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New York | This week The Institutional Risk analyst released our latest credit profile on the housing GSEs, Fannie Mae and Freddie Mac, which is now available in our online store . Registered readers received a special coupon code to save 50% through COB this Friday. (Hint: "Calabria") Suffice to say that our outlook on the credit profiles of the GSEs is negative. The posture of the world class regulator, the Federal Housing Finance Agency , is confusing to both lenders and investors in conventional mortgage backed securities. The lack of support shown to conventional lenders is particularly of concern since it undermines the value of the entire asset class. On the one hand, the FHFA is reducing the footprint of the GSEs and ignoring the liquidity needs of the conventional market. On the other hand, the two GSEs are preparing to raise money from investors, this despite the lack of clarity on the future business model. Can you do both? No. But wait, if all this were not enough, FHFA is also imposing impossible and really silly Basle III style bank capital requirements on the GSEs. We write: “The FHFA capital proposal attempts to benchmark the capital of the GSEs with that of the largest bank SIFIs. In the narrative to the rule, the FHFA makes clear that they seek to not only ensure sufficient capital to remediate losses on insured loans, but to also provide sufficient mass financially to keep the enterprises liquid in a stressed economic scenario. Ensuring 100% safety against credit loss and market stress is not possible in an economic sense, raising basic questions about the FHFA capital framework.” And in the back of the minds of lenders, there is worry that the GSEs will seek to reject conventional loans that fall into default once the borrowers exit the CARES Act forbearance. It has happened before, after all. Indeed, senior officials at FHFA have made clear that any perceived defect in credit underwriting after March will result in the GSEs cranking up the good old loan repurchase engine as in the 2009-2015 period. But truth to tell, while we remain concerned about the lack of clarity coming from the FHFA on COVID19 forbearance and conventional loans, we are far more concerned about the state of commercial real estate and how this catastrophe will impact state and local finances. How things change and so quickly. A year ago, equity REITs that owned prime commercial real estate in New York and other major metros were the top of the heap in the world of real estate investing. Today these same investors face the prospect of foreclosures and protracted litigation over busted commercial properties. And the impact of this economic collapse on the revenues of major cities is enormous. Matthew Haag writing in The New York Times describes how the decline in rent payments to landlords means an inevitable drop in tax payments to New York City. “The drop in commercial rent payments could imperil property tax collections that pay for city services,” notes Haag concisely in what may be the most important article published by the Times this year. He illustrates the disaster: “The cascading impact of the coronavirus pandemic and stay-at-home orders on New York City have reached a breaking point, property owners and developers say. Two months into the crisis, the steep drop in rental income now threatens their ability to pay bills, taxes and vendors — a looming catastrophe for the city, they warn.” The impact of the disruption in commercial real estate will be felt by REITs, banks and bond investors widely. We hear tell that a favorite trade chosen by some managers was to pair commercial mortgage backed securities (CMBS) with credit risk transfer (CRT) bonds issued by the GSEs, both leveraged of course. Both exposures went sideways at the same time! Wonderful. But now the CMBS paper and the derivative indices that some managers found so fascinating have both crapped out, leaving investors with another example of the fickle nature of markets. Where is Joanie McCullough when we need her? Indeed, there are distressed investors already buying up CRT paper at triple digit spreads, a testament to the ability of the speculative classes to become comfortable after any market event. The CMBS delinquency rate, which measures payments that are late for more than 30 days, climbed 22 basis points to 2.29% in April, the biggest jump since June 2017, according to Trepp . No surprisingly, lodging and retail loans were among the hardest hit. May data should show CMBS delinquency well into double digits. JPMorgan (NYSE:JPM) estimates that new issue CMBS volumes will be cut in half this year as retail and hotel deals were sidelined. The spreading disruption in CMBS is already forcing investors to take a “different” approach to loan delinquency for loans in a given deal, namely ignore it. Extend and pretend as we say in the world of risk. Kroll Bond Ratings wrote in a surveillance report on COVID19 at the end of April: “[M]any deal participants are considering whether it may be in the best interest of the trust to allow certain relief requests, including temporary debt service forbearance, to be accomplished without a transfer to special servicer. Given the immediacy and severity of the cash flow disruptions to many properties (in particular, lodging and retail) and great uncertainty as to how long the economic disruption will last, some believe that short-term relief may be warranted, particularly for properties that were performing well prior to the pandemic.” It is important to state that there are deals getting done in the world of CMBS. Blackstone Group (NYSE:BX) just brought a $608 million deal for its REIT comprised of loan participations on commercial properties, including a portfolio of 68 warehouse and logistics facilities, but no hotels or retail properties please. There is a great separation underway between viable CRE assets and commercial properties with retail and office tenants. While stocks have rallied in recent weeks on the elation arising from the economic opening after 90 days of lockdown, the joy is not being felt by many subsectors of the financial ghetto. Bank for example have rallied double digits in the past 30 days, but are still well off the highs of 2019. Names such as JPM are currently trading near 1.3x book, but are still down for the past 52 weeks. And Q2 2020 earnings loom ahead in just six weeks. Banks, lest we forget, have lots of exposure to commercial real estate. Meanwhile, equity REITs such as Equity Residential (NYSE:EQR) and Starwood Properties (NYSE”STWD) are deeply depressed, reflecting the negative expectations for the group as a whole. Meanwhile in the world of CMBS, the “AAA” CMBX index still trades well off the highs of the past year, reflecting the fact that some investors still don’t quite know how bad the crash will be in commercial real estate. We certainly do know that the world of commercial real estate will be really, really dreadful in the next several years. Default rates could exceed peak losses of the 1990s by a wide margin. Act accordingly. And as you read about the trials and tribulations affecting the commercial real estate sector, remember that the big northern cities like New York and Chicago are right behind the busted property deals. Social distancing means financial Armageddon for commercial real estate and municipalities in coming months. Get used to it.

New York | This week, The Institutional Risk Analyst releases our Q1 2020 bank earnings report, which is for sale in our online store . In our latest credit comment, we feature net loss rate and earnings estimates for JPMorgan (NYSE:JPM) , U.S. Bancorp (NYSE:USB) , Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS) through Q2 2020. Suffice to say that our view of Q1 2020 bank earnings is pretty grim, but the real fun won’t start until the Q2 2020 earnings are released in about 90 days. The key variable in the credit analysis for both banks and bond investors: unemployment. In March, unemployment reached 4.5% nationally. Estimates for April vary but are all in double digits. We write: “We expect that commercial banks too will take losses on default events involving commercial real estate. Imagine, for example, the wreckage that will result from the impending default of WeWork and other leveraged investors in commercial and high end residential real estate in major cities like New York, Los Angeles and Miami." Distressed credit investors are already assembling funds to take advantage of what may be the largest liquidation of commercial properties in a century. Rather than 2008, however, the operative model for the COVID19 crisis may be closer to the deflationary years of the mid-1930s. The chart below shows unemployment through March from the Bureau of Labor Statistics and the consensus estimate for April unemployment. Source: BLS, Survey Despite the grim unemployment numbers and related loan loss estimates for US banks, it is important to remember that the US banking industry is quite liquid and well-capitalized. While there are a lot of dire predictions about the economy and employment, remember that in Q4 2019, US banks had almost $150 billion in net income, dividends and cash used for share repurchases available potentially to absorb losses. This substantial cash flow is now about to absorb the full weight of the COVID19 virus disruption. In our latest IRA Bank Earnings analysis , we assume that US bank loan loss provisions double in Q1 and then double again in Q2 2020, taking American banks back to 2009 levels of loss reserve build. Yes, the numbers for credit losses due to COVID19 are large and earnings will be ugly for the rest of the year, but in our judgement, the task is more than manageable by the US banking system. Because US banks are stable and healthy, these institutions will be more than able to weather the huge storm of credit losses to come. In addition to $45 billion per quarter in cash earnings, the industry has $35-40 billion in share repurchases and $50 billion or so in dividends each quarter. Just by suspending share repurchases, the largest banks will retain over $100 billion annually in additional equity capital, as shown in the table below. Source: Federal Reserve Form Y-9C While the banks may be islands of liquidity, though, the bond market and particularly “fringe” products such as non-QM residential mortgages and non-bank business loans and the like are going through the meat grinder. The Fed has agreed to buy limited amounts of AAA and recently investment grade paper, but there are piles of leverage loans and real estate paper that is currently looking for a bid. If we get to 5% loss rates on 1-4 family loans owned by US banks – roughly 2x the levels of 2008 – we should count ourselves lucky. Anything close to double digit loss on $2.5 trillion in residential mortgage loans owned by banks is a problem for everyone. Why? Because if bank default rates on 1-4s go to 5%, then loss rates on the other $8 trillion in agency and government loans will be higher. The GSEs, Fannie Mae and Freddie Mac , will be swamped by loan repurchase demands and will require additional capital funds from the US Treasury. And, meanwhile, the carnage in commercial loans, CLOs and all other manner of ineligible securities will be equally bad but also will provide a sizable opportunity for the vultures. All that said, between Fed Chairman Jerome Powell’s commitment to do “whatever it takes" to liquefy the system and Dr. Fauci’s determination that the rate of infection from COVID19 may have crested, the index of FRED Spreads created by our friend Fred Feldkamp dropped 280 bps last week (a little more than 10% of its total rise during the crisis). As we all know, falling credit spreads are good. Some people are even talking about getting “AAA” CLOs restarted by June. We’ll see. Until you see HY spreads inside of 500 bps over the curve, not much is likely to happen in sub-investment grade debt. Be well.

