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Montevideo | In this issue of The Institutional Risk Analyst, we feature the comments of Dr. Robert Eisenbeis, Vice Chairman & Chief Monetary Economist at Cumberland Advisors in Sarasota, FL . Reading a number of the tributes to Paul Volcker, who passed away last week, and recitations of his contributions brought back my own experiences with him when I was on the staff of the Federal Reserve Board from 1976–1981.  Among his key attributes were his integrity, the quality of his public service, his concern for the independence of the Fed, and his commitment to break the back of inflation despite the personal and political attacks he incurred in response to his policies designed to achieve that end. By way of background, prior to Volcker’s ascending from being president of the Federal Reserve Bank of New York to becoming Board and FOMC chairman in August 1979, the FOMC had been raising rates fairly steadily by 25 to 50 basis points from the fall of 1977 through August, at which point inflation was running at an annual rate of about 8%. One month later, after Volcker assumed the chairmanship, the fed funds rate was at 11.5% for September, and inflation was at 11.9%. By late October 1979, the funds rate was at 15.5%, before it declined to 14% in late November. A recession started in January 1980, and the funds rate peaked at 20% in March.  What we forget is that at that time the FOMC was not pursuing a funds rate target per se, but rather had in 1978 and through the period focused on specifying growth rates for the monetary aggregates through bank reserve control while articulating target ranges for the funds rate, given growth in the aggregates.  Today, of course, there is no mention in either the minutes or transcripts of monetary aggregates. Volcker was not unmindful that his policies of trying to slow the growth of the money supply would have implications for interest rates, but in addition he was concerned about the effects of interest rates on bank safety and soundness, since the banks tended to fund longer-term assets with short-term liabilities whose costs could increase to the point that earnings might go negative and eat up banks’ capital cushion. I was not involved at all in monetary policy during the time Volcker was chairman, but I was the senior officer in the research division responsible for bank and bank holding company research and policy, as well as research support on bank supervisory issues, consumer affairs concerns, and payments system issues.  Because of these duties, in late 1979 I was summoned to Volcker’s office together with another colleague and told that we were to attempt to determine how much pressure money center banks could stand on their capital positions should interest rates move higher.  Moreover, we were instructed not to tell anyone that we were working on that issue, not even the other governors. Needless to say, this task put both of us in a very uncomfortable position, since the culture of the Fed was that we worked for the Board and not individual governors or the chairman. This experience showed the depth of Volcker’s concerns about the possible unintended consequences of his attempt to break the back of inflation. Volcker’s policies were extremely unpopular both politically with the White House and with the general public.  The Board was bombarded with shipments of 18-inch two by fours from the houses that weren’t being built and received many nail kegs filled with keys from cars and houses that had not been sold. Constitution Avenue in front of the Board building was the scene of parades of farmers on tractors protesting the policies. In fact, Volcker was reluctant to go out to dinner because people would recognize him and harangue him about his policies. In the end, however, he was successful; and the negatives expressed at the time have long disappeared as his contribution has been recognized. Volcker had economic views that extended far beyond monetary policy.  For example, he was quite conservative when it came bank holding company policies. He was, for example, against permitting bank holding companies from acquiring thrift institutions. Remember that the thrift crisis of the 1980s was a creature of the combination of binding Reg Q ceilings and the run-up in interest rates that caused many thrifts to fail. Volker’s view was that keeping certain institutions balkanized in market segments would provide a safety net should one part of an industry experience financial difficulties. The problems would not infect other financial market sectors, causing a broad financial crisis. This view was what was behind the so-called “Volcker Rule” that was included in the Dodd-Frank legislation, designed to limit banks’ ability to engage in proprietary trading of securities, derivatives, options, and commodity futures. It also barred banks or insured institutions from acquiring ownership in hedge funds and private equity funds.  