaps by Italy and/or China in several years’ time, we suspect that the demand for fiat dollars will only grow. Global central banks are deliberately engineering a shrinkage of the stock of risk-free assets via asset purchases or QE. This continued manipulation of credit spreads is perhaps the single biggest risk to the market in 2020. We wonder when the FOMC will realize that it is easier to be a price setter rather than trying to physically manipulate the short-term money markets.

New York | This week in The Institutional Risk Analyst , we review the new book by David Enrich , “ Dark Towers: Deutsche Bank, Donald Trump, and an Epic Trail of Destruction. ” Enrich is currently financial editor at The New York Times and was previously an editor at The Wall Street Journal covering financial institutions. This important book puts in perspective the history of Deutsche Bank AG (NYSE:DB) , one of the most mismanaged and politically tainted global banks in modern history. “Dark Towers” also tells the story of how Deutsche Bank provided $2 billion in financing to President Donald Trump , cash that enabled the former real estate developer to continue in business despite his many poor business decisions and credit defaults. As the book makes clear, the only reason that Donald Trump was able to win the American presidency was due to the financial support of Deutsche Bank over more than two decades. Reading “Dark Towers,” one is left with the impression that Deutsche Bank is less a financial institution and more an ongoing criminal enterprise. We published a negative credit profile of DB earlier this year , but frankly our assessment was far too generous. Deutsche Bank cut a swath of destruction “and is about the consequences—dead people, doomed companies, broken economies,” Enrich writes, “and the 45th president of the United States—that Deutsche Bank wrought on the world.” From the founding of Deutsche Bank in the 1870s, to the bank’s near failure financing an American railroad baron, to its active support for the Nazis under Adolf Hitler , to its involvement in money laundering, risky derivatives and the subprime mortgage crisis in the early 2000s, the history of the “German Bank” is a tale of malfeasance and mismanagement that has few equals. As we said to a senior Fed official last week: Everyone in the Federal Reserve System needs to read this book and ask a basic question: why was this bank not shut down? The simple answer is politics. The Fed and other agencies would not or could not do their jobs as required by US law for fear of the political ramifications in Germany. “Dark Towers” follows the transformation of Deutsche Bank from a small, relatively low risk institution that existed after WWII to a malignant cancer on the body of global political economy. The bank’s focus on derivatives and investment banking, albeit as a second-rate player in the global capital markets, is presented in simple terms that leaves a sense of astonishment, even for veteran risk professionals. The poorly considered strategies, acquisitions, and geopolitical machinations of Deutsche Bank are skillfully described in a concise yet detailed fashion, reflecting hundreds of interviews and thousands of documents obtained during the research for the book. Enrich follows the tragic careers of Edson Mitchell and his sidekick and best friend, Bill Broeksmit , who took his own life in 2014 when the businesses accumulated within Deutsche Bank starting in the 1980s finally exploded two decades later. Neither the Federal Reserve System, EU regulators, Deutsche Bank’s management nor the German government are spared from the harsh light of scrutiny that this book brings into sharp focus. The fact that Deutsche Bank laundered billions in dirty money for the likes of Russian dictator Vladimir Putin and others via Deutsche Bank Trust Company in New York raises basic question about the efficacy of the bank supervision functions of the Federal Reserve, the State of New York and other agencies around the globe. The fact that Deutsche Bank's US subsidiary was home to both the Trump loans and the money-laundering Russian mirror trades makes the culpability of American regulators even more alarming. While the Fed emerges badly tainted from the narrative so skillfully presented in “Dark Towers,” the incompetence and indifference of European regulators and political leaders also is laid bare. The role played by former Deutsche Bank CEO Josef Ackerman , in particular, is painted by Enrich as being extremely damaging to the bank and the global financial system. Starting from the acquisition of Morgan Grenfell in 1990 and then Bankers Trust a decade later, Deutsche Bank officials oversaw a sharp increase in the bank’s risk-taking activities that was neither prudent nor well-supervised. By the time Ackerman left Deutsche Bank in 2012, the bank was the largest in the word but was also in serious trouble, difficulties that would bring it to the brink of financial failure. In particular, Ackerman’s obsession with an absurd 25% target for equity returns and his focus on Russia seemed to doom the bank to take ever increasing risks and violate laws in the search for profits. Enrich writes of Ackerman’s doomed strategy to expand in Russia in the early 2000s: “Doubling down on Russia with the United Financial acquisition only added to the risks the bank was taking. But this was what it took to achieve Ackermann’s return-on-equity target—especially since Ackermann himself was an unabashed cheerleader of the bank’s expansion into Russia. Just as Georg von Siemens’s entrancement with the United States had led Deutsche into the Henry Villard swamp a century earlier, now Ackermann’s fixation with Russia would spur Deutsche into a similar quagmire. Like Siemens in America, Ackermann was blinded by his fascination with Russian culture and had developed tastes for its theater, opera, and food (blini with caviar was among his favorite dishes). He visited the country as much as once a month, striking up what he described as friendships with some of the bankers in Vladimir Putin’s inner circle.” At times the story told in “Dark Towers” is extremely sad, particularly following the trail of dead bodies that seemed to follow this very large global banking institution. At other times, the narrative will almost seem absurd to financial professionals as the accumulation of poor management decisions and outright criminality created an impossible situation. Enrich writes: “Inside Deutsche, some senior executives, including Anshu Jain , warned Mitchell that Bankers Trust was a third-rate institution with a lot of third-rate employees and a deep well of managerial, financial, and accounting problems. Jain expressed his preference to acquire a more conservative and well-respected firm like Lehman Brothers .” The deliberate indifference to risk and the overt willingness of Deutsche Bank officials to engage in money laundering, fraud and other wanton acts of criminality raises basic questions about the ability of governments in the EU to regulate financial institutions. Officials up to the board level of Deutsche Bank, for example, apparently were aware of illegal activities such as providing billions in cash to the Revolutionary Guards in Iran, yet did nothing to stop the activity. Enrich reports that “By 2006, Deutsche had zapped nearly $11 billion into Iran, Burma, Syria, Libya, and Sudan, providing desperately needed hard currency to the world’s outlaw regimes and singlehandedly eroding the effectiveness of peaceful efforts to defuse international crises.” The book seemingly confirms a 2018 lawsuit which alleges that Deutsche played an “integral role in helping Iran finance, orchestrate, and support terrorist attacks on U.S. peacekeeping forces in Iraq from 2004 to 2011.” The book also documents the role of Deutsche Bank in financing the real estate activities of President Donald Trump, presenting a textbook case of failure to manage credit and reputational risk. The comical situation where one arm of Deutsche Bank refused to lend to Trump while another aggressively pursued his business provides a classic example of “unsafe and unsound” banking practices in the United States. But, again, the Federal Reserve Board and other US regulators repeatedly refused to shut down this renegade institution. Enrich describes how “for nearly two decades, Deutsche had been the only mainstream bank consistently willing to do business with [Trump]. It had bankrolled his development of luxury high rises, golf