New York | In this issue of The Institutional Risk Analyst , we review some of the credit developments that have occurred since the explosion of the COVID19 pandemic and related hysteria. But first a few comments about the American political economy seem to be warranted. With the panic-stricken response to COVID19, any semblance of fiscal probity in the major industrial nations has long since been tossed into the dumper. In Washington, the national Congress passed the largest unfunded mandate in American history with the CARES Act and promptly left town for safer climes. Would that Mark Twain were alive today. Full nationalization of the US credit markets has been achieved. The US Treasury bond market and the government-covered mortgage related markets are the only liquid markets remaining outside of the crap shoot/inflation hedge we call global equities. The markets for Treasury and agency securities have now been turned into a terrarium project for the fun and amusement of the Federal Open Market Committee . Of course, this development was inevitable following the equally great social sacrifice of two World Wars a century ago. We are living in the aftermath of the Somme and Verdun, Guadalcanal and D-Day. As we noted in the inside page of the 2010 book, “ Inflated: How Money and Debt Built the American Dream, ” democratic societies inevitably fail because of fiscal profligacy. And these fiscal demands often come about as the result of or in the aftermath of war. “ I do not think it is an exaggeration to say that it is wholly impossible for a central bank subject to political control, or even exposed to serious political pressure, to regulate the quantity of money in a way conducive to a smoothly functioning market order. A good money, like good law, must operate without regard to the effect that decisions of the issuer will have on known groups or individuals. A benevolent dictator might conceivably disregard these effects; no democratic government dependent on a number of special interests can possibly do so. ” F. A. Hayek Denationalization of Money, Institute of Economic Affairs (1978) Four decades later, Hayek's observation clearly has been proven right. The FOMC has lost control over the size and growth rate of the dollar as a currency. Hyperinflation beckons, at least after we get done with the debt deflation of COVID19. The phone rings and the Federal Reserve Bank of New York buys securities until the market are sated – sometimes beyond that point. And the Fed has been forced to finance a growing offshore float in dollars that now totals some $15 trillion and climbing. As we've noted in past comments, the Fed's efforts have made it cheaper to borrow dollars offshore than in domestic US markets. The offshore demand for dollars is the largest and largely unspoken variable in the FOMC's monetary policy puzzle. Meanwhile, the Trump Administration is dropping helicopter dollars in advance of the November 2020 election. Like a Latin caudillo handing out free groceries on election day, the hundreds of billions in fiscal assistance in response to COVID19 are merely targeted gratuities for a desperate electorate. With all of the “action” from Washington, the lockdown to avoid the worst aspects of COVID19 has probably taken US GDP down at least 10-15% in terms of lost employment and businesses in the services sector alone. The levels of reserves seen in bank earnings so far suggests that depository institutions are expecting a wave of loan defaults far larger than 2008. When JPMorgan (NYSE:JPM) took loss provisions up 450% from the previous quarter, then tightened credit across various wholesale channels, the message was clear: credit needs to tighten, a lot. Exposure at default at most major US banks (Basel I) has gone from the low teens to near 100% in just 30 days. Yet banks are literally awash in cash due to the resumption of QE. Other banks and agencies, including the housing GSEs such as Fannie Mae and Freddie Mac have followed suit, reducing credit availability to a broad swath of the US economy. We even hear tales of the Federal Home Loan Banks liquidating financing positions for collateralized loan obligations (CLOs). Yes, that’s right. The FHLBs were so hungry for business that they were financing “AAA” tranches of CLOs. Outside of the world of eligible collateral that can be pledged as security for loans at the Federal Reserve Bank of New York , the situation is dire. Liquidity has left the market for private label loans of all types. Once again, as in the late 1990s, we see fringe lending products such as marketplace loans and prime jumbo mortgages trading at a steep discount. This morning, the bid for performing prime jumbo loans is in the low 90s. The situation facing the private-label market for prime jumbo mortgages is significant for the banks. Properly seen, the market for government and agency mortgages is only about $9 trillion in unpaid principal balance (UPB). But the $2.5 trillion market in bank owned prime mortgages is really a private label market. Thus when the market bid for prime jumbos disappears, the banks retreat, no longer able to price these assets. Food for thought for the Fed as they consider supporting the market for prime jumbos loans. Just to show you that God does have a sense of humor, just before the COVID19 crisis got underway, the Federal Deposit Insurance Corporation approved the applications submitted by Square, Inc. (NYSE:SQ) , and Nelnet, Inc to create two de novo industrial banks in UT. Square Financial Services, Inc., will originate commercial loans to merchants that process card transactions through SQ's payments system from Salt Lake City. Nelnet Bank will originate and service private student loans and other consumer loans as an internet-only bank operating from a single office in Salt Lake City. Sadly, the markets to be served by these two nonbank pioneers have been badly damaged by the COVID19 crisis. John Davis at Raymond James calls COVID19 “kryptonite” for the once high-flying SQ and says that the economic contraction will hurt both credit card processing volumes and the firm’s infant lending business for years to come. “COVID19 illustrates the cyclicality of the business that simply does not justify a double-digit revenue multiple,” he adds. As this difficult week comes to an end, the financials seem to have settled-down into a trading range at or just above book value for the exemplars in the group. While we do anticipate a wave of loan defaults hitting US banks in coming quarters, the industry should be able to handle the load without any more inconvenience than suspending share buybacks. To us, the bigger question facing financials is when the housing GSEs, Fannie Mae and Freddie Mac, will be forced to seek financial assistance from the US Treasury to fund loan repurchase obligations. Black Knight (NYSE:BKI) reports that the 3.4 million American homeowners now in CARES Act forbearance plans represent 6.4% of all active mortgages. But what about the millions of homeowners who could not qualify for forbearance? How many consumers will ultimately default? Reading the body language of the commercial banks and non-bank lending markets, we anticipate a wave of defaults across a range of asset classes that will be far larger than 2008. Whereas the great financial crisis saw severe credit default events across a range of residential mortgages and related securities, this time the picture looks more like the 1930s. We anticipate that net loss rates will rise quickly from the historic lows seen over the past several years to and even exceeding 100% loss in many asset classes. Prepare accordingly.

New York | This week in The Institutional Risk Analyst , we ponder the state of the bezzle, that fluffy, frothy portion atop the political economy that feeds the purveyors of fraud and dubious financial schemes. Six months ago, the bezzle seemed set to expand infinitely thanks to the largess of the Federal Open Market Committee . But now with the COVID19 disaster, all of the air has been let out of the global economy, leaving those who feed on the bezzle scrambling. The term bezzle, lest we forget, was coined by John Kenneth Galbraith in his classic 1961 book, “The Great Crash of 1929.” Our friend Mark Melcher at Prudential Securities loved to describe the current state of the bezzle in his research. Galbraith himself describes the bezzle as the “inventory of undiscovered embezzlements,” that grow in times of rising markets. He wrote: “At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.” Under the strange regime put in place by the FOMC after 2008, markets are inflated with fiat money to avoid any hint of asset price deflation. We are told that falling interest rates are meant to encourage employment, but the worst examples found in the world of finance are the real winners with quantitative easing. The generous estate of zero net-cost leverage allows for ever greater acts of fraud and chicanery, all floated upon a cushion of hysterical investor demand and a newly minted pile of fiat paper dollars. Yet such an artificial market bubble is hardly stable, to invoke Nassim Taleb’s “black swans,” particularly when the civil authorities in many countries decided to shut down their economies for three months. James Glassman stated: capitalism without bankruptcy is like Christianity without Hell. Well, thanks to an understandable overreaction by civil authorities to COVID19, America is seeing a wave of insolvency unlike anything experienced in the past century. Now that the bezzle has basically disappeared, the speculative classes are left to rationalize strategies that, just 90 days ago, made sense. Let’s ponder some of the winners and losers as the proverbial tide goes out, exposing millions of failed companies, denuded business strategies, defaulted securities and busted individuals. Some of the biggest losers in the wake of the great flushing are investors in commercial real estate. The new age pyramid scheme known as WeWork probably jumps to mind first, a debt driven speculative plan hatched by a barefoot visionary whereby temporary workers would support retail pricing for office space and free snacks. WeWork did not make sense before February of 2020. Now it is just completely ridiculous. Low rates care of the FOMC made WeWork possible. Another favorite example of the age of QE is Wirecard , Germany’s technology darling which has been under assault by the financial media and investors due to questions about the accuracy of the firm’s accounting. Even after a much anticipated examination by KPMG , questions about Wirecard remain, in part because the firm apparently cannot produce bank records to substantiate claimed revenue to the tune of $1 billion. The Financial Times notes that KPMG could not confirm “that the sales revenues exist and are correct in terms of their amount, nor can it make any statement that the sales revenues do not exist and are incorrect in terms of their amount.” Certainly, this report fills us with confidence. And then, of course, there is the iconic speculative fraud of the age of zero interest rates, Softbank , which naturally has put cash into both WeWork and Wirecard . How the FOMC did not get awarded free call options on Softbank for enabling these and other “investments” by guru visionary Masayoshi Son we’ll never know. A century ago, two guys named Morgenthau and Brandeis would be fighting for the honor of putting Masa San in state issued garb. The Real Deal reports that Softbank is preparing to write down its stake in WeWork to basically zero . “Every writedown takes WeWork’s carrying value closer to reality. Clearly the value is zero,” Kirk Boodry , analyst at Redex Holdings , told Reuters . The creditors and owners of the select real estate chosen by WeWork are now busted too. In fact, the owners of commercial and residential properties in most major metros around the US have seen a good portion of their tenant base literally disappear in the past 60 days thanks to the Great Lockdown. Rent collections are down sharply and many of these absent tenants may never return. Notice that REITs with commercial and retail exposures are faring rather badly, but specialty REITs such as American Tower (NYSE:AMT) are actually up. When we are all living a bad version of “Return to Thunderdome,” with House Speaker Nancy Pelosi in the lead role, at least we’ll have 5G. Empire State Realty Trust , the owner of the Empire State Building and 13 other commercial properties in the New York region, last week reported in its first-quarter earnings that it collected only 73% of its April office rents and 46% of its retail rents due in April. We expect to see even worse numbers from the equity REITs in May. We hear reports of residential and commercial tenants fleeing New York or demanding rate reductions from landlords, with obvious downward pressure on pricing for vacant space. Listed rates for rental apartments are in free fall. Landlords will essentially need to eat lost rents on millions of small commercial properties or see the space go vacant. And even if landlords do eat 90 days of lost rent, many small businesses may fail anyway due to the economic dislocation caused by the Great Lockdown. As we’ve noted in past missives, the rate of price appreciation in commercial real estate (CRE) over the past five years drove loss rates post-default negative, just as was the case with residential exposures. Now, however, the dread externality known as COVID19 has evaporated a big chunk of the services sector. This, in turn, is leading to defaults and requests seeking forbearance