The aim was to prevent excessive risk taking by federally insured banking institutions and to limit speculative trading that might pose undue risks to bank customers. To Volcker, segmentation meant protection and financial stability. Finally, when we remember Volcker’s tenure at the Fed, it is also important to note that he tended to be relatively secluded when it came to policy. He relied mainly on just a handful of advisors, which included Jerry Corrigan. Corrigan had been a senior officer at the New York Fed, and Volcker had brought him along at the beginning of his tenure. Corrigan subsequently became president of the Federal Reserve Bank of Minneapolis before moving to the presidency of the New York Fed. Another confidant was the general counsel Mike Bradfield, whom Volcker hired. Bradfield was not attuned to the Fed culture and was a pit bull when it came to pursuing issues and asserting power. Bradfield surfaced in the aftermath of the financial crisis as a proponent of the Volcker Rule and also played a role as the driving force that uncovered dormant Swiss bank accounts that had been owned by victims of Nazi persecutions. Bradfield was known as Volcker’s enforcer, and he never fully adjusted while at the Fed to being a lawyer in an institution controlled by economists. To that point, on his first trip to the Fed of Kansas City’s Jackson Hole conference, Bradfield went on a whitewater rafting trip the first day, during which he fell off the raft and lost his glasses. I had several staff claim to me during the conference that they were the ones who pushed him. Volcker’s final key confidant was Steve Axelrod, who was Staff Director for Monetary Policy, a position in the office of the Board members that does not exist now. Steve was in charge of coordinating monetary policy for the Board. He was not a division director but because of his position he could order any of the research staff to do his bidding. Despite Volcker’s tendency to listen to only a few close associates when it came to key policy issues, but unlike Arthur Burns, he was respectful and tolerant of staff. I was fortunate enough to have a chance five years or so ago to sit down with Paul at a Federal Reserve Bank of Chicago conference and discuss the past. Despite my previous position as one of just many Fed staffers, he was cordial and more than willing to talk about old times and experiences. The qualities noted at the beginning of this piece were still as strong as ever. That conversation was a real treat that I will always remember.

New York | In this issue of The Institutional Risk Analyst , we feature a timely conversation with Dr. George Selgin , senior fellow and director of the Center for Monetary and Financial Alternatives at the Cato Institute and Professor Emeritus of Economics at the University of Georgia. He is the author of a number of books, including Floored! How a Misguided Fed Experiment Deepened and Prolonged the Great Recession (The Cato Institute, 2018) and writes frequently on monetary policy, payments and related topics for Alt-M . We spoke to Dr. Selgin last week from his office in Washington. The IRA: George, thank you for taking the time to speak with us today. Let’s start with the snafu in the world of repurchase agreements and short-term money markets and then move to the equally important question of payments. First thing, how do you explain the liquidity problems seen in the REPO market over the past year to ordinary citizens and particularly members of Congress? More important, how do you link the policy narrative coming from the Federal Open Market Committee with what the Fed is actually doing in the markets? The two often seem disconnected. Selgin: Those are some big questions. You start by observing that for some decades now the Fed like other central banks has insisted that its task is to regulate short-term interest rates. So, when interest rates do something that the Fed has not planned for them to do, that’s a problem. If the Fed isn’t able to control interest rates, then what is it doing and what is it able to do? I’d start with that premise, that the Fed is supposed to be able to keep interest rates on the desired target or target range, but in fact has been having trouble doing so. It had trouble keeping rates in line in September and it may soon have trouble doing so again. The IRA: Well, investors may not cooperate. The whole idea of targeting interest rates, as you noted in your book “Floored,” essentially amounts to the nationalization of a heretofore private financial market. But do continue. Selgin: The second point to make is that under the post 2008 system, banks are supposed to have all kinds of liquidity; they should have so much liquidity that they never have to resort to borrowing from other banks to cover shortfalls in reserves. But things haven’t turned out that way. It was the desire of some banks to cover reserve shortfalls, for example, plus the unwillingness of other banks to lend was the proximate cause of problems in September and may become one again. The IRA: Indeed. Isn’t it remarkable to see Fed Governor Randal Quarles at the Fed and Zoltan Pozsar at Credit Suisse (CS) each put various pieces of the puzzle forward for our consideration, but no one really talks about your point namely the idiosyncratic behavior of individual banks. Wells Fargo (WFC) , for example, has 15% more liquidity than it needs to fulfill the liquidity coverage ratio (LCR) and other tests. JPMorgan Chase (JPM) likewise is no longer providing liquidity to the markets as year-end approaches. Trillions of dollars in liquidity is essentially out of the market. Selgin: That’s right. There are two ways to understand why reserves ended up in short supply. One which the Fed has tended to emphasize is that the Fed miscalculated how many reserves would be required to keep the system flush, particularly in making plans for reducing the size of the balance sheet starting in October 2017. Consequently, it seems to have overdone things a little bit. The IRA: Ya think? Do our colleagues in the Fed system appreciate just how close we came to running the ship