courses, and hotels. Over the past eighteen years, the bank had doled out well over $2 billion in loans to Trump and his companies…” “Dark Towers” is an important and very timely book. It reveals the seamy underside of the world of illicit banking and money laundering but also documents the incompetence of regulators in the US and Europe. This book makes a mockery of American banking and anti-money laundering laws, and raises basic questions about the state of prudential regulation on both sides of the Atlantic. The role of Deutsche Bank in these activities was a deliberate choice by management that is impossible to explain away as the result of innocent errors and omissions. Here was a bank that decided that it needed to be large and hyper-profitable, and was willing to do literally anything to achieve these goals. As readers of The Institutional Risk Analyst know well, when a bank pretends to deliver supra-normal equity returns without excessive risk, you can be sure that there is something wrong with the institution. After reading “Dark Towers,” most reasonable observers will ask one basic question: Why is this bank still open for business at all but specifically in the United States? Sadly, neither officials of the Federal Reserve Board, the US Treasury nor the other agencies responsible for oversight and surveillance of financial institutions and markets have ever been called to account for their failure to supervise Deutsche Bank. " China’s Iron Fist Is Turning The Coronavirus Into An Economic Disaster " The American Conservative

New York | Last week, Goldman Sachs Group (NYSE:GS) held its long awaited investor day event. As GS says on its web site: “Our senior leadership team delivered presentations on the firm’s strategic priorities and how we are focused on driving shareholder value.” The message was tight, the presentation polished as usual – but not entirely well-executed. GS made its treasured investors wait through hours of banal presentations before allowing any questions. The PPT runs to 263 glorious pages of investment bankster BS . There was even the required panel on “sustainability.” The conversation between GS and investors could have taken 90 minutes and ten slides, but GS instead took a whole day from investors and still did not answer the question. What are you going to do with the business? Images were conjured, horizons were illuminated. China, post corona virus of course, was dangled before investors as a possible revenue driver. GS talked about few tangibles during the presentations, but some were notable. Increasing FICC revenues, for example, while driving down funding costs by $250 million out of $13.5 billion in quarterly interest expense over three years. No, talk to us about how much funding costs will rise in 2020. Fact is, GS is too small to be credible as a commercial bank and too big to just be a nonbank broker dealer. And still there is no talk – yet – about a transformational transaction to grow deposits and add real stability to the business. Recall that of $1 trillion or so in total assets, GS has less than $70 billion in true core deposits. Compare that with U.S. Bancorp (NYSE:USB) , for which we own the common and preferred, with half the assets, $400 billion in core deposits and among the lowest cost of funds of the top five money center banks. Yes, USB is a money center bank, GS is a customer of the larger banks. Source: FFIEC When GS talks about being competitive as a lender without growing the bank significantly – i.e hundreds of incremental percent of core deposits - that is your signal to call “bullshit” in a loud and clear voice. We’ve suggested acquiring Key Corp (NYSE:KEY) because of the $100 billion in core deposits and the focus on commercial real estate financing and servicing. But there was no significant discussion of a large acquisition/merger last week during GS investor day. To us, GS should display those famous corporate huevos and go cut a merger of equals deal with U.S. Bancorp. Let the bankers run the bank while the GS traders and investment bankers focus on advisory and asset management. Combined company would be more than big enough to go toe-to-toe with Jamie Dimon and JPMorgan (NYSE:JPM) . But do the Goldman bankers have the courage to just let go of the old club house? Combined USB+GS entity would trade above 2x book with the assurance of $500 billion in core deposits. Yet in the entire GS Investor Day there is no focus on real change which means becoming a big bank. Instead, there is a lot of consultant ya-ya that says that David Solomon and his colleagues intend to continue doing business as usual. The stock closed above book value on Friday, but only after giving up double digits on Thursday and Friday. Suffice to say that GS will remain in the IRA Bank Dead Pool for now. In related news, another member of the IRA Bank Dead Pool – Citigroup Inc. (NYSE:C) – is reported to be gearing up to re-enter the market for government insured mortgage loans. Bank have generally fled from the market for FHA/VA/USDA loans and GNMA securities because of poor profitability and the outsized risks involved in facing Uncle Sam as a business partner. Watching Citi diving back into the subprime mortgage market brings back some difficult memories, but also is relevant to a discussion of retail opportunities. In the early 1980s, as the nonbanks known as S&Ls were headed into the wood chipper of mortgage finance, Citi introduced a new global product called “Mortgage Power.” This no doc, no-income verification product was designed for the self-employed. This was the first truly subprime, no-doc mortgage product offered by a large US bank. By the early 1990s, Citi’s credit losses in mortgages were in double digits, not just in the US but in a number of other markets around the world where this subprime loan product was available. Mortgage Power was shuttered for a few years, but by 2000 Citi was ready to dive back into the subprime mosh pit. The bank acquired Associates First Capital Corporation for $31 billion in September of that year. Citi’s acquisition of the largest American consumer finance company set the stage for the bank’s collapse in 2008. ''This transaction really fits better than most anything that we could think about,'' said Sanford I. Weill , then chairman and chief executive of Citigroup, of the Associates acquisition. ''From the consumer finance point of view, the exciting thing is the global presence.'' Weill eventually would be forced out of Citi by the WorldCom scandal. The Associates transaction, which was approved by the Federal Reserve Board and other agencies, set the stage for the failure of Citigroup less than a decade later. So when these same federal regulators talk to us about the risks from nonbanks, which have never caused a systemic event, we point to banks like Citi and Wachovia and WaMU and Countrywide as the true examples of reckless, idiotic behavior in the world of residential mortgage lending. Citi, in particular, was responsible for socializing the no-doc, no-income verification subprime toxic loan into the world of commercial banks. In the 1980s, commercial banks did not make unsecured loans to consumers. But Citi blazed the subprime trail. Everything that followed, including Lehman Brothers and Bear, Stearns & Co came from that tainted subprime wellspring created by Citi two decades before with “Mortgage Power.” Should Citi actually re-enter subprime mortgage lending in the government-insured market, then we’d take that as a sign that the post-2008 cycle in mortgage credit has truly troughed. Source: FFIEC The moral of the story with respect to both Citi and Goldman Sachs is that there is no salvation awaiting either of these underperformers in the world of consumer finance or retail wealth management. The internal customer default rate target of C is a good bit higher than that of GS, probably “B”/”CCC” on average. But Citi at least gets paid double digits for taking risk on consumers, one reason that the underperforming commercial bank makes money overall. The story coming from GS is more dire. When the house built by Marcus Goldman, Samuel Sachs and Sidney Weinberg on institutional business tells you that it is going retail, meaning down market and down in average customer size, to find profits, there is good reason to be skeptical. Down is the land of Deutsche Bank AG (NYSE:DB) and HSBC Group (NYSE:HSBC) , two other members of The IRA Bank Dead pool that we shall discuss in a future comment. Coming to Dallas Next Week?