that only find parallels in the early 1900s. We suspect that the downward skew in loss given default (LGD) seen in all real estate exposures will normalize and start to climb above 100% in some cases. The chart below shows LGD for bank-owned multifamily properties and our guess as to what Q1 and Q2 are likely to show once some significant adjustments and restatements of Q1 losses are eventually tabulated. Notice that we expect to be above 80% LGD for bank multifamily exposures by Q2 2020. The 30-year average LGD for bank owned multifamily loans is 70%. Source: FDIC/WGA LLC We know of a number of businesses in the NYC area that have received PPP loans from their banks. Many will only use a portion of the funds and will return the balance, but with the big positive of keeping their staff employed and health insurance intact. But the sad fact is that many smaller businesses will not be saved and their employees and owners are now busted flat. We observed in an earlier comment that the world of jumbo loans for banks and investors has pretty much stopped. We know a couple of lenders, each owned by Buy Side sponsors, who’d forsaken the world of agency lending for making non-QM mortgage loans. Through February 2020, these firms were doing growing volumes in non-QM loans, which were being purchased by banks, REITs and hard money investors. Today, however, these lenders have pivoted, disavowed non-QM and returned 100% to government lending in the FHA and Ginnie Mae market. Government lending, as it was a decade ago, is the only stable market in residential housing finance today. And remember, non-QM lenders never lose the risk of claims based upon the ability to repay (ATR) rule that was put in place in 2010 by the Dodd-Frank legislation. Remember those three letters: ATR. As the true extent of the pull-back in many real estate markets becomes apparent, look for groups of trial lawyers to start testing the ATR rule as the basis for tort claims against some of the larger non-QM lenders -- and the Buy Side players who financed these activities, firms like PIMCO and Blackstone (NYSE:BX) . Meanwhile, the earnings from Fannie Mae and Freddie Mac last week suggest dreadful days lie ahead for the GSEs. As we noted in National Mortgages News (“Why the FHFA's latest move undermines the MBS market” ), Washington is now the problem in conventional loans. The Federal Housing Finance Agency has effectively been taken over by the Cato Institute , which wants to implement free market principles just as the housing sector faces its worst challenge since the Great Depression. For years conservatives wanted to shrink or even kill the GSEs. Now the opportunity arrives. At precisely when we need the mutualized risk sharing power of the GSEs to support 1-4s, the FHFA is trying to shrink the GSE’s role in housing. Dick Bove of Odeon writes that FHFA Director Mark Calabria believes that “the government should not be in the housing industry; The government sponsored enterprises (GSE) should be taken out of government. No bank is too big to fail.” What the COVID19 event proves in housing is that in times of stress, no amount of private capital can support $11 trillion in single family housing assets or another $1.5 trillion in multifamily properties. Banks own a quarter of the 1-4 family housing market, the FHA/VA/USDA about 18% and the rest – about $6 trillion in loans -- is supported by the GSEs. Without financing support, we expect residential home prices will start to fall in many markets around the US before the end of 2020. Meanwhile, the REITs and funds are the chief victims in this cycle. Think L Shaped recovery in services, and related CRE and multi-family assets. The hard money investors we work with in the market for CRE, small commercial and non-QM residential loans see lots of opportunities, but also a lot of risk. The current judgement seems to be that we need to be thinking about 40-50% discounts off peak valuations to make the risk/reward equation start to make sense. As we consider the wreckage in the credit markets caused by the Great Lockdown, a couple of things to ponder. First, the response to COVID19 is doing more damage than the disease itself. The dislocation to the economy, especially the real estate and services sectors, will set back global economic growth by decades. Second, the unwillingness of politicians to admit that the universal lockdown was a mistake is now a major obstacle to moving forward. We need to protect the vulnerable and send everybody else back to work, without masks and social distancing. Otherwise the global economy is headed for depression like conditions for decades to come. And finally, the damage inflicted on the speculative classes in the past 90 days is just the appetizer. The unwind of leverage in real estate and many parts of the world of secured finance is just starting. Aircraft leases? Hotels? Casinos? Yet the agency loan sector, including government guaranteed residential and multifamily loans, will be an island of stability in a sea of woe. The deflation of the bezzle may be very painful indeed.

“The very numbers you use in counting are more than you take them for. They are at the same time mythological entities (for the Pythagoreans they were even divine), but you are certainly unaware of this when you use numbers for a practical purpose.” C. G. Jung (1961) New York | Financials swooned this week as Federal Reserve Board Chairman Jay Powell rejected the idea of negative rates as a matter of monetary policy, that is to say, interest rate targets. Since the Federal Open Market Committee decided decades ago to turn the federal funds rate into a policy tool, the setting of interest rate targets and related signals has become the stuff of national fascination. But like any benchmark, the significance of fed funds for financials has changed over time. Most important, Chairman Powell rejected the idea of negative interest rates, something we think is obvious but some economists cannot seem to appreciate. The deflation that negative penalty rates imply clearly is antithetical to economic growth. Negative interest rates mandated by government are a tax, plain and simple, not a means to encourage growth. Negative rates shrink private capital leverage and growth possibilities to benefit the indebted state. Only heavily indebted nations could possibly find utility in a negative interest rate regime. In mathematics and in the real world of people and commerce, natural numbers are those used for counting and ordering, the common means of accounting for global economic activity. In common mathematical terminology, those words used for counting are called "cardinal numbers" and words connected to ordering represent "ordinal numbers.” In the world of natural numbers, negative values do not exist independently and are, at best, derivatives of natural values. Zero is a natural number and so too are the positive values that follow, but negative values have no place at all in the world of natural numbers or economics. Mathematician Leopold Kronecker (1823–1891) is reported to have said, “The dear God has made the whole numbers; all the rest is man’s work.” Negative values do not exist in the natural world. You can possess nothing, or something more than zero, but in the real world you cannot have a negative quantity of something. Why don’t many economists seem to understand these basic human distinctions when it comes to numbers? Beyond mere values, numbers impart qualitative aspects to social interactions that we call “markets.” Numbers define value, enable commerce and compensate for work. Negative numbers retard these basic human functions. If an asset does not generate a positive return, no matter how small, then the asset has no value relative to the cash used to purchase it. Will the worker pay for the right to work? No. But fortunately, so long as the United States still has a private bond market, economists who have not been confirmed by the Senate will not be allowed to make such decisions. Meanwhile, the process of value destruction and creation in the global capital markets proceeds apace, but there are also some opportunities. This is not nearly 2008 in terms of capital markets dysfunction and resulting litigation and nastiness. Instead, we are entering a process of plain old commercial defaults that will clog the arteries of finance and the bankruptcy courts for years to come. This work will employ some members of the bar, but perhaps not in the custom they might expect. The spectacle of most major law firms cutting headcount and compensation is a leading indicator of tough days ahead. In the center ring, we have the large cap financials defending the post-selloff rally, but with little in the way of hope for the immediate future. We cannot wait to see the Q1 2020 financials from the FDIC and FFIEC on the US banking industry. Suffice to say that the markets cannot discount what we cannot quantify. As we noted in our Q1 bank earnings report , the magnitude of loss facing US banks is larger in terms of the dollar of credit loss and broader in terms of the sector of the economy affected than in 2008. We expect to see early and frequent guidance from the major banks ahead of Q2 2020 earnings. When the likes of Corelogic (NASDAQ:CLGX) and Black Knight Inc. (NYSE:BKI) , data monopolies with a privileged view of the backend pipes in the world of asset backed securities, are competing for the most gruesome headline on forward residential loan defaults, it makes maintaining a positive outlook difficult but not impossible. For you see, there are opportunities scattered amidst those steaming cow pies in the world of mortgage finance. Consider the world of mortgage servicing rights (MSRs). Our friend Joe Garrett at Garrett, McCauley & Co. in San Francisco put together this handy table of the Q1 marks for bank MSRs as reported by these leading residential mortgage issuer/servicers. In the past year, MSRs have lost about 1/3rd of their value due to interest rate volatility and related changes in assumptions about the maturity or option-adjusted duration of mortgage backed securities. Notice that Mr. Cooper (NASDAQ:COOP) , which has excellent performance in terms of the recapture of loan refinance opportunities that come off its servicing book, has a relatively high multiple for the MSR. And by no coincidence, COOP is one of the better performers in the nonbank mortgage sector. Other nonbank lenders like Quicken , Freedom , Amerihome and PennyMac (NYSE:PMT) are also very efficient at recapture. The big banks don’t really make loans and therefore have little or no benefit from recapture, thus we see lower valuations for the large bank-owned MSR. But Flagstar (NYSE:FBC) and U.S. Bancorp (NYSE:USB) which we own , are in the middle in terms of recapture and thus market value of the MSR. It all comes down to this: Can you defend the value of your MSR by capturing mortgage loan refinance opportunities? Now there is a school of thought that says that MSRs have no or even negative value due to the cost of forbearance as a result of COVID19 and the absurd mortgage payment holiday thrown into the CARES Act by Congress. Yet even as investors focus on the temporary drop in servicing income due to loan forbearance, loan prepayments are also falling. Hmmm.... As and when loan prepayments eventually rise again due to accelerating mortgage refinance transactions, the new MSRs created in 2020 and beyond should have multiples that are higher than current vintages, especially for government insured loans in the FHA/VA/USDA markets. Default rates on FHA loans will be high based upon the latest delinquency data, but each defaulted loan is also an opportunity for another gain-on-sale. Always look on the sunny side.... Just as negative interest rates are not a valid policy option for the FOMC, so too you cannot have negative rates on mortgage loans or mortgage servicing assets in a democratic, free market system. The fascist states of Europe and Asia may be able to impose negative rates via government supported banks, but the US bond market is still a bit too large for the Fed to manipulate. If the Fed tried to impose negative rates on private mortgage investors or loan servicers, the investors and lenders that populate the world of nonbank finance would simply go home. That is why we will not see negative interest rates in the US and why too there is a lot of value being created today in mortgage servicing assets. Note in the FRED chart below, for example, that even as Treasury bond yields have dropped a point since February, 30-year mortgage rates have not followed. Suffice to say that the compression in terms of valuation multiples for MSRs begins to approximate the similar crushing compression seen in both MBS coupons and Treasuries thanks to the Fed’s purchases since mid-March. And yes, we did invoke the gods by asking the FOMC to buy GNMA 2s until the markets bled. And yes, they did. Thank you, oh Great Jay. Most operators in the mortgage sector fully expect to see GNMA 2s trading in TBAs by June. We can only say to the desk at the Federal Reserve Bank of New York: Be gentle with us. Indeed, the system open market account (SOMA) will own about 40% percent of all agency mortgage securities by the end of 2020. This is not a bad thing, but we’d only offer to the folks on Liberty Street that if the markets starts to strain in terms of collateral, sell the MBS back into the market demand. As in 2008 and 2018, lest we forget, the ability and willingness of the Street to support leverage is the key indicator of the true state of things.