aground? Last December particularly? Selgin: I think they do now! What they don’t appreciate enough, but are coming around to appreciating, is that the problem is not simply that there are not enough total reserves in the system, but that those reserves are concentrated in a few large banks, including Wells but also others. And they failed to reckon with the fact that, even though these banks on paper had sufficient liquidity to meet the LCR rule and other liquidity requirements, in fact they did not feel comfortable lending out what seems to be a surfeit of reserves—not even in response to high rates and for short periods. The IRA: Or even to their own people. We reported on one case where the bank side of a certain money center essentially told the capital markets desk of the same bank that they had to pay those elevated market rates. Selgin: There are subtle regulatory constraints, including some rules that are unwritten, or written as it were on the margins of the regulations. Those rules are constraining banks more than the Fed and other regulatory authorities, or the bankers’ themselves, expected. The Fed is learning that the banks are interpreting the rules in such as way that they really need to keep more liquidity than was once thought necessary. The IRA: To that point, isn’t the “island of liquidity” notion adopted by the Fed and other prudential regulators, where a large money center bank need not transact with the market for 30 days or more, a little extreme? It reminds us of the ridiculous requirement in the Volcker Rule that banks not trade around their treasury portfolios, a requirement that killed liquidity in the bond market. The cumulative effect of all of these rules is to reduce market liquidity. Selgin: I think it probably is a little excessive. After every major financial crisis, the tendency isn’t just for the regulatory authorities to shut the barn gate after the horses have bolted. They slam the gate shut so tight that you can’t get new horses out for exercise. That’s what’s happened since the 2008 crisis; that the regulatory pendulum has swung too far in the direction of stringency. Now we have a system where in theory there are plenty of reserves, way more than 2008, but various requirements, some interacting in subtle ways, mean that all of that liquidity is frozen. It does not move around that way it did pre-2008. So, you have large amounts of reserves that can’t go where they’re needed. As I said in a Tweet recently, something can be liquid or it can be frozen. Today the liquid reserves of the banking system aren’t really liquid because they’re frozen. The IRA: Hasn’t this been the approach all along, going back to the 1990s to reduce liquidity via regulation? In the 1990s, when the SEC changed Rule 2a-7 and essentially made it impossible for nonbanks to sell pass through securities to money market funds, we created a monopoly on short-term funding for banks. The regulators keep taking functionality out of the money markets, then they wonder why there is a liquidity problem to your point. Selgin: That’s right. But you can go back a lot further than the 1990s. You can go back to the 19th century, when countries, including the United States, started to experiment with various types of reserve requirements. What most nations eventually discovered is that, when you make these requirements strict enough, the reserves simply don’t do what you want them to do. That is, the banks can’t use them when it would benefit them and the economy for them to do so. Uniquely among industrialized nations, the United States still has nominally fixed reserve requirements for banks. Most other nations got smart and dispensed with them years ago. They came around to the view that, while liquidity is very important, rigidly enforced reserve requirements did not make banks more liquid. If anything, they made them less liquid. History now seems to be repeating itself in the US, where Basel and other rules have made banks less rather than more liquid. The IRA: Based upon the Fed’s clumsy handling of the liquidity issue, we’ll not hold our breath waiting for a comprehensive fix of the problem you describe. Moving now from the money markets to payments, let’s talk about why the Fed seems intent upon creating a new payments system to compete with the Clearing House Association. The Fed today enforces a monopoly on payments reserved exclusively for insured depository institutions, but now the central bank seemingly wants to compete with the private sector. Selgin: It’s generally true that if you want to have innovation in payments, you must have a system that interacts with the established banking system payments network. That is the big one. There are other networks out there that could potentially support important payments systems, such as Facebook (FB) with its proposed Libra exchange medium. Still, the banking system has a huge advantage when it comes to dollar-based payments, and when it comes to dollar payments would-be non-bank innovators must be able to tap into the bank-based payments network. This creates a huge problem for non-banks that want to get a piece of the action in payments without needing the cooperation of a potential rival. That’s one challenge. The other challenge for innovation is that banks themselves have to work with the Fed. The big challenge for banks is that the Fed can itself compete with their efforts to expedite payments. Everybody is talking about FedNow , the Fed’s plan for a new real-time retail payments system. FedNow will compete with RTP, a