Washington | Last week, we released a paper rebutting the 2019 report by the Financial Stability Oversight Council (FSOC) , which claims rather incredibly that nonbank mortgage servicing companies could pose a “systemic risk” to the markets and the US economy. The FSOC report singles out potential risks arising from nonbanks servicing defaulted mortgages and also risk to banks providing loans to finance these activities. Do Nonbank Mortgage Companies Pose Systemic Risk to the US Economy? [ https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3519454 ] The notion that cash generating asset managers like mortgage loan servicers could cause a systemic risk event is pretty laughable. Read the FSOC paper and references if you want details, but the agency seems to be again ignoring market basics as well as the public record in formulating its dire pronouncements. We said as much in an interview in Real Vision , released yesterday. The Dodd-Frank agency FSOC asserts with respect to nonbank mortgage servicers that "if delinquency rates rise or nonbanks otherwise experience solvency or liquidity strains, their distress could transmit risk to the financial system." The FSOC report provides no analytical backing for this sweeping statement and ignores the highly detailed public record with respect to the insolvency of nonbank mortgage companies that goes back decades. The FSOC report states: "Widespread defaults or financial difficulties among nonbank mortgage companies could result in a decline in mortgage credit availability among these borrowers." Again, the FSOC offers no analytical backing for this statement and ignores the public record of defaults by nonbank finance companies. We’ve written several papers on the topic of muneris interruptio since our days at Kroll Bond Rating Agency . As with the unfortunate case of MetLife (NYSE:MET) , the FSOC report is based on “implausible, contrived scenarios” rather than “substantial evidence in the record” and “logical inferences from the record.” We don’t think that the FSOC articulates a credible scenario for the systemic failure of a nonbank residential loan servicer. Simply stated, the scenario advanced by staff from the Federal Reserve Board and the Conference of State Bank Supervisors seems disconnected from current commercial practice in the market for secured financing. Former New York Fed Chief Gerald Corrigan defined a systemic risk as when markets are surprised. The shock in 2008 caused such dismay among investors – and eliminated market liquidity in mortgage backed securities -- that Lehman Brothers, Bear Stearns, American International Group (NYSE:AIG) and Citigroup (NYSE:C) all failed as a result. Surprise in the financial markets stems from an asymmetry between information and risk. When the imbalance is repaired, money moves – sometimes violently -- to restore the balance between perception and actual risk. Banks such as Citi and Deutsche Bank (NYSE:DB) , which have in past hidden risk from investors, have suffered severe consequences and, in one case, failed and caused a systemic shock. Nonbank companies, by comparison, tend to die quietly in the hands of a US Bankruptcy Trustee. Concealing material information with respect to a security is still fraud in the US, thus the cause of a systemic risk event would seem likely to involve fraud. The tough part for the FSOC, of course, is identifying the particular information asymmetry and related mispricing of securities such that a systemic risk event might occur. Sadly, the mission of the FSOC strikes us as a fool’s errand. No agency is likely to predict the next market break. As we noted in our conversation with RealVision , the FSOC agencies will be the last to know about future market contagion. Because predicting a systemic market break is essentially impossible, the FSOC instead has decided to focus on companies or even whole industries that might be catalysts for market breaks. The 2019 FSOC report mischaracterizes the risk from nonbank mortgage companies and also does a disservice to the commercial banks operating in this sector as lenders. If a “systemic event” did not occur in 2018, when much of the mortgage lending industry was losing money, then it is not likely to occur dear colleagues. The FSOC report illustrates the intellectual bias against nonbank companies that exists in much of the regulatory community, both in the US and around the globe. The term “shadow banks” is pejorative and demeaning to private sector firms, but is frequently used by regulators and researchers when discussing nonbank financial firms. Nonbank companies represent the private sector, while commercial banks are government sponsored entities (GSEs) that enjoy enormous subsidies such as federal deposit insurance, access to the Fed’s discount window and the Federal Home Loan Banks. Commercial banks operate with leverage ratios of 15:1 or higher, when off-balance sheet exposures and derivatives are considered. Even with these advantages, however, commercial banks are far less efficient than their nonbank peers when operating in the mortgage market. As a result, some regulators view nonbanks as a threat to commercial banks. We can think of lots of areas in the market today that warrant concern when it comes to systemic risk, but nonbank loan servicing is definitely not one of them. We work in the sector as advisors to a number of players in the world of mortgage finance, so call us biased. But the FSOC’s report is a bad piece of work and an embarrassment to Treasury Secretary Stephen Mnuchin . If we were talking about lenders or issuers of securities, for example, there might be a basis for an interesting conversation. But to focus the FSOC’s attention on mortgage servicing suggests a misunderstanding of the world of secured financing and the multi-trillion dollar “too be announced” or TBA market for mortgage agency collateral. Looking at the world of finance, the chief risk to the system is the growing atrophy of banks in the EU and Asia, particularly Japan, and related extensions of risk to compensate. Thus, came the world of transformation repo. Off-balance sheet dollar financing. And before that, off-balance sheet finance by US banks. All of these concessions to the zombie banks create systemic risk by the bucketload. When we asked Paul Volcker in 2017 about allowing banks into off-balance sheet finance, this after the Third World debt defaults of the 1970-80s, he answered: “They were broke. What else could we do?” At the end of the day, for all of us it’s all about hiding the risk, maximizing the rating and minimizing the spread over funding -- for the entire world. Thus we think that the next systemic risk event could very well originate outside of the regulated US market. So much for our Platonic guardians.

New York | In this issue of The Institutional Risk Analyst , we ponder the unfolding ninth sovereign debt default of progressive Argentina, this from the perspective of neighboring Uruguay. The convenient muñeca , President Alberto Fernandez , is steering the Argentine ship of state onto the rocks, again. The puppet master, Cristina Elisabet Fernández de Kirchner , holds the title of Vice President and is the power-in-fact in Buenos Aires. Bendict Mander , writing for the Financial Times , reports that the Fernandez government is content with a 40% inflation rate in 2020. A steady run of dollars from Argentine banks suggests that the situation is neither stable nor likely to be improving in the near term. The imposition of a 30% tax on foreign credit card transactions will further drive away dollars from the domestic economy. The Argentine peso has lost more than half its value since before the election of the Fernandez government, but Uruguay has largely held its ground and now its currency trades at a substantial premium to Argentina. But the Fernandez y Fernandez regime is fast burning through its remaining dollar reserves and a future, maxi currency devaluation may impend. The default of the province of Buenos Aires this past week, we note, could be the start of a more generalized default by Argentina and perhaps leading to other sympathetic events of default. Argentina was as much a beneficiary of “quantitative easing” as corporate bond issuers in the US. All manner of corporate and sovereign debt is mispriced by a least a full ratings category. A number of financial analysts fret about the corporate debt overhang, yet the state of the offshore dollar debt market strikes us as a bit more alarming. The assumption that there will be a new debt deal for Argentina by March deserves careful inspection. The International Monetary Fund , which less than a year ago touted the success of Argentina, has more than half of its total exposure tied to Buenos Aires. “This is the biggest single programme that they’ve ever put up, and their reputation is on the line,” said Bill Rhodes , a former top Citigroup (NYSE:C) executive, to the FT last year. Meanwhile across the Rio de la Plata in Montevideo, economic prospects are rising. The new government of Luis Lacalle Pou , the son of a former president of Uruguay, is planning to restore his nation’s role as the Switzerland of Latin America. Known as “ ququito ” in honor of his much-admired father, Luis Alberto Lacalle, the new Uruguayan leader is facing a number of challenges and also some great opportunities. While Argentina and Brazil have defaulted on their debts in the past, little Uruguay has been remarkably stable and in years past was the domicile of choice for residents of surrounding countries. Prior to the Argentina debt crises of 2001, many US and European banks were deposit takers in Montevideo, including Republic National Bank and Israel Discount Bank of New York. Private banks and family offices proliferated in the 2000s. Even as Argentina defaulted on some $95 billion in debt, little Uruguay stood its ground and honored its commitments at par in those dark years, but got little credit for doing so. Lacalle Pou, who will take office on March 1, wants to loosen regulations to attract Argentine businesses and get them to bring their money and perhaps even settle permanently in Uruguay. But President-elect Luis Lacalle Pou’s proposal of attracting Argentine investment and immigration does not have the approval of one his predecessors, José ‘Pepe’ Mujica. Mujica, a former terrorist, served as president of Uruguay from 2010 through 2015. During his benevolent rule, the foreign media compared Mujica favorably with Jesus Christ. The cumulative negative impact of the policies followed by Mujica and his successor led to Lacalle Pou’s election late last year. Under two successive leftist regimes, the civil society in Uruguay was weakened and social insecurity was rising. Crime was on the increase and the government’s fiscal affairs were slipping, leading some analysts to predict that Uruguay would lose it coveted investment grade rating. But with the defeat of the “Frente Amplio,” as the Uruguayan left tendency is called, Uruguayans are hopeful that civil order and fiscal discipline will be restored to a nation that has one of the strongest civil societies in Latin America. The troubles in Argentina, however, will likely make Lachalle’s job of attracting new investment to Uruguay far easier. Over the Christmas holiday, which stretches from before the 25th of December to the Día de los Reyes Magos on January 6th, there were fewer Argentine’s in evidence at the beach or in the stores and cafes of Punta del Este. Yet the prospect of years of socialist misrule under the Vice President Fernandez will likely drive a good bit of cash and investment to Uruguay. Some of the major multifamily real estate projects in Montevideo and in Punta del Este are owned and managed by Argentine families with a long history of successful development projects from Chile to Miami. Several people close to this community of developers predicted that the flow of new capital is likely to be directed to Uruguay because of the change in government and the general economic success and stability that Uruguay has enjoyed in recent years. Indeed, during our trip to Uruguay we heard that the long-delayed project sponsored by the Trump Organization will now be completed. Moribund for some five years, the Trump Tower project was backed by Argentine investors and is located in a prime position on the ocean or “ playa brava ” side of Punta de Este. The Institutional Risk Analyst is told that, since the Argentine election, the money has been committed to finish the project. As the peso continues to lose value under the projected mid-double-digit inflation rate in 2020, Uruguay’s largely dollarized economy will continue to attract investment from a variety of investors around the globe. The Finnish forestry giant UPM-Kymmene Oyj and Swedish-Norwegian-Uruguayan businessman Alex Vik are just some of the global investors that have made substantial commitments to Uruguay in recent years. The situation in Argentina, however, may hold serious potential for systemic contagion in 2020. Many investors have been lulled to sleep when it comes to credit default risk. As it becomes apparent that the IMF is not going to rescue Argentina, and also that the US is not going to rescue the IMF from its folly under Director Christine Lagarde , investors may back away from Argentina. The combination of a default by Buenos Aires later this year and a potentially crippling loss to the IMF could be a bit more of a surprise than the financial markets have comes to expect in recent years. Further Reading Return of banks to government loan market still doubtful National Mortgage News https://www.nationalmortgagenews.com/opinion/return-of-banks-to-government-loan-market-still-doubtful Mexico: Policy Failure, Moral Hazard, and Market Solutions Cato Institute Policy Analysis No. 243 (1995) https://www.cato.org/sites/cato.org/files/pubs/pdf/pa243.pdf