New York | There is a great fuss and bother in Washington about whether the Federal Reserve Board should “allow” banks to pay dividends to their shareholders. Even former FDIC Chairman Sheila Bair has gotten into the act, saying that we don’t know "how bad things will get." Of course, none of the people worried about bank dividends offer any numbers or analysis to put an actual scale to the worry. In this issue of The Institutional Risk Analyst , let’s see if we can help, yes? As we’ve noted in past comments, merely ending bank share repurchases is worth about $130 billion per year of capital retention for the 125 members of Peer Group 1 , which is basically every bank above $10 billion in total assets. Between Q4 of 2008 and Q4 of 2009, US banks charged off $116 billion on total loan losses net of recoveries. Net charge offs as a percentage of total loans and leases topped out at 3% in Q4 of 2009. Loss given default on all US banks climbed into the 90% range, but quickly fell as the economy and property values recovered through the 2010s, as shown in the chart below. Source: FDIC/WGA LLC So, let’s assume for a moment that the great COVID19 lockdown is going to drive up bank loan loss rates to 2x 2008 levels. Loss rates on residential exposures will probably be a lot lower than some of the worst-case scenarios, but multifamily and commercial loan exposures seem destined to blow out previous metrics for net loss rates. Loss severities on some smaller multifamily residential and commercial properties could exceed 100%, suggesting that abandonment may become a problem in some localities. Yet despite the horrific unemployment figures, the credit losses could be lower than expected because low income households don’t use much credit. The chart below shows historic data from the FDIC and our best guess for the rest of 2020. Source: FDIC/WGA LLC If US banks see loan loss rates rise to 2x 2009 levels, does that mean that banks will need to suspend dividends? Maybe. First, in addition to the cash available from ending share repurchases, the US banking industry has about $50 billion in quarterly income to use to fund provisions. Call the total funds available per quarter $80 billion. Should banks still suspend dividends? Maybe, but not because of some bureaucratic edict from Washington. Some banks may choose to cut dividends, but other may just go to the market and raise equity. There are more than a few large banks still trading above book value, so issuance is something we should expect in coming months. Members of The IRA Bank Dead Pool , however, are unlikely to be in the markets raising common equity anytime soon. Each bank is best able to assess its own credit loss profile and act accordingly. Banks with lots of consumer exposures such as Capital One (NYSE:COF) as well as Citigroup (NYSE:C) may see higher loss rates than in 2009, when net charge off rates for credit cards peaked about 10% for the industry. Given the current levels of unemployment nationally and dislocation visible in many sectors, we could easily see consumer loss rates for banks well above 2009 levels. Here's an idea: Rather than asking some bureaucrat in Washington, let’s let the market decide. If your bank’s equity is trading below book value over the previous 90 days, then you must suspend dividends and build capital. Hopefully that will satisfy our favorite left-wing Republican from Kansas. Hey, we could leave this rule in place permanently and suspend the Fed’s annual stress test circus. If your bank’s stock trades at a premium to book, you may pay dividends. Zombie Love Meanwhile at Deutsche Bank AG’s (NYSE:DB) New York unit, the hits just keep on coming. Laura Noonan of the FT last week reported that DB’s US unit, which happens to be one of the more important players in the world of custody and administration for agency mortgage loans, is still rated a “4” by federal examiners. In the world of prudential regulation, "1" is excellent, "3" is acceptable, and "4" is on the skids -- especially when you've been rated "4" or lower for years. As we noted in our review of David Enrich’s new book ( “Dark Towers: Deutsche Bank, Donald Trump, and an Epic Trail of Destruction” ): “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.” The question remains. The situation at DB is a classic example of moral hazard in operation. A smaller bank would have already been sold to another institution, but Deutsche Bank Trust Co of New York continues in operation. The list of material weaknesses in the bank’s operations is long and apparently has been unresolved for years, according to one executive close to the matter. Deutsche Bank apparently either cannot or will not comply with US law and regulation, yet the Federal Reserve Board refuses to act in an area where it has primary responsibility. American regulators should have nothing further to say about bank capital or safety and soundness until the DB situation is resolved with finality. As we wrote in January 2020 in our IRA Bank Profile of DB: “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.” While some may see the Fed’s leniency as a sign of political conflict due to the continuing business ties between Deutsche Bank and President Donald Trump , in fact the reasons are far more profound. Were the US to follow its own laws and force the sale or wind down Deutsche Bank’s US operations, the ramifications in European markets would be extremely serious. With Europe’s banking system already hanging by a thread in terms of capital and profits, the demise of DB would force a wholesale consolidation of EU banks into several explicitly state supported zombies. You can be pretty sure that German Chancellor Angela Merkel does not want to see a state rescue of DB as the last chapter of her glorious political career. Moving from the sublime to the truly silly, last week saw a bit of a ruckus in the financial media when an enterprising member of the press decided that Goldman Sachs Group (NYSE:GS) was considering a merger with the likes of U.S. Bancorp (NYSE:USB) and PNC Financial (NYSE:PNC) . Not going to happen in our lifetime. Let us count the reasons. First, none of the largest depositories have any interest in acquiring the GS franchise, even at a significant discount to current market value. While many businesses go at a premium to book value in acquisitions, in this case GS would go at a discount to partially compensate for the numerous known unknowns. Like DB, GS is a vile risk sandwich of indeterminate size and condimentation. The idea of the board members of USB or PNC approving the acquisition of GS is fanciful. Second and more important, the situation at GS with respect to what is perhaps the largest fraud scandal in modern history remains unresolved. Andrew Cockburn writes in Harpers in “The Malaysian Job: How Wall Street enabled a global financial scandal ” : “Beginning in 2009, billions of dollars were diverted from a Malaysian sovereign-wealth fund called 1Malaysia Development Berhad (1MDB) into covert campaign-finance accounts, U.S. political campaigns, Hollywood movies, and the pockets of innumerable other recipients.” Third and perhaps more important, we doubt that the Federal Reserve Board would allow the principals of GS to play a significant role in the management of a larger depository. As we tweeted to Charles Gasparino at Fox News last week, GS has barely $100 billion in core deposits underneath $1 trillion in miscellaneous assets and the largest derivative book on the Street in relative terms. The GS business has uneven profitability, poor core funding and outsized risk factors, making it problematic from the perspective of federal regulators. We see a combination between Deutsche Bank and JPMorgan Chase (NYSE:JPM) as more likely than a voluntary combination between GS and any other bank. One exception might be a white knight rescue of GS by Morgan Stanley (NYSE:MS) , but that is about the only possibility we see. Of course we could merge GS and DB together and move the officers and directors to a Caribbean island with no electronic access, plenty of fresh water and gear for surf fishing. Instantaneously, the financial world would become a safer if less interesting place.