private real-time payments network created by The Clearing House (TCH) . which has been up and running since 2017. Another challenge is getting the Fed to improve those portions of the dollar payments system that it monopolizes upon which other payments service providers depend. This is really the elephant in the room when it comes to payments. The IRA: Well, the future of payments is FedNow, right? The Fed is a GSE just like Ginnie Mae and the Federal Home Loan Banks. No private entity, even a big bank, can compete with a GSE. Selgin: Not easily. And the Fed regulates the banks behind RTP, the system FedNow will compete with TCH.. Does competition from the Fed help or hurt consumers of payments services? There is a fundamental conflict of interest for the Fed to be competing with the banks that it regulates. But the bigger issue is not FedNow or the huge amounts of money that the Fed is likely to spend creating its alternative instant payments system. It’s what the Fed is not planning to do. There needs to be more discussion of how the Fed can improve the payment services it already provides, especially by extending the operating hours of its wholesale payments services, FedWire and the National Settlement Service. By enhancing those systems it would help to support private-system payment system innovations, like RTP. Instead of competing with RTP, the Fed would do more good by improving the speed and efficiency of the wholesale payment services upon which all existing non-cash retail dollar payments depend. All of the payments systems that exist or are contemplated depend upon one or both of the Fed’s wholesale payment services. The IRA: So how should the Fed proceed? Selgin: The entire legacy payments system sits atop the FedWire and the National Settlement Service foundation. All ACH payments, all check payments, are settled using one or both of those services. Why is it that ordinary payments between two US banks can take days to clear? Hold onto your hat: FedWire and the National Settlement Service are not open on weekends or holidays. In fact, the business-day hours are so limited as to substantially reduce the extent to which ACH payments can be completed on a single day.. Simply extending those services’ hours, including keeping them open on weekends and holidays, would enormously enhance the speed and efficiency of traditional payments. Just keeping the system open another 30 minutes each weekday would make a great difference. Instead of working on a controversial, expensive and possibly redundant FedNow system, why doesn’t the Fed first improve its existing, core payments services? The IRA: And who knows, accelerating the velocity of payments might even have economic benefits! Imagine that! Thanks George.

New York | Over the past several months, news reports have suggested that the global auto industry is about to disappear. Ford Motor (F) announced a 10 percent reduction in executive ranks earlier this year. Daimler AG (DAI) has just announced additional job cuts. Analysts blame consumer angst regarding global warming and the imminent conversion of the industry to battery-powered electric motors. But sad to say, we think that politically motivated climate change hype inspires unwarranted pessimism about the prospects for autos, a skew in thinking which seems to color every discussion about every industry. A better explanation of downsizing in the auto industry is the end of a massive credit expansion and the continued industry rationalization that defies efforts to reduce overcapacity. That is, the same old story. Everybody wants to have a domestic auto industry. Many times, these industries are heavily subsidized, as in the case of electric cars in the US, Europe and China. Private producers in the US and EU are constantly forced to cut costs to keep pace. In regions like western Europe, where regulation and taxation are extreme, operating auto manufacturing operations is increasingly problematic. But if you want a real example of global deflation, forget the autos. Instead, take a gander at the earnings prospects facing global banks and particularly banks in Europe. The good news for American investors is that US banks are still easily the leaders in terms of capital and profits, but the outlook for global financial institutions is dreadful. Read about the most recent results for the US banking sector in The IRA Bank Book Q4 2019 , which is for sale now in our online store. Credit is strong, but the outlook for earnings not so much. The bad news is that banks in Europe and Asia face a period of restructuring and consolidation unlike any time in the century since WWI. Indeed, the vast demographic and financial expansion that drove global economic growth for the past 100 years appears to be ebbing around the globe. Markets outside the US seem to be particularly at risk. One chief risk officer tells The IRA that just about every major European and Asian bank will be forced to downsize or eliminate their capital markets arms in 2020. "Everyone has the same problem," he demurs. EUROGROUP Consulting, for example, reports that European banks are “struggling and losing out to American banks,” which have managed to strengthen their position in Europe, notably by relying on a large domestic market and a more favorable regulatory landscape. Simple stated, the insane, anti-growth regulatory and tax regime in the EU is killing the continent’s banks. And another big part of the problem facing EU banks and industrial companies alike, of course, is the tax known as negative