José Ignacio, Uruguay Punta del Este | As we head into Q4 2019 earnings this week, US financials have never been so expensive and risk indicators have never been so skewed. Just as last July we called the problems brewing in the short-term money markets in a discussion on CNBC's Halftime Report with Mike Mayo of Wells Fargo (NYSE:WFC) , today we want to put down a marker regarding the concealed credit risk inside US banks. Our favorite bank portfolio holding, U.S. Bancorp (NYSE:USB), closed Friday at 1.87x book value, down about 5% from the peak in December just over $60 and 2x book. Still a little too rich to add more to our portfolio of USB common, but we continue to accumulate a number of bank preferred issues. With the number of profitless unicorns dying at an accelerating rate, steady cash flow has a certain appeal right about now. More important, credit default swap (CDS) spreads for high quality issuers are also at all time lows. JPMorganChase (NYSE:JPM) is inside 40bp or around a “A” rating for the largest bank in the US. In 2015, JPM’s CDS was trading close to 120bp over sovereign swaps. Question is, does the market know, really, how much risk sits on Jamie Dimon’s books in the world of corporate CDS and more obscure credit products, like “transformation repo.” We think not. For those not familiar with the wonders of OTC derivatives and collateral swapping, see our 2019 comment “ HELOCs and Transformational REPO .” We wrote in March of last year: “The dealer bank trades corporate debt for cash (for a fee), but uses its own government or agency collateral to meet the margin call for the customer. The bank holds the crap and all of the market and credit risk – sometimes for its own book, sometimes for clients. Tales of MF Global . Recall that the margin rules in Dodd-Frank and other laws and regulations around the world are meant to increase the proverbial “skin in da game” for swaps customers, especially the non-bank customers of banks.” Outgoing Bank of England governor Mark Carney worries that the global economy is heading towards a “liquidity trap” that would undermine central banks’ efforts to avoid a future recession, according to the Financial Times . Former Fed Chairman Benjamin “QE” Bernanke is screaming for new fiscal policy measures to combat a non-existent recession – this as the negative after effects of “quantitative” monetary policy measures are growing. These central banksters may be right, but to us the bigger question is the unrecognized threat to the financial system from underpriced long-credit positions embedded on the balance sheets of global banks and bond funds. Bank interest earnings have long been subsidized by QE, but now banks are being squeezed by the same forces of market manipulation as credit starts to roll over. Suffice to say that the Street seems to finally understand that bank earnings are going to be a tad light, again, this quarter, due to the hangover from Uncle Ben’s QE electric KoolAid. The chart below shows net interest income for JPM. Source: FFIEC Despite the rosy economic outlook, bears continue to see reasons for despair in the world of credit – and we agree. The repo market sailed through year-end cushioned on a soft pillow of liquidity provided by Federal Open Market Committee . With the Fed announcing an end to the not-QE liquidity injection operations, though, we look forward to the next learning-by-doing adventure from Federal Reserve Chairman Jerome Powell . Should the repo markets again start to seize up when the Fed ends its extraordinary liquidity injections, then Chairman Powell’s job may actually be on the line – and not because of President Donald Trump . The looming threat to Powell and other members of the FOMC is the tightly coiled but largely invisible long credit/short put positions on the books of major banks. This is a largely hidden risk that arises from years of market manipulation by global central banks. But hold that thought... We appreciate the flow of questions and comments about the latest IRA Bank Profile on Deutsche Bank AG (NYSE:DB) . As we wrote in the profile: “We assign a negative outlook to DB and have little expectation that the situation will change in the near term. In our view, the most promising way to resolve what is an increasingly precarious situation would be for DB to sell its US operations in their entirety and wind up the remaining bank operations. Since Germany political leaders refuse to consider such a possibility, we expect that DB will stagger along, depleting capital and creating outsized risks, until such time as the bank’s poor management makes a mistake of sufficient magnitude to cause the bank to fail.” Just to review, DB is one of four value destroyers in The IRA Bank Dead Pool . Banks that are members of the IRA Dead Bank Pool have poor financial performance, inferior equity market valuations and no apparent plan to correct these deficiencies. Even with US financials at the highest equity market valuations in a decade, the four institutions in the IRA Dead Pool – DB, Goldman Sachs (NYSE:GS) , Citigroup (NYSE:C) and HSBC Holdings (NYSE:HSBC) – all trade at or below book value. DB has the lowest multiple of equity price to book value of any major bank. In a recent twitter post, our pal @Stimpyz1 reminds us that negative interest rates are not the only source of risk to global banks. “Deutsche bank might be in the crosshairs, but don't forget HSBC," he avers. “Hong Kong is looking like a black hole, and HSBC exposure to real estate on the island makes the DB balance sheet look like Microsoft .” Like DB, HSBC’s US operations are in pretty bad shape, with years of credit losses and poor operational performance. Once upon a time, HSBC was a good comp for Citigroup, but today we would not even bother running the numbers. But when it comes to risk, we are far more focused on the bond market than banks, which are generally under-leveraged but contain a lot of undisclosed credit risk. The lingering negative effect of the Bernanke-Yellen monetary benevolence is so pronounced in fixed income that a number of institutional managers we know have begun to lighten up on investment grade (IG) exposures based on the belief that a ratings-driven correction is coming. Michael Carrion of TCW wrote before the holiday: “Much ink has been spilled this year on the topic of how strong the technicals are within the investment grade credit market and for good reason as they have been the dominant underlying driver of overall IG spreads all year. The resurgent strength derives from this year’s re-expansion of central bank balance sheets, which has resulted in a relentless supply/demand imbalance for IG bonds. Demand for IG credit reached a year-to-date peak in November, particularly in the second half of month as the pace of primary market new issuance slowed.” Patti Domm of CNBC , quoting a research report from Hans Mikkelsen , head of investment grade corporate strategy at BofA Securities, wrote after the close on Friday: “ Lured by low rates, companies issue high grade debt at one of the fastest paces ever this week ,” this as interest rates touched a three-year low. The combination of market reaction to political uncertainty and central bank purchases of risk-free debt has created a credit trap for global banks and bond investors. One of the things we learned from our colleague Dennis Santiago years ago at Institutional Risk Analytics is that when a credit spread looks to good to be true, it probably is. In those days, we’d convert the apparent default rate of a bank portfolio into a bond rating equivalent, then look at loss given default (LGD) to try to figure out how much the rate was understated. Today LGDs in the real estate sector are so skewed as to suggest that default rates are understated by at least 100%. At the end of Q3 2019, the implied rating on the 0.51% of gross defaults for the $10.5 trillion in loans held by all US banks mapped to a “BBB” rating using the S&P default scale. If you believe that the aggregate rating of all obligors of US banks is investment grade, then we have some WeWork shares we’d like to sell you. Step right up. Source: FDIC The issuance of IG debt has set new records for the past several years, but most of this paper is clustered around “BBB" ratings. This suggests that the proverbial lemmings could fall off of the ratings cliff with little or no notice. As we all hopefully learned in the Adam McKay film “Big Short,” the major credit rating agencies don’t have the capacity or the courage to react quickly as and when economic and/or market conditions dictate a change for dozens of issuers. The investors that own long positions in underpriced corporate risk positions will be long dead before the ratings change. The potential ratings volatility embedded in corporate debt has huge implications for banks, which have been “transforming” crap collateral into high IG in order to partially satiate the investor demand for low- or no-risk paper. TCW confirms our earlier colloquy with @Stimpyz1 on Twitter the other day: This implies that there is an embedded credit put on the books of a lot of banks and funds as and when the QE party well and truly ends. Perhaps this is why John Carney and Ben Bernanke are so insistent of a shift to fiscal stimulus. But it needs to be said that no amount of fiscal push will fix the credit risk that the Fed and other central banks have created via "quantitative easing." We’ve been talking about the misalignment of credit ratings and corporate fundamentals for the past several years, but the continuation of QE in Europe and Asia has managed to prevent a reversion to the valuation mean. The divergence seen in junk rated collateral sold into collateralized loan obligations (CLOs) and superior credits suggests to us that an adjustment may finally be underway. The inferior assets always fall first. And to recall John Kenneth Galbraith's great book about the 1920s: "Genius comes after the fall." While interest rate movements are suppressing net interest margins at major US banks, the prospect of a wholesale slip below investment grade for literally hundreds of weak bond issuers may be a far more worrisome problem. Bad ratings concealed the true risk in billions of dollars-worth of mortgage backed securities prior to the 2008 crisis. The new area for securities fraud and ratings malfeasance is the corporate bond market. If you think the liquidity problems we saw last summer in plain vanilla repo were bad, imagine what happens when margin calls on collateral swaps start to swamp the dealer banks.