New York | Jonathan Miller is President and CEO of Miller Samuel Inc., a real estate appraisal and consulting firm he co-founded in 1986. In addition to a command of the particular when it comes to asset valuation, He covers 35 different markets around the U.S. for Douglas Elliman , making Jonathan a keen judge of the real estate market environment and the economy. The Institutional Risk Analyst spoke to Jonathan from his lockdown operations center in Connecticut. The IRA: Thank you for taking time Jonathan. The onset of COVID19 and related hysteria is a shock to many people around the world. We are hearing reports of falling rent rolls and defaults by large anchor tenants here in Gotham. What is it like in the world of New York real estate for landlords? Miller: The overview is that landlords are between a rock and a hard place. There has been a tremendous drop in new leasing activity. We are seeing new leasing activity down year over year some 70 plus percent. Brokers cannot show space due to the lockdown, so this has an impact despite virtual tools. This is not lease renewals, which we cannot see. A typical building might have one third new leases and two thirds renewals. If we are seeing a drop in new leases, then we are probably having a spike in renewals. But that is information that is never shared with the public. The IRA: How about pricing? We are hearing stories of tenants asking – or demanding – rent reductions due to COVID19? Is a tenant rebellion underway? Miller: We certainly are facing liquidity issues in the markets. You might expect to see lease pricing falling, but not so far. We are actually seeing pricing flat to slightly up for rentals. On the sales market we are seeing not much activity at all. The process of getting the deal written up, reviewed by counsel and finalized has slowed considerably. There has been contract activity that brokers will point to as evidence of activity earlier in 2020, but most of those deals were initiated prior to COVID-19. The IRA: Poor pull through is not a good thing. The April number was bad, but May will be even better, yes? Miller: In most markets around the country, the first quarter of the year was better than expected. If you are a weak market, it was a little bit stronger. If you are a strong market, it was even better than that and so on. And this was both in terms of transactions and price trends. So for all intents and purposes, the Spring 2020 market looked to be pretty robust – up until the last two weeks of market. We only really got two and a half months in before the crisis hit mid-March. The IRA: So, the first quarter results are shy two weeks. What’s next? Any happy thoughts on Q2 2020? Miller: The second quarter is likely going to be as bleak and dark as you can imagine and it will be accompanied by a sharp drop in overall activity. In some ways, this trend is going to run counter to the increase in activity that will occur as the shelter in place protocols are lifted. You’ll see a ramp up in listings coming onto the market and contracts being signed. There will be a disconnect between what the numbers show in terms of closings and pending transactions, vs the surge in new listings. What you can actually feel and see in person is not going to be reflected in the results as measured by closings. The IRA: So is this "a short, sharp shock," to borrow from Gilbert & Sullivan's Mikado , or does the real estate market rebound take years? Miller: The market will over-correct in the second quarter and then will still be negative but better in terms of activity. One point on top of this to say that there is no Spring Market this year. It has been surgically removed from the calendar. We are going to transplant elements of it atop an existing market down the road, whether it’s the Summer or the Fall. Let’s just say it happens to be the Fall season. The Fall is the second hump of a two-hump annual cycle in terms of new inventory coming to market. Now you’re going to take the pent-up supply and demand from the Spring and put it into the Fall. Inventory is going to ramp up to a high level. I don’t think demand will meet supply because of economic damage, layoffs, etc. The IRA: That makes sense, but is there more to it than merely a delay coming to market? Spring vs Fall sounds so pleasant. Miller: Yes. There is this idea in some circles that inventory is scarce because people pulled properties off the market or didn’t bring them onto the market at all. The narrative goes that falling inventory will support prices. I have heard this talk in a number of circles and find it rather bizarre. What is really going to happen is that we’ll see a significant runup in supply that will make pricing less than where we went into the COVID19 experience. The real question is whether and how fast we see demand rebound. The IRA: That sounds reasonable. More supply than demand suggests a buyers’ market in real estate. We’ve been thinking that net loss rates are about to rise back to and above the long-term averages in bank prime mortgage product. Does that sound right? How has the collapse of the private label loan market affected the availability of prime mortgage from banks? Miller: From my standpoint, jumbo financing is extremely limited in availability. We can see it. Lenders have pulled back from the jumbo market, but banks are still mitigating risk, which is a big difference compared with the 2008 crisis. Banks are doing what they are supposed to do as unemployment rises possibly ten-fold. But whereas the national mortgage rates from Freddie Mac are lower, we are seeing jumbo rate actually rising. We are seeing much more equity required, higher credit scores, and lower LTVs as a result. And the banks really only seem to be interested in writing loans for existing relationships. The IRA: Correct. Once the private label market and the REITs stopped issuing new MBS deals and buying new jumbo loans, the entire channel for non-QM loans effectively stopped. The banks and non-banks then dropped correspondent and wholesale business lines, where they buy from other lenders, cutting off the brokers and small IMBs. So now that bid for bank portfolio is the only game in town outside of the conventional and government markets. Miller: We are certainly seeing that behavior on the front-lines. We expect to see huge demand for appraisals in the next six months. A big junk of our business stems from litigation support and restructuring. Looking out several months and even out a few years, sadly we are going to have more business than we know what to do with as the flow of foreclosure, bankruptcy, REO, workouts, refis, divorce and other matters starts to peak. The IRA: What is the situation for New York high end residential over the next several years? Miller: Going into the crisis, New York high end residential was under siege. The SALT tax change was already hitting valuations hard and Albany came along and passed a mansion tax that further weakened prices. It was like somebody flipped a switch and prices simply fell. And we just dodged a bullet last year when Albany almost passed a pied-à-terre tax. As proposed it mandated annual tax on second homes worth $5 million or more. Instead, it was replaced with the progressive mansion tax, a one-time fee that affects home sales of $2 million or more starting at 1%, capping at a 3.9% tax on home sales of $25 million or more. This was a terrible move for the City and the New York City real estate market. We saw an immediate drop in home sales activity and a surge in high end rental activity. We call it “camping out” while people decide whether to leave the City entirely. And on top of that we had the new rent law from Albany, which essentially punished high end condo and home investors. Investors are now subject to all of these archaic landlord type rules including one that allows only one month rent to be collected in advance no matter the risk presented by the tenant. The IRA: Albany does not care about investors any more. They are seen as the enemy. Until New York State finally comes to a day of reckoning financially, the madness in Albany will continue. Miller: On top of everything I’ve just described, the new condo development market was already suffering. Think of 2014 as the peak in terms of development and sales for new construction in New York City. As we went through 2015 and 2016, prices weakened. So that now, looking back over the past five years, pricing has already fallen by an average of 25% and we are not nearly done. You can see this in the apples-to-apples comparisons of units that went to contract in 2014 and units that went in 2016 and after. Prices were cut by developers anywhere from 15 to 40% depending upon how aggressive the ask was from the developer. The IRA: That is rather breathtaking. And we have more fun yet to come? Miller: One of the things I have learned in 40 years in the real estate business is that it generally takes one to two years for the seller, whether it is a developer or homeowner, to capitulate to the lower market condition and not feel that they left money on the table. In 2019, we had started to see sales activity that reflected a more realistic perspective on the part of sellers. The price cutting paid off and we saw an increase in activity. Then boom, we had this crisis. The IRA, Yeah, boom. Be well Jonathan. "What the boom-and-bust cycle of non-QM lending can teach us" National Mortgage News , May 7, 2020

In this issue of The Institutional Risk Analyst, we republish an important comment by Robert Eisenbeis , Vice Chairman & Chief Monetary Economist at Cumberland Advisors , on the fight to create narrow banks that do not require federal deposit insurance. This decision has broad implications for other parties seeking access to the Fed's payments network. For now, in order to gain access to a master account at a federal reserve bank, the applicant need be an "insured depository institution" as defined by Section 12 of the U.S. Code. "Narrow Banks" Robert Eisenbeis Cumberland Advisors April 17, 2020 In a move largely overlooked due to the virus pandemic, on March 25, Judge Andrew L. Carter, Jr ., of the United States District Court for the Southern District of New York dismissed a case filed by principals of The Narrow Bank (TNB) against the Federal Reserve Bank of New York . What is The Narrow Bank, and what are the issues it poses? Narrow Banks For the past two years, a former Fed employee and investors have been pursuing a charter for what they call The Narrow Bank . The Narrow Bank would be structured as a state-chartered, uninsured, non-retail bank whose sole function would be to hold a master account at the Federal Reserve Bank of New York, through which it would earn interest on its reserve holdings and pass that return, after extracting a small fee, to its depositors, comprised of hedge funds, accredited investors and other financially sound institutions. The proposed bank applied for a charter in Connecticut, whose banking department issued a temporary approval subject to conditions, including obtaining a master reserve account at the Federal Reserve Bank of New York before final approval would be granted. All states require that a bank that accepts retail deposits (deposits from individuals who are not accredited investors) must have Federal Deposit Insurance from the Federal Deposit Insurance Corporation. However, because TNB would not accept retail deposits, it would be regulated only by the State of Connecticut and not need FDIC insurance, nor would it be regulated by the FDIC or any other federal bank regulator. It would also not be subject to the FDIC’s large bank risk assessment charge that large federally insured banks must pay should TNB attract significant deposits. As noted in the judge’s ruling, the master account application process involves a one- page form and is usually acted upon in a week or so. But in this case the process dragged on for weeks, with the New York Fed’s attorney finally indicated that several conditions must be met, including having at least $500K in deposits, proof of final charter approval, and completion of due diligence by the New York Fed. In late December 2017 the application was escalated to the Fed’s Board of Governors, which was concerned about the implications of such an institution for the efficacy of the Fed’s monetary policy tools, including IOER (interest on excess reserves). On March 6, 2019 the Board issued proposed changes to Regulation D that would lower the interest rate paid on reserves to institutions such as The Narrow Bank, essentially making TNB uneconomic. No final ruling has been forthcoming from the Board, but the advent of the COVID-19 financial crisis has essentially made TNB uneconomic for the moment, given that the IOER is at 0.1%, compared with the 1.0% that it was in August 2017, when TNB was granted a temporary charter certificate, or the 2.4% that it reached in December 2018 before plunging to its current level. Some might claim that TNB has been treated unfairly and has been denied due process, an argument that at least one court has rejected. But TNB raises three general policy questions. First, is there a public policy reason to broaden access to Federal Reserve services and interest on reserves beyond banks, perhaps even to individuals? Second, are there risks associated with narrow banks that may impact financial stability? Finally, what implications are there for the efficacy of the Fed’s monetary policy tools? The answers to these questions are complex and not always clear. As for who should have access to Federal Reserve services, it should be recognized that as a central bank, the institution’s main function is to conduct monetary policy, not to provide payments services to individuals or to the general public. It does provide wholesale payments clearing and settlement services, which evolved out of its historical check-clearing activities. It also serves as fiscal agent for the US Treasury and aids in issuance of Treasury debt. The appeal of TNB and similar entities when it comes to retail payments is that they provide a riskless alternative. In this respect the idea of a 100% reserve backing as a means to provide riskless payments services to individuals is not new. Irving Fisher and others put forth such a proposal in 1935 in the aftermath of the Great Depression; and later, Milton Friedman supported a 100% reserve requirement for checking accounts to counter what many thought was the inherent instability of a fractional reserve banking system . Today, there are many payments options, and for individuals it is possible to have FDIC insurance to cover most payments and savings needs. (There have even evolved workarounds to get more than $250K of insurance on accounts). So the case for individuals to have access to the central bank is weak and could provide a distraction to the Fed’s main monetary policy function. The second concern is potential risks that TNB and similar institutions might pose to financial stability. Because narrow banks’ only assets are reserves on deposit at the Federal