interest rates. When Fiat Chrysler (FCAU) and Groupe PSA , the owner of Peugeot, agreed in October to combine forces to create the world's fourth-largest carmaker by production volume, this was not a sign of the impact of global warming on consumer preferences. Instead, two of the least efficient players in the auto industry in Europe were finally forced to consolidate in an industry with chronic overcapacity. Look for more combinations in coming months, particularly in Europe. Sales in the global auto industry peaked two years ago over 80 million vehicles, leading many observers to predict the imminent collapse of the sector. But what really seems to be at work here, in our view, is more of a normalization of production and demand to lower levels. The past decade of manic increases in vehicle sales were driven by low or negative interest rates, but the impetus for further growth seems to be ebbing fast. Notice that US sales of cars and light trucks has gone sideways since 2016. A decade ago, when US auto sales were limping along at 10 million units annually, the US auto sector was in danger of extinction. The fixed costs involved in making vehicles could not support three independent US automakers at this level of volume. As we wrote in “Ford Men: From Inspiration to Enterprise,” the departure of Lee Iacocca from Ford Motor in 1978 led to Chrysler surviving as an independent producer for another three decades. The persistence of Chrysler and the acquisition by Fiat in 2014, in turn, weakened Ford Motor and General Motors (GM) . With the US auto industry now operating at over 17 million vehicles per year, however, many observers have come to believe that this level of production is “normal” and sustainable for North American sales of light vehicles. That may not be the case. The expansion of non-housing debt helped to fuel the boom in auto sales since 2014. The availability of credit has driven the surge in auto production in North America to almost 18 million units. Source: FDIC The FRBNY reported in November that total auto debt, including $475 billion in bank owned auto loans, is $1.3 trillion. The auto loan asset class has basically grown by one third over the past decade. Or to put it another way, subprime auto loans account for about half of the $1.6 trillion in asset-backed securities tracked by SIFMA. Total household debt is now $1.3 trillion higher, in nominal terms, than the previous peak of $12.68 trillion in the third quarter of 2008, according to the FRBNY. “New credit extensions were strong in the third quarter of 2019, with auto loan originations reaching near-record highs and mortgage originations increasing significantly year-over-year,” said Donghoon Lee , research officer at the New York Fed. “The data suggest that households are taking advantage of a low-interest rate environment to secure credit.” So, is the US auto sector facing the apocalypse? No, but you may indeed see sales dip back toward 16-17 million units in North America. And expect some frightful restructuring of automakers in Europe, including the operations of US automakers. Auto makers globally are reducing headcount at the fastest rate since the 2008 financial crisis, a year before both GM and Chrysler filed bankruptcy. We may indeed see further acquisitions and some restructurings in the auto sector in 2020. Our bet: Look for Ford to eventually cut a deal to combine with a major European automaker. The ongoing restructuring of the global auto sector will be accompanied by an accelerating consolidation of the banks, particularly outside the US. The hostile business and regulatory environment in the EU is killing the banking system in Europe, but the politicians there seem to be largely indifferent. Unless and until leaders in Europe and Asia reject the insanity of negative interest rates and start to focus on the real problem -- namely excessive public sector debt -- banks in Europe will remain an endangered species and, to us, unsuitable for investors of any stripe. #Ford #Daimler #autos

New York | Even as a record 50 million Americans hit the road for Thanksgiving last week, the Federal Deposit Insurance Corp released the Q3 2019 financial results for the US banking industry, reminding us why reading the press on holidays is essential. Headline: Bank earnings are falling and have been since last year. But hold that thought… Below we look at several charts that tell the story as the US heads into year end 2019. And just a reminder that registered readers of The Institutional Risk Analyst can still take advantage of the " Black Friday Sale " through Monday December 2nd. The code we sent readers on Friday gives you a 30% discount off of the list price for our bank profiles. Perhaps the most significant change from last quarter was the fact that loss given default (LGD) for the $2.5 trillion in 1-4 family mortgage loans owned by banks reversed direction as home prices surged again, reaching a record low of -38% in the third quarter. Think of falling resolution costs as the inverse of home price appreciation. Memo: Send another thank you note to Fed Chairman Jay Powell. Gross charge-offs in 1-4s also fell to a post 2008 financial crisis low, confirming that credit conditions in the housing sector continue to appear benevolent, but also badly skewed compared. Of note, the long-term average LGD for bank owned 1-4 family mortgage notes over the past half century is 65%. The impact of monetary policy, a shortage of new and existing dwellings and a change in the behavior of older home owners has created