Quantitative Factors At some $1.5 trillion in total assets, Deutsche Bank AG (NYSE:DB) ranks 17th in the world by assets -- if you include the state-owned banks in communist China on the list of global depositories. At the end of 2019, DB closed below $8 per share, equating to 0.2x book value with a projected earnings growth (5 years) of negative 5%. DB is a bank that increasingly has no clear reason to exist. It has been shrinking its assets and off-balance sheet swap exposures as management attempts to rationalize the bank’s business model, but most recently management has backtracked and begun to again expand these activities. Like Citigroup (NYSE:C) and Goldman Sachs Group (NYSE:GS) , DB’s business is heavily focused on capital markets and derivatives trading, and equally light on traditional banking business and core deposits. In the Appendix to this report, we feature an interview with Achim Dübel , who discussed the origins and defects in the business model of DB and other German institutions. Only 30% of the bank’s revenue and funding come from operations in Germany, thus the future of DB as a going concern is largely based upon its foreign non-bank securities operations. Less than one third of DB’s balance sheet is funded with deposits with the remainder supported by borrowings in the capital markets. The table below shows the rough allocation of the assets and pre-tax revenue different business lines of DB: Source: Deutsche Bank The Corporate Bank has displayed relative stability in terms of revenue, but has slipped into loss periodically. The Investment Bank, DB’s largest and most variable business line, has been under pressure in recent quarters. In the nine months ended Q3 2019, the investment bank generated only €537 million in pre-profits or less than half the previous level. One of the difficulties of performing a financial analysis of DB is illustrated by the table above. The presentation of DB financials is opaque to put it mildly. Note that when you add up the total assets of the different business units in the DB Q3 2019 financials, the total is €400 billion less than the €1.501 trillion in “total assets” included in the Q3 financials. The difference is allocated to what DB management calls the “Capital Release Unit,” which is essentially the repository for the bad assets and non-core businesses accumulated over the past decade. There is little or no visibility into the contents of this business unit. One of the most important points to make about DB is that the bank is critically under-capitalized. The €1.5 trillion in total assets is supported by €58 billion in total shareholder equity for a “fully loaded” leverage ratio of less than 4% as of September 30, 2019. Tangible equity is just $51 billion and has been falling for several years. Virtually all of the intangible assets within DB, some $8.9 billion as of 9/30/19, is carried on the books of its top-tier US unit, DB USA Corporation (RSSD:2816906), a $120 billion asset bank holding company that ranks 37th by assets among US banks. The holding company has dozens of US and foreign affiliates, including Deutsche Bank Securities and Deutsche Bank Trust Company. When you subtract the intangibles from the reported total equity capital of DB USA Corporation of $13.5 billion, the common equity of the BHC is essentially wiped out. What’s left is a bit more than $4 billion in perpetual preferred stock. The US unit of DB includes several important business lines that provide administration and custody services to the US capital markets. The chart below shows the results of DB USA Corp as reported to the Federal Reserve Board. Source: FFIEC The management of DB generally does not talk very much about the capital shortfall in its investor presentations, preferring instead to focus on the fantasy view of “risk weighted assets” (RWA) afforded by the Basel framework. DB’s RWA is €344 billion, allowing the bank to report to investors and regulators a ratio of Common Equity Tier 1 (CET1) capital to RWA of 13%. But the reality is very different and raises basic questions as to how DB continues to do business in the US market, at least as a bank holding company subject to regulation by the Federal Reserve Board. Most European banks, like DB, largely play the game of referring to RWA in their financial disclosure to investors. EU bank regulators are entirely complicit in this charade. Indeed, since the end of 2017 DB’s total capital has actually fallen every quarter. The bank has sought for years to raise new common equity, but with the bank’s stock trading at 20% of book value, there is no real possibility of completing an offering of new common shares. The purchase of DB shares by HNA of China using substantial leverage was a ridiculous episode that provided no new common equity to the bank. HNA has largely sold its position in DB as the company has sought to reduce debt. When DB CEO Christian Sewing says that DB’s capital is “at the high end of our international peer group,” he is correct when the focus is only European banks. In comparison with its US peers, however, DB ranks toward the bottom of the list in terms of capital, efficiency and profitability. This is one of the key reasons that we include DB in the IRA Bank Dead Pool. Banks that are members of the IRA Dead Pool have poor financial performance, inferior equity market valuations and no apparent plan to correct these deficiencies. As this IRA Bank Profile was finalized, US financials were at the highest equity market valuations in a decade, but the four institutions in the IRA Dead Pool – DB, GS, C and HSBC Holdings (HSBC) – all trade at or below book value. DB has the lowest multiple of equity price to book value of any major bank. One area where DB has been hurt in Europe is the negative interest rates maintained by the European Central Bank. That said, however, it is important to note that the bank has a higher cost of funds than many of its peers. The chart below shows the cost of funds of DB USA Corporation vs some of the largest US banks and the 128 largest banks in Peer Group 1. At the end of Q3 2019, the cost of funds for DB USA Corporation was 250% of the average for Peer Group 1. Source: FFIEC DB has been mostly focused in recent quarters on decreasing leverage and releasing capital to placate frustrated investors, something that is a positive trend in credit terms but is unlikely to increase profitability in the near term unless accompanies by further cuts in overhead expenses. The transfer of the bank’s Prime Finance and Electronic Equities business to BNP Paribas (BNP) is a key part of this strategy, according to DB management. Qualitative Factors The fundamental issue when it comes to the qualitative analysis of DB is the business model and the bank’s execution of that strategy. Both the management team and the board of DB are culpable in this regard but frankly have few easy choices when it comes to repositioning the bank. Market Strategy First on the list of concerns is market strategy. In terms of management and corporate governance, DB has struggled for years to find a business approach to deliver consistent profitability, the key measure of stability for any bank. The supervising board of DB has likewise been unable or unwilling to make positive changes to the direction of the bank. For the full year 2017, the bank lost €735 million. In 2018, DB delivered a profit of just €341 million. In the first nine months of 2019, DB lost €832 million. As yet, the management team has been unable to articulate a coherent plan to move forward to avoid such poor results. Most recently, CEO Sewing has indicated that the bank wants to grow in private banking, a highly competitive area that is unlikely to yield quick results in terms of business volumes or profits. Of note, in the middle of 2019, DB announced that it was re-entering the market for credit default swaps (“CDS”) as a dealer, illustrating the bank’s desperate need for revenue and, again, raising questions as to the long-term business model of the bank. As noted above, DB shut down CDS trading in 2014 in an effort to de-risk the bank and focus on other areas of banking. “[The] return to CDS trading stands in contrast to the group’s ongoing disposals of assets as it retreats from parts of investment banking, Bloomberg News reported in September of 2019. “Sewing has marked the entire equities trading division and large parts of interest-rate trading for wind down.” While the bank is cutting back in some unprofitable areas such as equities trading, it continues to embrace high risk, highly leveraged activities such as investment banking and derivatives trading as a key part of its business. Risk Management The second factor to consider is risk management. The quantity and quality of DB’s earnings is inferior to that of other large banks operating in the global capital markets. From underwriting sub-prime mortgage loans to money laundering to inferior quality investment banking clients, DB has been willing to accept business from dubious sources in a desperate effort to boost earnings – creating oversize operational and reputation risks for the bank in the process. More, the bank has refused to make adequate disclosure of these risks to investors. One example of DB’s poor management and disclosure of risk is in the US market for subprime mortgages. In 2017, the US Justice Department, along with federal partners, announced a $7.2 billion settlement resolving federal civil claims that DB misled investors in the packaging, securitization, marketing, sale and issuance of residential mortgage-backed securities (RMBS) between 2006 and 2007. The poor quality of DB’s subprime mortgage lending and securitization activity is legendary among institutional investors. The $7.2 billion agreement represented the largest ever RMBS resolution for the conduct of a single entity and included a $3.1 billion cash payment and $4 billion in assistance to relief to