Reserve, they are essentially riskless, and the rate that they earn is a riskless rate. In times of financial stress, when there is a flight to quality, the concern is that funds would disintermediate from the Treasury market, from money market funds, and from banks into narrow banks, thereby creating liquidity and, potentially, solvency problems. While this is a hypothetical concern, recent experience in both the repo market and the liquidity problems that have emerged across a wide range of financial markets during the pandemic shows that in desperate times there can be extreme pressures on certain financial markets and institutions. The recently announced nine Fed programs to support primary dealers, the corporate credit market, the municipal market, money market mutual funds, and the commercial credit market are but a few examples of the need to address such stresses. Finally, and perhaps most importantly, there is concern about the implications of narrow banks for the efficacy of the tools the Fed employs to implement monetary policy. These tools include, but are not limited to, reserve requirements, interest on reserves (IOER), the discount rate, and the federal funds rate. These tools provide levers that flow into the economy through short-term money markets and across the term structure. Reserve requirements have receded into the background as a tool, since they are so low as to not be binding. The Fed could not pay interest on reserves until it was permitted to do so under the Economic Stabilization Act of 2008, which authorized payment of interest on both required and excess reserves. Because of the Fed’s asset purchase programs, bank reserves ballooned; and the Fed began paying the same rate of interest on both excess reserves and required reserves. That remains the case today. The IOER was intended to put a floor on the band within which the Fed would set its fed funds target rate. However, for much of the period since IOER was adopted, the effective federal funds rate was slightly below the floor supposedly set by IOER. The reason for this lies in a technical problem, in that Freddie Mac and Fannie Mae as well as the Federal Home Loan Banks are permitted to hold deposits at the Fed but are not permitted to receive interest on those funds. So they lend the funds out in the overnight market at rates slightly below IOER. These entities would appear to be prime candidates for placing deposits in TNB and similar narrow banks. While eliminating the discrepancy between the effective federal funds rate and IOER might be a desirable outcome, it is not obvious that simply permitting the Fed to pay interest on GSE and Home Loan Bank funds is not a better alternative, especially since these entities are, at present, government institutions. In summary, the issues raised by the narrow bank proposals are complex and not always clear. What is needed at this point is a serious and in-depth reassessment of the Fed’s policy tools, the structure of the markets in which those tools are applied, and how the tools are linked, both theoretically and practically, to the macroeconomy. Just one example may serve to illustrate that need. The present primary dealer system is a relic of the past when Treasury securities were paper documents and primary dealers submitted paper bids in connection with daily open-market operations. With the evolution of technology, including digital securities and electronic bidding, there is no reason that all sound member banks and other qualified entities should not be permitted to bid and eliminate the privileged position of the primary dealers. Right now, more than half of primary dealers are affiliates or subsidiaries of foreign banking institutions that are currently being supported by the Fed though the primary dealer credit program, effectively subsidizing foreign institutions. Growing Up With Central Bankers for Company Bloomberg News (April 28, 2020)

In this issue of the Institutional Risk Analyst, we feature a comment by David Stevens , CEO of Mountain Lake Consulting and former President and CEO of the Mortgage Bankers Association (MBA) . Prior to assuming this position, Dave served as the Assistant Secretary for Housing and Federal Housing Commissioner at the U.S. Department of Housing and Urban Development (HUD) . By David Stevens When America realized that it had to shelter itself and implement safety and distancing measures to respond to COVID19, most public policy makers jumped into high gear. Addressing housing was part of this enormous series of response measures in an effort to cushion the US economy and its people. Almost all sectors of the federal government's apparatus dove in, from the Federal Reserve , to Congress and the White House, HUD, and more rallied to do their parts. But notably absent was was Federal Housing Finance Agency (FHFA) ? With an excess supply of mortgage backed securities ( MBS) in the market as investors repositioned their balance sheets, the Fed began aggressively buying agency MBS removing the excess, creating a short, plunging yields lower and prices higher eliminating the risk of failure to companies holding these bonds. When the Fed realized it had pushed rates down too hard, risking a severe blow to nonbank lenders with short hedge positions on their production pipelines, they quickly slowed the purchases. Rates stayed low but margin calls slowed and the mortgage markets stabilized. But the Fed did not stop its commitment to support liquidity in the agency markets. Beyond simply purchasing Treasuries and MBS at an unprecedented level, Fed Chairman Jerome Powell took to the airwaves to spread a message of their commitment to cushion the economy. To his credit, Powell appeared in multiple interviews including the Today Show , something rare for a Fed Chairman. He understood that supporting the markets, financially and rhetorically, was important. ABC reported last week, Federal Reserve Chairman Jerome Powell pledged Friday that the Fed will “use our tools" to support the economy, an effort to ease fears over the viral outbreak” one of many stories in early March that were followed by rate cuts and more. In came Congress to help pass a sweeping bi-partisan piece of legislation, signed into law by President Donald Trump that provided $1.8 trillion in aid to spread across small business, consumers, housing, and more. It was this piece of Legislation that created a new form of forbearance. Rather than follow the blueprint from the last recession, where one had to prove something called “hardship,” in order to insure that taxpayer dollars only went to those who needed it, this was quite different. First, CARES Act forbearance was made available to all homeowners with a government backed mortgage. That removed any friction in allowing people to get relief from mortgage payment. Yet it also introduced moral hazard by allowing people who were still employed and able to make their payments to skip them anyway. Unlike 2008, consumers need only ask for assistance with no proof of hardship. Second , The CARES Act offered 6 months of forbearance with an option to extend for another 6 months, a term far longer then the four month terms used previously. Third , the legislation stated that loans in forbearance were to be considered “current” and the consumers credit would be reported as such; Forbearance loans would not be considered delinquent mortgages. There were gasps heard across the mortgage industry simply due to the magnitude of the CARES Act forbearance. Estimates of impact showed massive dollars of outlays depending on who would take forbearance. This is also where the FHFA and Director Mark Calabria began to ignore the facts and depart from basic commercial market practice in the world of secured mortgage finance. The Mortgage Bankers Association as well as top economists began looking at potential impact in ranges of $40 billion to $100 billion in skipped payments. Calabria, an economist, made his prediction in public comments that total forbearances would be under 1 million borrowers by May, but the actual number was already more than three times that and rising by the 3rd week of April. The risks were clear to almost all in housing. From mortgage bankers to consumer groups, realtors, and members of Congress, all took aim at Calabria warning of the impact to bank and nonbank servicers, calling for a liquidity facility to be established to help make advances. As noted in an article by Mike Calhoun, Jim Parrott, and Mark Zandi : “Congress hasn't made the repayment obligation disappear, but simply moved it from the borrower to the mortgage servicer.” The Cares Act offered this to all borrowers with a government backed mortgage. Because forbearance lasts 6 months or more, and because these "performing" loans would remain in the securities rather than being repurchased out of pools, there was an open ended funding requirement for all servicers, banks or nonbanks. The amount of advances required looked to wipe out some smaller servicers. This unprecedented liquidity requirement thrust on industry by Congress was in excess of any available source of funds. But Director Calabria not only turned a deaf ear to such real world concerns, he made things worse by making public statements about his willingness to let nonbank mortgage servicers fail. In shocking remarks as reported : Calabria suggested, incredibly, that Fannie Mae and Freddie Mae "could just transfer servicing in a way that's not too disruptive" and give those mortgage servicing rights owned by independent mortgage banks to other entities – either larger nonbank servicers or the banks themselves. He even suggested that some homeowners might be better off dealing with larger banks, a dangerous fiction everyone in the mortgage industry knows to be untrue. His comments set off a chain of events that tightened credit. Rather than calm markets like other Federal regulators and use the tools of government under his authority to step in and support this legislation, Calabria's public comments sent a message to warehouse lenders, MBS investors, broker dealers, and more that they might get caught holding the bag should one of these companies fail. Investors might lose their back stop for reps and warrants made, warehouse lenders might get stuck with a pipeline of forbearance loans, etc. So credit overlays started rolling out and the result is significant tightening in credit terms for 1-4s. Minimum credit scores rose, debt to income ratios dropped, certain programs like bond loans, high balance GSE loans, and more simply began to vanish. What’s most outrageous perhaps is FHFA's view about transferring servicing and consumer experience when the opposite is true. First, no servicer wants to take on a new volume of in-forbearance loans, particularly not in the midst of a rising credit loss cycle. The FHFA's position shifts the advance burden for forbearance and actual loan defaults to the servicers, who must fund and manage the workout process to be done post forbearance. The costs would be significant and the GSE’s would have to essentially pay handsomely for any servicer to take that on. Second, as the FHFA Director knows first hand, the transfer itself is disruptive to the consumer and simply shifting to a “larger” servicer adds no benefit to the experience. Far from providing liquidity, the FHFA aided and abetted a credit tightening event at a time when liquidity is needed most. HUD, in contrast, approached this in a different and far more responsible way. Rather than shake the markets, HUD moved quickly and quietly to calm them. GNMA took a liquidity facility once only used for servicers in technical default and facing collapse and expanded it to all of their issuers thus easing the concern about finding the money to make these advances. In addition, the FHA's tools were already in place to handle the borrower and the servicer once the forbearance period ended. The servicer submits a partial claim to FHA and the balance to be repaid by the borrower is tacked onto the back of the loan in the form of a “secretary’s lien.” The forbearance is to be paid back at minimum when the home is sold or refinanced. In effect, HUD is financing the CARES Act forbearance. After weeks of pressure on Director Calabria, he came back with partial help by capping the forbearance payments to four months. But much of the damage had already been done. Credit had already tightened in the correspondent lending and other channels . And, as of this writing, because these loans will remain in the security there is no reasonable timeline for the servicer to get the advances returned. Keep in mind, all of the $5.5 trillion of conventional servicing is owned by the GSE’s. It’s their legal asset as the owner of the mortgage notes and issuer of the UMBS securities. In the conventional market, the servicer owns the loan level servicing and acts as essentially an agent for the note holder, servicing the loan for the GSEs and, indirectly, the investors in the UMBS securities. The FHFA did not protect these crucial assets owned by the GSE’s It should have authorized a liquidity facility to be established by the GSE’s to make advances and thereby protect the value of this servicing asset. A GSE-led liquidity facility would not impose any risks on the GSEs and, indeed, would have made Director Calabria the hero of this story. Sadly, his lack of understanding of the rules of secured mortgage finance blinded him to this obvious political win. A GSE-led liquidity facility would have alleviated the risk to the massive non bank market that dominates the US mortgage finance system, accounting for over 60% of all mortgages made. The risk, fully secured by 1-4 family mortgages, would be placed it where it should be - in the hands of two companies controlled by the federal government and under the control of this federal regulator. The sort of extremis that is the COVID19 crisis was the reason Congress created Fannie Mae almost a century ago, to provide liquidity to the mortgage market in times of crisis and, more than anything, to buy time. When Congress created Fannie Mae in 1938 it was about buying time. The wave of defaults that are right behind the CARES Act forbearance issue should be the focus of our attention. The complex web of inaction, obfuscation, and belligerence in the midst of a national crisis when all other federal agencies, Congress, and the President dove in is remarkable. Calabria’s ignorance about how the GSEs and the mortgage industry function as well as consumer behavior only adds to the danger. When the FHFA and GSE’s announced a new policy of charging 700 basis points for acquiring first payment forbearance loans and refusing to buy those that were legitimate, agency eligible cash out refinances, this just added to the absurdity of the responsibility that the GSE’s were shirking. And here we sit today with the outcome. Announcements from lenders include things like stopping all cash out refinances, having a 700 minimum FICO score and maximum 80% LTV. The loss of product availability is incredible. According to the Urban Institute these overlays produce an outcome where approximately 64% of all purchase loans fail at least one of these overlays. History will look back at this incredible time that took over the world. The response from the US government will certainly undergo scrutiny about preparedness, response, and subsequent efforts to return to work and the post effects of these moves. For housing the response from the Federal Reserve, Congress, the White House, and HUD was swift and effective. The inept actions taken by the leadership team at FHFA to date are inexcusable. To not use two government controlled and backed companies whose primary mission is to provide liquidity especially in a counter cyclical period is unforgivable. With billions of dollars at stake on assets owned and guaranteed by Fannie and Freddie, this FHFA Director has shirked his responsibility as the Conservator of the GSEs to protect the value of the servicing assets owned by the GSEs and the conventional market that gives the enterprises economic life. The behavior of FHFA these past weeks has been incredible. They are putting confusion and uncertainty into the market. Instead, FHFA should join other federal agencies and leverage these tools of government to help the economy and provide a cushion as they are able to . There is still time to get this right. More stuff National Mortgage News: Why the FHFA's latest move undermines the MBS market https://www.nationalmortgagenews.com/opinion/why-the-fhfas-latest-move-undermines-the-mbs-market Masters in Business: Chris Whalen & Barry Ritholtz on Bloomberg Radio https://www.bloomberg.com/news/audio/2020-04-24/chris-whalen-on-ppp-loans-podcast