a perfect storm of rising home prices and declining affordability. As a result of the increase in home prices, when those rare residential mortgage default events actually occur, the lenders profit on the resolution of the asset, as shown in the chart below. For many Americans, the dream of home ownership is simply no longer possible. A future of tenancy and insecurity awaits. Source: FDIC/Whalen Global Advisors LLC The chart above suggests that lending on prime 1-4 family homes has no cost in terms of credit, clearly an erroneous statement. Yet looking at the extraordinarily good credit performance of bank-owned 1-4s, it seems that those bearish warnings from some quarters of an impending recession in 2020 may have been a tad overstated. In prime auto loans held by banks, to look at another consumer facing sector, there is likewise evidence of stability in credit metrics. LGDs for auto loans fell below 50% for the first time since 2014. The average LGDs for bank owned auto loans is 56% going back to 2012, when the FDIC started requiring banks to break out this important consumer loan category in their quarterly disclosure. All that said, the trend in terms of net charge-offs and past due of bank owned auto loans continues to move higher, as shown in the chart below. Source: FDIC/Whalen Global Advisors LLC The next chart we selected from the Q3 2019 data from the FDIC is the net growth of total deposits and total loans, one of the most important relationships in terms of the overall condition of the US economy. In the period immediately leading up to the 2008 financial crisis, the rate of growth in deposits and therefore loans were quite high by historical standards. Then, following the 2008 crisis, the level of loans and deposits fell sharply as the industry took over $100 billion in losses that year, destroying both bad loans and the related deposit liabilities. Notice the huge downward skew in loans in Q4 2009, when the industry charged off $60 billion in bad loans in a single quarter. Since then however, despite or even because of the radical policies followed by the Federal Reserve Board, the level of deposit and lending growth rates have fallen, as shown in the chart below. The graphic shows the period end portfolio levels of loans and deposits, net of redemptions and new originations. Source: FDIC/Whalen Global Advisors LLC Finally, to return to that question about bank earnings, we take a look at after-tax bank results, both in terms of asset and equity returns. As we have been writing for almost two years in The Institutional Risk Analyst , the steady increase in bank funding costs have slowed and now reversed the steady growth in bank income since 2008. The one time increase in “returns to us” caused by the 2017 tax legislation is now long behind bank stock investors. Our friends in the worlds of asset management and financial journalism have trouble describing a decline in income to their various constituencies, but the numbers tell the tale very simply. US banking Industry net income peaked at almost $62 billion in Q3 2018 and has now fallen to $57.3 billion last quarter. That’s a ten percent decline, but you rarely read or hear that fact in the financial press. We must always be constructive, even if it means misleading the investing public. While the rate of increase in bank interest expense has slowed since Q2 2019, the deterioration in bank asset and equity returns is clear. Including large markdowns of mortgage servicing assets, "the average return on assets declined from 1.41 percent in third quarter 2018 to 1.25 percent," notes the FDIC. But the "one-time" events do not explain the downward trend in bank earnings. The peak of bank asset and equity returns was Q3 2018 at 14.8% and 1.4%, respectively. Income is falling, but the total assets of the industry continue to rise. The chart below shows asset and equity returns for all US banks. Source: FDIC/Whalen Global Advisors LLC The bottom line is credit quality in the US banking industry remains strong -- if you believe the data. The skew in home prices for the reasons described above raise doubts about the long-term credit cost of loans being originated today. It is interesting, of note, to see the LGDs for Commercial & Industrial loans and Total Bank Loans climbing, suggesting a slow but steady deterioration in credit quality is underway outside of the badly skewed world of residential housing. More troubling, however, is the lack of net growth in spreads on new lending and the secular decline in deposit growth rates since the Fed instituted “quantitative tightening” two years ago. The cessation in QT and the sharp reversal by the FOMC to add back liquidity to the money markets has not yet delivered an increase in domestic bank deposit growth rates. Without deposit growth, you cannot have strong loan growth – contrary to what many economists seem to believe. The continued increase in bank funding costs, regardless of what the Fed does or does not do, will remain a negative factor affecting bank earnings. Even with the change in direction of US monetary policy since the end of 2018, the pressure on bank earnings continues both due to rising funding costs and secular pressure on asset returns in the age of negative interest rates. A decade since the financial crisis, US banks have still not recovered to previous levels of asset and equity returns and are now losing ground. We will be covering many of these issues in greater detail inside the next edition of The IRA Bank Book and in our individual bank profiles .