underwater homeowners, distressed borrowers and affected communities. Consider another example. In February 2019, for example, the Wall Street Journal reported that DB had lost approximately $1.6 billion over a decade in a bond strategy gone awry, but failed to disclose the loss to investors in a timely fashion. “The loss, which hasn’t previously been reported, represents one of Deutsche Bank’s largest ever from a single wager—roughly quadruple its entire 2018 profit—and ranks as one of the banking industry’s biggest soured bets in the last decade,” Jenny Strasburg and Gretchen Morgenson of the Journal reported. The tendency of DB and other EU banks to fail to perform adequate risk management when it comes to market, operational and other hazards is a serious qualitative deficiency. In a prominent example, the role of DB in laundering billions of dollars for Russian criminals with links to the Kremlin, the old KGB and its main successor, the FSB, badly damaged the bank’s credibility. Last year, DB conceded that the “Global Laundromat” scandal hurt its “global brand” and is likely to cause “client attrition,” loss of investor confidence and a decline in its market value. DB is known on Wall Street as a bottom feeder that supports shoddy deals and is not afraid to use bribery and other questionable means to obtain business. As The New York Times reported in October 2019: “[T]he German lender used gifts and political maneuvers over 15 years to become a major player in China. More than 100 relatives of high-level Communist Party members were hired for jobs at the bank without meeting qualifications, and millions of dollars were paid to Chinese consultants with access to politicians.” Needless to say, there is in DB an appearance of a culture of corruption which carries with it enormous operational and reputation risk for the bank. In an interview with The Financial Times in July last year, CEO Sewing described DB as a business where “we lost our compass in the last two decades.” He accused his predecessors of a “culture of poor capital allocation” and chasing revenue, without concern for sustainable profits. Yet he has never mentioned the poor management and weak corporate governance that allowed these events to occur in the first instance. But perhaps more important than even seeking stable profits is the need to avoid investment banking business that threatens the bank’s reputation and ability to continue as a going concern. It is significant that even as Sewing has focused on reducing risk and leverage, DB has begun to rebuild its investment bank. At the end of 2019, in a change of tone that surprised many analysts, CEO Sewing revised upwards the 2022 financial guidance targets, signaling that the investment bank will again become DB’s fastest-growing business. Liquidity The third qualitative factor, namely liquidity, has been addressed above from a quantitative perspective, but is also a reflection of management and the bank’s reputation. The fact that DB has been willing to follow business strategies that hurt the bank’s reputation and standing with global regulators makes it difficult to convince counterparties to support the bank with either deposits or capital. The bank’s possible role in a vast money-laundering scandal at the Danish lender Danske Bank, for example, marks another instance where DB management and supervisory board failed to adequately oversee the bank’s operations and enforce anti-money laundering laws. These lapses, in turn, have damaged the bank’s reputation, which impacts the ability of DB to fund its operations. Given the clear quantitative evidence in the bank’s US disclosure that the cost of funds for DB is significantly higher than that of its peers, it is difficult not to conclude that poor management is the key contributing factor to this inferior market position. The failure to supervise the bank’s operations and, more important, the choices of business strategy have contributed not only to a sharp drop in the bank’s equity market valuations, but a related increased in the bank’s cost of funds. When an issuer has a deeply depressed stock price, this factor tends to affect debt spreads and credit derivatives markets such as CDS. Early in 2019, DB’s CDS was trading 200bp over the Treasury yield curve because of investor concerns about an imminent default. Since, the middle of 2019, however, the market expectations regarding a default by DB moderated and CDS prices have fallen dramatically. This welcome improvement, however, did not translate into a stronger price for the bank’s common stock. The fact of central bank action to drive down benchmark interest rates and credit spreads must also be factored into the analysis of DB’s improving pricing in CDS. Operating Environment Finally, the global market for universal banks is more competitive now than at any time since 2008. The fact of negative interest rates in Europe, combined with the competition from larger, better capitalized and managed institutions in the US, creates a very difficult operating environment for DB and other European banks. The fact that DB under current leadership thinks that it can grow in areas such as investment banking and CDS dealing suggests that the bank’s management is badly out of touch with reality. In 2019, EU commercial and investment banks across the board saw a significant decline in such areas as equity trading, prime brokerage and investment banking. This is one reason that DB made a decision to sell business units in these areas. In order to replace the lost revenue from these areas, DB decided to move back into CDS trading, albeit limited to cleared swap contracts that have lower capital and margin requirements. As the requirements of Basel III for posting initial margin for many derivatives contracts come into full effect in 2020, however, it remains to be seen whether DB will have the capital to grow or even maintain this business. More, the embedded risk in CDS contracts, which is ultimately tied to credit spreads on individual corporate exposures, creates the potential for future surprises that could put the stability of DB at risk. The huge number of sub-investment grade issuers such as SoftBank, which have traditionally been the sweet spot for DB’s investment banking clients, creates the potential for a negative credit event that could adversely impact the bank. Caught between regulatory requirements, much needed infrastructure investments and cost reduction initiatives, all of the major universal banks in Europe are being squeezed in terms of profitability and are being forced to downsize. Eurogroup Consulting noted in a 2019 report: “US CIBs have strengthened their position outside their home borders notably as a result of a strong domestic market with a more favourable regulatory landscape. European CIBs have been crippled by stringent regulation and scarce resources, whilst attempting to implement cost reductions programmes to address their cost base European CIBs must now consider drastic structural changes and address the fundamental constraints the industry is currently facing: cost inelasticity and revenue decline. They should focus on Asset Industrialisation and Structured Finance opportunities.” Translated into plain terms, DB and other EU banks need to shed high-risk business such as trading and traditional investment banking, and instead become asset managers and originators of structured finance transactions. Models such as UBS Group (NYSE:UBS) , Credit Suisse Group (NYSE:CS) and Morgan Stanley (NYSE:MS) come to mind, but DB simply seems to lack the tools and the vision to make this type of dramatic change. We view the prospect of DB doubling down in markets such as investment banking and CDS trading with alarm and wonder whether prudential regulators in the EU and the US fully understand the implications of the latest strategy pronouncements by DB’s leadership. Assessment After considering the quantitative and qualitative factors affecting DB, its is relatively easy to reach an overall assessment for the bank which is negative. But perhaps the most significant and disturbing factor facing DB is the feebleness of the bank’s management and corporate governance. DB exhibits a striking weakness in terms of business model selection and internal systems and controls, yet the bank seems unable or unwilling to change. Putting scarce capital into growing market share in investment banking, OTC derivatives, leveraged loans and collateralized loan obligations (CLOs), for example, strikes us a distinctly unattractive at the present times. But the fact is that for the past decade or more, DB has made a living of sorts by advising inferior banking clients and underwriting equally suspect assets that other global banks will not touch. The legal and reputational risk from these activities have been enormously costly to the bank and its shareholders. Despite this and other examples of the toxic nature of the DB business, the management of DB, along with the supervisory board as well as senior German politicians up to the highest-level, refuse to accept that the bank has fundament problems. CEO Sewing told investors last year: “[w]e are seen as one of the better banks in this business and, therefore, we see increasing volume.” The vision of DB inside the executive suite as well as in German business circles seems to be taken from a parallel universe where bad intentions and equally bad actions are somehow seen in a positive light. We assign a negative outlook to DB and have little expectation that the situation will change in the near term. In our view, the most promising way to resolve what is an increasingly precarious situation would be for DB to sell its US operations in their entirety and wind up the remaining bank operations. Since Germany political leaders refuse to consider such a possibility, we expect that DB will stagger along, depleting capital and creating outsized risks, until such time as the bank’s