In this issue of The Institutional Risk Analyst, we feature a comment from Michael Bright , CEO of the Structured Finance Association . Prior to joining the Structured Finance Association, Michael was the EVP and Chief Operating Officer of the Government National Mortgage Association (Ginnie Mae), which guarantees $2.2 trillion in residential mortgages. The Fannie-Freddie Forbearance Bailout By Michael Bright Forbearance is certainly the new trending word. It’s all over the media. And suddenly everyone is an expert on the once-arcane business of mortgage servicing. Dire predictions are being made about nonbank servicers, although the data is coming in one week at a time. Thus far, the nonbanks are generally holding in, and they are supporting the secondary markets and their borrowers as best they can. Many nonbanks are also taking the lead in addressing COVID19 on behalf of the global investors in mortgage backed securities (MBS) they represent. No one knows the mortgage business better than the servicers, other than perhaps the GSEs – Fannie Mae and Freddie Mac . And right now, the scoreboard is Government Enterprises: 100, Private Servicers: O. That’s not by chance. The servicers appear to face a deliberate strategy designed by the Federal Housing Finance Agency (FHFA) to stick the private market with the cost of dealing with COVID19 in the conventional loan space. T his is not a reluctance to bail out private nonbanks with public funds, as some have argued. Instead, this looks more like the expropriation of private resources of banks, nonbanks and bond investors to shield Fannie Mae and Freddie Mac! The FHFA agenda is tantamount to a bailout for the GSEs at the expense of bank and nonbank servicers, and bond holders. Here’s why. Under normal circumstances, Fannie Mae and Freddie Mac make arrangements with their seller servicers to buy delinquent mortgages out of MBS securities once those mortgages go 120 days delinquent. A servicer will collect and then advance borrowers’ monthly payments to the GSEs. They do this in exchange for a small servicing fee of typically around 25 basis points plus ancillary fees that cover the elevated cost of default servicing Often, a small percentage of borrowers miss their mortgage, and the servicers advance payment of principal and interest for them, then collect the arrears when they either resolve the default or foreclose and sell the house. If, however, a borrower goes from one or two months missing their payment to full 120 days – or four months – delinquent, the delinquent loan shifts from being the servicers’ problem and becomes the problem of Fannie or Freddie. The role of guarantor, and of performing this function, is the essence of the GSEs’ business. Fannie and Freddie take on the credit risk of conventional loans in exchange for a guarantee fee (which is much larger than the servicer fee). All makes sense, right? But then we get back to the kicker - the way the GSE COVID-19 forbearance program is designed, it puts all of the cost of administering it on the servicers. Why? Because this program’s “forbearance” never triggers the clock to when a borrower is 120 days delinquent. Again, that is a private sector bailout of the government in all but name. Adding to the challenge of today’s market, originators are reacting to the FHFA stance by curtailing conventional lending. If the originators (also called “seller-servicer” to the GSEs) are unable to deliver loans into GSE securities because between the time the loan funds and is delivered, the borrower requests a forbearance, then they won’t do conventional loans How many new conventional loans will seek forbearance? No one knows for sure. The numbers from mortgage servicers suggest that participation could be well into double digits. But to protect against this eventuality, lenders are now only originating loans that they have a VERY high degree of certainty will not go to forbearance prior to delivery. The position of the FHFA in refusing to support loan servicers, banks and nonbanks alike, is adding to the restriction of mortgage credit in the economy at this time. The irony of this situation is quite stunning. I like to be positive and look for silver linings in any situation. Clearly, the FHFA has a strong desire to shrink the role of the GSEs in our economy. Fine. But moving forward with this agenda at a time when the alternatives, particularly the market for private label mortgages, has evaporated for now seems short-sighted. The FHFA may have had some thought about re-positioning the GSEs in the private label market, but that option is not viable until investors come back to the table. The FHFA’s position is making that process of restoring investor confidence even more difficult than it need be. At a bare minimum, FHFA should help advocate that the Fed provide liquidity to "AAA" private RMBS the way it is doing for other asset classes such as commercial real estate. That won’t save private label mortgages alone, but it could help limit the damage to an important market that exists alongside the conventional market. It remains to be seen whether we will experience large scale defaults that cause servicers to go bankrupt. And it remains to be seen whether or not the Fed and Treasury will step in to help the conventional market. With 22 million newly unemployed in just a month, surely the delinquency numbers will rise and could force Treasury’s hand. If the Fed does act, remember one thing: the real recipients of this emergency assistance are the firms that took on the credit risk. That is, Fannie and Freddie.

“Because uncertainty about the future is fundamental, financial mistakes will continue to be made. They will be made by entrepreneurs, bankers, borrowers, central bankers, government regulators, politicians, and, notably, by the interaction of all of the above.” “ Boom & Bust: Financial Cycles and Human Prosperity ” Alex Pollock (2010) New York | In this issue of The Institutional Risk Analyst , we consider the practical aspects of systemic risk, something that everyone talks about but nobody seems able to understand or quantify. And we are reminded of the wisdom of our friend Alex Pollock , formerly of R Street Institute and now Principal Deputy Director at the Office of Financial Research . He wrote in his 2010 book which we quote above: “How can you regulate the systemic risk when you are the systemic risk?” Witness the world of nonbank finance. A few months back, we were warned by no less authority than the Financial Stability Oversight Council or “FSOC” that nonbank financial companies were a source of systemic risk. Mark Calabria , who heads that world class regulatory agency known as the Federal Housing Finance Authority or FHFA, apparently encouraged this line of thinking. And Director Calabria and the FSOC turn out to be totally wrong. Instead of nonbanks causing systemic risk, in fact the mounting threat to the US financial system is coming from government sponsored enterprises and the members of the FSOC itself, particularly Mr. Calabria. The FHFA is led by somebody who thinks his job is to “protect the taxpayer” – even if this means standing by as the conventional mortgage market implodes due to a lack of liquidity -- liquidity for obligations that are guaranteed by the United States. Last week, the GSEs Fannie Mae and Freddie Mac had a liquidity facility ready to put in place to support issuers. Meetings were scheduled with members of Congress to discuss the plan. Then suddenly, Mr. Calabria told the GSEs to stand down and shelve plans to support the industry. To say that people in and around the housing industry were flabbergasted is an understatement. Following Calabria’s action to shut down the servicer liquidity facility planned by the GSEs, the FSOC met and decided to take a “wait and see” approach to providing liquidity to mortgage servicers, banks and nonbanks alike. Again, we are told that the FSOC’s decision was largely taken because of erroneous advice from Director Calabria, who has never actually worked in finance much less in the housing industry. As we note in our comment in National Mortgage News , “ Financial tsunami threatens housing sector ,” the mortgage industry can probably manage to make the April payments of principal and interest due on $11.5 trillion in agency and government insured mortgage backed securities. But by May, the national payments system will be running out of money and the Treasury will face default. The alarm bells are already ringing in Washington and at central banks around the globe. If a government issuer has a deficiency as a result of the Congressionally mandated payment holiday , then they will notify Ginnie Mae and the agency will then call the Treasury to seek financial support to pay the bond holders. If a conventional issuer has a deficiency as a result of the Congressionally mandated payment holiday, then they will notify Fannie Mae and Freddie Mac, which will immediately inform the FHFA. The FHFA, in turn, will call the Treasury seeking financial support. All roads lead back to the Treasury and Secretary Steven Mnuchin . After counseling the FSOC the take a “wait and see” attitude on providing liquidity to nonbanks, including the GSEs it’s important to add, Director Calabria then decided to give an interview to the Financial Times . In the interview, Calabria predicted that the GSEs will run out of money in just six weeks and will then require yet another federal bailout. Mr. Calabria loves talking to the media, you see. Calabria’s ill-considered comments made many people in the mortgage industry question the judgment and state of mind of the FHFA head. For one thing, federal regulators are not supposed to make gratuitous comments in the media about the financial institutions they regulate. His actions seem calculated to undermine confidence in the GSEs and the mortgage market. As one leading mortgage industry CEO told us on Friday: “ No action IS an action. Calabria is turning into the caricature people feared if/when a crisis hit. ” The failure of the FHFA to allow the GSEs to provide liquidity support to servicers of conventional loans is not only threatening the solvency of mortgage firms and smaller banks, but it is also negatively impacting the new issue market for MBS. Years from now, Director Calabria may be remembered for starting the housing industry meltdown of 2020. What investor would want to buy Fannie Mae or Freddie Mac securities if they are uncertain as to whether the inevitable arrears from payment holidays can be financed? The same goes for Ginnie Mae MBS, government guarantee or not. Of course, Director Calabria claims to be concerned about “protecting the taxpayer,” but his actions say quite the opposite. It’s almost as though Calabria was intentionally trying to make things worse in the mortgage finance sector. The collapse of the agency mortgage market is a far greater danger than any short-term losses the GSEs may absorb. Again, Mark, agency securities are guaranteed by the United States. And the irrational and dangerous actions of Director Calabria are also visible with the other GSEs. Witness the experience of prime mortgage issuer Redwood Trust (NYSE:RWT) , which was apparently pushed away last week from the Federal Home Loan Banks and forced to sell a large chunk of agency mortgages at a double-digit loss. JMP Securities wrote last week: “[I]t appears FHLB Chicago made changes to the terms of its lending relationship with Redwood that caused the company to elect to voluntarily and quickly step away from that facility. While there are certainly other significant challenges facing mortgage lenders and investors these days, we believe the souring of this relationship was a major contributor to updated results disclosed on April 2” With the GSEs backing away from the very markets they are meant to support, is there any question that the FHFA is following the wrong policies? Without immediate action to provide liquidity to servicers of both conventional and government loans, the US mortgage market is going to seize up. When the servicers cannot fund their operations, then the new issue market will come to a halt – as it has now. Because of the ill-considered actions of the FHFA, the US Treasury may now be forced to take the GSEs out of conservatorship and take formal control of both Fannie Mae and Freddie Mac by converting the government’s warrant into common equity. By taking active control of the GSEs, the Treasury can push aside Director Calabria and the FHFA, and get the GSEs to work providing liquidity to the conventional market. The current mess in the housing sector is entirely the fault of Washington, a city which is so dysfunctional and so conflicted that it cannot even allow the agencies created to support financial markets in time of stress to operate correctly. Anybody who thinks that the market for US Treasury securities can survive the collapse of the agency and government-insured mortgage markets should think again. President Donald Trump needs to remove Director Calabria from his position at the FHFA forthwith and direct the Treasury to take control of the GSEs. We must get Fannie May and Freddie Mac into the fight to save the conventional mortgage market – and the US financial system – from a serious and unnecessary crisis. And we must act quickly because the opening of trading in the US bond market is likely to be messy on Monday.