poor management makes a mistake of sufficient magnitude to cause the bank to fail. Appendix: Interview with Achim Dübel Achim Dübel on Deutsche Bank AG The Institutional Risk Analyst May 6, 2019 New York | In this issue of The Institutional Risk Analyst , we talk to our friend Hans-Joachim (Achim) Dübel of FINPOLCONSULT in Berlin to provide some context for the latest troubles affecting Deutsche Bank AG (DB) and the German banking system more broadly. Dübel is one of those rare independent analysts of the banking sector in the EU and has worked on a number of internal and external debt restructurings. In our conversation, Dübel reminds us of the obvious, namely that the largest “bank” in Germany is not really a bank at all when compared with US institutions. Even the $2 trillion asset JPMorgan Chase (JPM) is still more than half core deposit funded and boasts a significant loan book focused on small and medium size enterprises (SMEs). A fatal flaw in the business model of Deutsche and many other private German lenders has led to the present juncture. Deutsche seems so toxic due to bad loans and inadequate disclosure that it cannot raise new equity capital or combine with another institution. “In a nutshell, German (and Japanese) banks are traditionally bond buyers and not lenders, notes Duebel. “All of them, not just Deutsche and Commerzbank AG. Germany doesn’t have a pension system, so much of our surplus has to go through bank deposits and bonds bought by banks.” He notes some of the structural differences between banks in Germany and the US, but cautions that these disparities are not sufficient to explain the decline of German banks. “Structurally they didn’t build up international retail and SME lending as opposed to, for example, BNP Paribas (BNP). As their corporate client base increasingly became banks themselves, Deutsche thought they could compensate through trading income,” he notes. “Of course the strong cooperative and public banking system made the domestic retail/SME market difficult, but that is no excuse. Consider the international success of BNP or Société General (SG) against strong domestic co-operative bank competition. German banks used to be internationally strong in Latin America, Russia and the Middle East, these markets are history today.” Once the focus on traditional corporate and SME lending started to fade, Deutsche Bank and others were lured by the big returns of global investment banking, notes Dübel. “Being securities-overweight, they jumped into extremely crowded investment banking, where banking is dominated by the soccer model (most profits end up with staff, not shareholders),” he relates. Dübel notes that Deutsche and other German banks reaped a large share of their profits from taking market as opposed to credit risk, which is extremely curve- and volatility-sensitive. In addition, due to weak regulations, the German banks pushed up risk levels across their portfolio, with disastrous results. “Where they ventured into credit risk especially,” Dübel notes, “Deutsche focused on the synthetic market where it didn’t have a natural hedge due to the absence of a real credit portfolio. They ran into legal troubles when seeking those opportunities in local governments, retail investors, etc. They were brutally hit by adverse selection in bonds from Anglo investment banks during the crisis. And they contributed to inflating the economy of our neighbors and the U.S. via the bond markets. With ZIRP and only low-yield alternatives in the bond market, Deutsche effectively was bailed out by American and German governments without any consequences.” Dübel believes that the key issue as first mentioned is the unhealthy structural development, that is, management mistakes at Deutsche. “Achleitner (Allianz, Goldman) fired Cryan because he wanted to correct the investment banking bias. Now he trapped himself into something worse,” says Dübel. “I believe in contrast that the money laundering allegations against Deutsche Bank are mostly politically driven. Look who is talking. Details are very hard to verify.” Dübel adds: “Also let us not forget that international banking is as brutal as international oil. German banks were strong for example in Russia and Iran – these countries were lost as clients due to political pressure. One serious mistake they made is to leave everything in between Central/Eastern Europe to Italian and Austrian banks. So bizarrely, today Unicredit (CRIN) of Italy is a more serious contender for a Commerzbank takeover today than Deutsche.” As we’ve noted in The IRA previously, Deutsche has been struggling to make a bad business model work for over a decade. Faced with the fatal structural flaws in the business, the bank has drifted without clear direction from its board of directors and management. German pride makes it impossible for the government of Chancellor Angela Merkel to admit the obvious, namely that Deutsche Bank needs to be wound down and sold. And the public anger at big banks makes it politically impossible for the German government to take an example from Italy and lead this process. Thus we wait to see a solution to the financial and operations problems at Deutsche Bank as the moral hazard risk facing the markets grows. The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. 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In this issue of The Institutional Risk Analyst , we ponder the world of fintech, a term everyone in business and finance knows but few can define with any particular detail. There are many companies that claim to be fintech firms, or at least have some components that have these characteristics, but there are very few that we can point to as being truly revolutionary. The term “fintech” is a contraction of two words -- “financial technology.” In a recent paper published by the University of New South Wales , Douglas W. Arner, Jànos Barberis and Ross P. Buckley note that the term fintech “refers to technology enabled financial solutions” that have evolved over the past 150 years. They continue: “It is often seen today as the new marriage of financial services and information technology. However, the interlinkage of finance and technology has a long history and has evolved over three distinct eras, during which finance and technology have evolved together.” Buy the Risk profile of Deutsche Bank AG in The Institutional Risk Analyst online store! The largest strides in the use to technology in the world of finance came many decades ago, when sending physical mail was supplanted by the telegraph and later the telephone. In the 1970s, when the first computers were introduced to banking, the time required to process financing transactions began to fall dramatically. Then, as today, what computers do best is count . Just as the invention of electricity changed industrial processes, the advent of computers to enable automated reconciliation tasks forever transformed finance. Fifty years ago, when some of today’s leaders in the consumer finance sector first entered the business of lending on residential homes, getting a mortgage could take months as data was assembled and validated. Payments were made using checks, which were then manually reconciled and presented to the originating bank. When this writer worked at the Federal Reserve Bank of New York in the 1980s, there were three shifts working 24 hours a day, five days a week, processing cash and checks across the banking system. Airplanes flew bags of paper checks around the country to be processed by the regional Federal Reserve Banks. It is interesting to note that, decades later, the Federal Reserve System still has not extended the hours of the FedWire to evenings or weekends. As we noted in our previous comment (" The Fed Takes a Baby Step Forward in Payments "), the Federal Reserve Board is only slowing bringing the bank-centric payment system in the US up to current technology. Yet despite such impediments, the evolution of technology is changing the way in which finance operates. Obtaining a mortgage today takes just days instead of months. Perhaps the biggest single task in the process is validating the information obtained from the borrower, including checking for fraud. The actual task of documenting the loan and the collateral has been greatly accelerated to the point where it is normally done in days or even hours. A great many of the advances in lending today are more incremental than revolutionary. Eliminating mistakes and the attendant legal and regulatory risks that process faults inevitably create is perhaps as important as speeding the volume of loan applications through the system. Mortgage lenders, for example, profit by making more loans, but making a single bad mortgage can wipe out the profit from hundreds of good loans. Last year, the average time it takes for homebuyers in the United States to close on home purchases was 47 days across all loan types, according to mortgage software company Ellie Mae . But there is natural tension between the desire for more sales and the imperative to avoid costly mistakes. Removing the possibility of mistakes in the loan underwriting process has become perhaps the single biggest goal in the mortgage industry, but is also important across all consumer loan categories. Enhanced productivity with fewer errors is the common goal of any lender facing consumers. For example, many consumer loan vendors provide tools to speed the validation of employment (VOE) by eliminating the transmission of personal financial data through email or fax. Lenders are able to complete more loans in less time. The laborious process of manually reviewing borrower-provided employment data has been replaced by an entirely deterministic process. Other technology providers focused on mortgage lending offer secure environments to assemble and validate all of the information in a loan file, focusing activity within a common digital workspace. Again, the object here is to improve the time required to complete a loan, reduce cost and also avoid errors and fraud that can result in costly credit events. All of these changes are important, but they are hardly revolutionary. Do the companies providing these banal tools deserve nose-bleed valuations? Hardly. As the benefits of technology to all aspects of credit and payments have become increasingly incremental, the hype surrounding the use of technology in finance has soared exponentially. Private equity funds and established companies tout the payback from fintech as though we were all witnessing the invention of electricity or silicon-based computing. But in fact most changes seen in finance today are incremental at best. One of our favorite examples of the ambiguous benefits of what we know as “fintech” is the payments company Square, Inc. (SQ) . Touted as a “disruptive” provider of payment processing for retailers small and large, Square in fact is an overlay of off-the-shelf tools and functionality that operates atop the legacy world of banking and payments. We owned the stock early on when it traded in single digits, but got out when SQ touched $100 per share. Despite the millions of words written about the disruptive aspects of fintech, companies like Square simply provide modern software that sits atop legacy banking systems. Today Square’s equity trades at almost 70 times forward earnings. This is not to say that evolution is unwelcome or without worth, but the value claimed by many "fintech" firms is an exaggeration. The Sell-Side hype surrounding fintech was largely responsible for the rise and fall of SQ, which today trades in the $60s. Lest we forget, payment processing is a legacy bank monopoly jealously protected by the Federal Reserve System and other central banks. Much of payments today follows a linear process map that harkens back to the days of paper before the invention of the telegraph. Fintech companies such as Square are not so much providers of new technology as they are the newest players among commodity payment providers such as Visa (V) and Mastercard (MA) . There is nothing “new” about payments companies such as Square or PayPal (PYPL) , they are simply more nimble than big dumb banks. But the banks will figure it out. There is nothing really new under the sun when it comes to technology, only new packaging and hype in the world of media and investments. Just as today's automobiles are merely evolutions from the original horseless carriages of a century ago, much of FinTech today is merely an evolution of existing technology. Virtually every fintech company we have examined over the past five years represents more a progression from existing tools rather than a fundamentally new process or technique. The next evolutionary step from computers enabling old, linear production processes such as lending will be data-centric applications. In the meantime, maybe it is time for us to stop writing terms like fintech with capital letters and focus instead on how “new” uses of existing technology add value for lenders, investors and consumers as measured in dollars and cents.

"In the last analysis, no mechanical system can be entirely 'fail safe' and also be commercially viable." Paul Volcker 1985 Punta del Este | In the waning days of 2019, the Federal Reserve Board took what is perhaps its most positive and significant policy action of the year – but not by providing liquidity to the money markets or adjusting monetary policy. Rather, the Board of Governors approved modifications to the Federal Reserve Banks' National Settlement Service (NSS) and Fedwire® Funds Service to support enhancements to the same-day automated clearinghouse (ACH) service. Specifically: The National Settlement Service will close at 6:30 p.m. ET, one hour later than its current closing at 5:30 p.m. ET. The opening time for the National Settlement Service will remain at 7:30 a.m. ET. The Fedwire Funds Service will close at 7:00 p.m. ET, 30 minutes later than its current cutoff at 6:30 p.m. ET. The Fedwire Funds third-party cutoff will occur at 6:45 p.m. ET, 45 minutes later than its current cutoff at 6:00 p.m. ET. The opening time for the Fedwire Funds Service will remain at 9 p.m. ET on the previous calendar day. The Reserve Banks will modify their current practice of maintaining a two-hour window between the closing and the reopening of the Fedwire Funds Service to maintain only a 90-minute window. The Reserve Banks will raise the threshold for granting extensions to the Fedwire Funds Service closing time from $1 billion to $3 billion. The Reserve Banks, in consultation with the Board, will determine whether further increases to the threshold are warranted to maintain the regular and consistent open of the Fedwire Funds Service at 9:00 p.m. ET. The Board is amending part II of the Payment System Risk (PSR) policy to add a new 6:00 p.m. ET posting time for same-day ACH transactions, remove the current 5:30 p.m. ET posting time for ACH return transactions, and make conforming changes to the daylight overdraft fee calculation. In a previous issue of The Institutional Risk Analyst , “ George Selgin on Frozen Money Markets & Competing With the Fed in Payments ,” we discussed the possibility of the Fed doing even more to support greater access to real time payments via ACH. While these changes fall short of what we discussed with Dr. Selgin, the additional time allowed for same-day ACH transfers should provide very tangible benefits to consumers and the US economy as a whole. This evolutionary process is difficult for the Fed, in part because of the key role it plays as the hub in the multi-trillion-dollar world of global payments and as liquidity provider to US banks. For many years, the Fed has crafted policy regarding the FedWire and NSS with risk foremost in mind, but advances in technology are forcing the US central bank to move faster in terms of modernizing the world of payments. Many readers of The Institutional Risk Analyst are too young to remember the fateful day in November 1985, when a computer glitch prevented the Bank of New York, predecessor of Bank of New York Mellon (BK) , from settling its daily securities sales and financing positions with the Federal Reserve Bank of New York . A similar problem had almost brought Manufacturers Hanover Trust Co to its knees earlier in the week, forcing the Fed to make an extraordinary $4 billion discount window loan to that entity. In those days, $4 billion was a great deal of money. Jay Rosenstein and Bartlett Naylor described the event in American Banker in December 1985: “The Bank of New York is the primary clearing agent for a number of major Wall Street brokers that buy and sell US Treasury instruments and other government securities. Last month, following a busy day processing transactions, the bank’s computerized link to the government securities network broke down and disrupted processing throughout the market. And since the Bank of New York was unable to transfer securities and collect payment from buyers before the end of the day, it had a deficit in its account at the New York Fed that had to be funded by the $22.6 billion overnight loan.” In 1985, the total assets of Bank of New York were not quite $30 billion, forcing the institution to pledge all of its assets to the Fed as collateral on the discount window loan – the largest emergency advance ever made by the Fed up to that time. The swift action by the New York Fed under President E. Gerald Corrigan averted a calamity, but the event caused great consternation in Congress. In the wake of the Fed’s rescue of Bank of New York, the Board placed additional controls and penalties upon daylight overdrafts on the FedWire. “I am concerned about the apparent concentration of responsibility for government securities transactions among the 35 or so primary dealers,” stated Ferdinand St Germain (D-RI) , Chairman of the House Banking Committee. In a reference to the failure of Continental Illinois Bank only a year before, he asked: “Are we not courting Continental-scale problems by permitting financial operations of such enormous magnitude and significance to be handled by so few institutions?” But the more immediate problem facing the Fed of New York that day was that the 90 minute breakdown in communications between Bank of New York and other firms had caused investors to start turning away from the bank and its clients. The disruption at Bank of New York, while brief, was enough to disrupt the securities markets and cause firms to stop honoring trades. "Most importantly," Corrigan told John Berry of the Washington Post , "there was also some evidence that investors were seeking to break trades and financing transactions with firms serviced by the Bank of New York." At the time there were four large clearing banks in New York, including Irving Trust and Manufacturers Hanover, both of which have since been acquired by BK and J PMorgan Chase (JPM) , respectively. Today the securities markets are even more concentrated and therefore brittle than they were 35 years ago. As the Fed moves forward with efforts to accommodate the ever-growing volume of financial payments and the related need for financing, the institutional memory of not just 2008 but of other, more idiosyncratic risk events such as the near collapse of Bank of New York haunt the dreams of Fed officials responsible for clearing and payments. One senior Congressional staffer focused on payments told The Institutional Risk Analyst : "It is great that the Federal Reserve is preparing to enter the 21st-century just as the rest of us are preparing to enter the third decade of the 21st-century." Suffice to say that the changes implemented by the Fed last week are perhaps less than we'd like to see, but nonetheless are an important step forward in making the dream of same day payments a reality for million of consumers, businesses and financial institutions around the world. ¡ Feliz Año Nuevo !