New York | In our March 22nd issue (“ What Must Be Done to Support Housing Finance? ”), we talked about what needed to happen in the market for mortgage backed securities last Monday to prevent the apocalypse in the short-term credit markets. The Federal Reserve and the GSEs rode to the rescue, and the markets for existing agency mortgage backed securities (MBS) started to settle down a bit last week. Indeed, some market participants think that the Fed even might have bought a wee too much in the past several weeks. Mortgage Bankers Association President Robert Broeksmit said in a weekend email to MBA board members: "T he Fed’s intervention was so strong that whipsawing mortgage prices threaten to swamp (bankrupt) dozens of IMBs with margin calls on their pipeline hedges. The combination of an industry hitting capacity constraints, unprecedented liquidity demands, and volatile financial markets is leading to severe distress amongst many in our membership." Meanwhile, the carnage in the broader markets continues. This week in The Institutional Risk Analyst , we focus on the new issue market, which has basically ground to a halt in the past several weeks. The chart below from the Securities Market Industry Association (SIFMA) shows issuance through February. The red line represents Treasury borrowing, while the green line just below represents MBS issuance, residential and commercial. Whereas the challenge facing the Fed and particularly the Federal Reserve Bank of New York last Monday was adding liquidity to the money markets, this week the shift focuses to reassuring investors that they should buy new issue Ginnie Mae and GSE MBS. The fate of many lenders, large and small, hangs in the balance based on what is done or not in the next several days. Suffice to say that if MBS prices continue to surge, margin calls could put a number of lenders out of business next week. But restoring confidence among bond investors is equally important. As the chart suggests, there is probably well north of $150 billion in new issue agency loans stuck in lender pipelines as March comes to a close. And this does not include the vast wreckage of non-QM loans, credit risk transfer (CRT) securities and other detritus now clogging the financial arteries. The various fringe markets that were flourishing at the end of February have vanished as an asset class. Last week, investors largely backed away from new issue Ginnie Mae MBS because of uncertainty as to home mortgage servicers would finance the huge advances that must be made on loans that go delinquent through the national payment holiday authorized by Congress. Incredibly, nobody in Congress seems to have considered the financial implications of declaring the Jubilee with respect to consumer loans of all descriptions. The Fed and other agencies are left to clean up the mounting mess. On Friday, Ginnie Mae announced that it was invoking Chapter 34 of the servicing guide that is authorized by the Stafford Act, allowing Ginnie Mae to provide emergency funding assistance for issuers . This is an enormously important development that President Donald Trump , HUD Secretary Ben Carson and other members of the administration should highlight in their public comments on the response to the crisis. Ginnie Mae stated Friday after the close of the markets: “Ginnie Mae fully anticipates implementing within the next two weeks, via an All Participants Memorandum (APM), a Pass-Through Assistance Program (PTAP) through which issuers with a P&I shortfall may request that Ginnie Mae advance the difference between available funds and the scheduled payment to investors. This PTAP will be effective immediately upon publication of the APM for Single Family program issuers, with corresponding changes made to Ginnie Mae’s MBS Guide in due course. We anticipate publishing PTAP terms for HMBS (reverse mortgage) and Multifamily issuers shortly thereafter.” The good news is that Ginnie Mae, backed by the US Treasury, is moving to support the $2.2 trillion market served by government mortgage issuers. This is good. But we’ve not even touched upon the bigger task, namely providing advance funding to issuers in the conventional loan market served by Fannie Mae and Freddie Mac. The conventional market represents half of all US mortgages and some $5.5 trillion in outstanding MBS. Federal Housing Finance Agency head Mark Calabria reportedly does not want the GSEs to provide any extraordinary assistance to the conventional loan market, but this reticence may not last through the end of this week. We’d suggest that instead of telling GSEs not to respond to market pressures “creatively,” being proactive in supporting issuers will pay big returns later. We’d also urge the FHFA to think of creative ways to leverage the Federal Home Loan Banks to finance servicer advances on agency and government loans. Rest assured, we will figure this out. The logic is compelling. Bank and nonbank loan servicers must continue to pay investors who hold Fannie Mae, Freddie Mac and Ginnie Mae securities. In the conventional market, Fannie and Freddie are the issuers and pay the bondholders. In the Ginnie Mae market, the individual banks and nonbanks are the issuers and pay the bondholders directly. If the banks/nonbanks cannot pay the GSEs, then Fannie and Freddie will very quickly hit a wall and require liquidity assistance from Fed and/or Treasury. In the government market, in the event of nonpayment by a bank/nonbank issuer, Ginnie Mae would immediately require Treasury to step in to make the payments. The next pay date for most mortgage backed securities is April 25th. Again, as we’ve noted previously, the Federal Reserve Board continues to protect the franchise of the primary dealers at the expense of other market participants in providing liquidity. The obvious solution to a lot of the liquidity problems facing the secondary mortgage market is to simply create a standing repo facility that can transact in a broad range of securities and loans backed by the US government. With the passage of the rescue legislation and the legal moratorium on agency loan payments, bank and nonbank mortgage servicers must scale up their operations dramatically to handle the load of customers who need help. Servicers are already buried in incoming calls from consumer seeking loan payment abatements. Call volumes are running an order of magnitude about February levels and dropped calls are soaring, a measure of building volumes. Now that missing consumer loan payments is authorized by government fiat, the US mortgage industry faces a massive servicing task that may exceed the 2008-2012 period. At the same time, investors must focus on some urgent details, specifically how the payment holiday for mortgages and other consumer/business loans is going to impact banks, nonbanks and the Treasury. In short-term, Fed needs to widen the specs of the TALF program to allow banks/nonbanks to pledge payment holiday advances on agency and government loans w/o a credit rating and directly with the Fed. The current spec is basically either to get a Fed loan 1) through a primary dealer or 2) directly for AAA securities. An advance backed by a GSE/FHA guaranteed loan should have the same eligibility for TALF as a "AAA" bond. Another small detail. Should HUD/FHA stick with their current post-forbearance plan and rely on loan modification that requires the servicer to buy out the loan early from the pool?  If, as many issuers anticipate, over 25% of all Ginnie Mae loans take advantage of the forbearance program, prepay speeds will accelerate dramatically. This will be followed by a slew of new issuance of seasoned loans recently off forbearance programs.  This is a lot of paperwork for nothing. If we follow the current HUD/FHFA plan, the US government would need to step in to support this down the road and may require even more significant Fed purchases.  Better to create a program that will leave the loans in the Ginnie Mae security (in other words, not modify the loan) and a partial claims process that would work without the need for modification, recording of lien, and secured financing.  Even better, a process that would help solve servicer T&I responsibility, would be leaving the loans in the pool and allow partial claims to be filed at the beginning of forbearance. This provides advance liquidity to issuers beyond the Ginnie Mae PTAP program. Servicers can handle this as a customer receivable advance that will be owed by the customer at loan payoff and will not cause further significant disruption in the Ginnie Mae securities market. We have great confidence that Secretary Steven Mnuchin and Fed Chairman Jay Powell will figure it out, but time is of the essence. There are a lot of lenders with fully locked mortgage production pipelines that may not survive through the end of next week. We need to see decisive action by the Fed and Treasury to reassure the concerns of large institutional investors in MBS – preferably before the opening on Monday in New York. Action needed now to support borrowers that IMBs serve Scott Olson National Mortgage News Financial tsunami threatens housing sector Chris Whalen National Mortgage News