New York | News reports suggest that The Charles Schwab Corporation (SCHW) may acquire TD Ameritrade Holding Corporation (AMTD) . SCHW is a $280 billion thrift holding company ( RSSD:1026632 ) that ranks 14th in the US among large depositories. With $3.2 trillion in assets under management (AUM), SCHW also has a dominant position in the world of providing clearing and custody services to registered investment advisors (RIAs). Darren Fonda notes in Barron’s that this fact – and the float that it generates – enables the banking side of SCHW to generate 70% of the firm’s combined revenue. It's all about the float kiddies. In our note in ZeroHedge last week (“ Schwab + TD Ameritrade: Banks Always Win ”) we opine that this gives SCHW an overall cost of funds just 40% of the average of Peer Group 1, as shown in the chart below. Source: FFIEC The fact that a combined SCHW and AMTD would have $5 trillion in AUM allow us to estimate that the combined deposit base would be over $300 billion, including customer balances and fiduciary float. Today Charles Schwab Bank, an S&L domiciled in Henderson, NV, has $200 billion in core deposits. This abundance of liquidity – and fee income – raises an interesting possibility, namely a counter-offer by The Toronto-Dominion Bank (TD), which is the custodian bank for AMTD. Barron’s notes that TD, which owns 43% of AMTD, is presently the bank custodian for the millions of RIAs and individual investors of the smaller non-bank brokerage firm. TD earns the interest on the float, minus a very legal rebate paid to AMTD. This is a similar arrangement to any non-bank company, which must deposit client balances with an investment grade insured depository institution and then borrow them back if needed. SO, the question arises: Does the management of TD in Toronto really want to see AMTD acquired by a competitor and another large bank at that? As Barron’s notes rather astutely (and the rest of financial journalism largely missed), the relationship between TD and AMTD is quite lucrative for the $1.3 trillion TD. Again, it’s all about the banking business. The brokerage side of the business is largely a commodity that does not matter in the grand calculus of valuation. But what supports the lofty valuations of both SCHW and AMTD? One word: AUM. With AMTD trading around a $26 billion market cap and SCHW at $60 billion, acquiring the 60% of the former it does not own would cost TD something on the order of $15-20 billion. TD trades in line with its large bank peers at ~ 2x book as of Friday, meaning a bid to acquire the rest of AMTD would be very expensive. News reports speculate that SCHW may cut a deal with TD to allow the Canadian bank to continue to service the deposit business of AMTD until the agreement expires in 2021. We think, however, that SCHW will be anxious to gain full control of the AMTD float as soon as possible. Telis Demos writes in The Wall Street Journal : “Schwab has long operated its own bank. Ameritrade partners with Toronto-Dominion Bank (a roughly 40% owner of the company) and others to distribute customer cash and earn what is, in effect, a net interest margin on that cash. Schwab currently generates a higher net interest margin than Ameritrade, so in theory that same customer cash could be more lucrative if deposited at Schwab’s bank.” Ditto Telis. And one veteran wealth manager tells The IRA that a counter-bid is unlikely because most of TD’s revenue comes from Canada, where it operates both a banking franchise and a large wealth management business. TD also has Waterhouse Securities, another discount brokerage which TD acquired two decades ago. Despite the prospect of losing the AMTD business, the manager views a possible counter-offer by TD for AMTD as a low probability event. TD has benefited from the entire float controlled by AMTD by owning just 40% of the company, but buying the other 60% at north of 3.5x book or higher is a bridge too far for the risk averse Canadians. TD has a very large core deposit base in Canada and, like most banks, suffers from a dearth of earning assets rather than a shortage of liquidity. A more likely scenario, the manager offers, comes with TD rebranding the Waterhouse brokerage business and taking the gain on the AMTD equity stake off the table. And, to the headlines about SCHW possibly “surging” above 3.5x book in the event the deal closes, validating the correlation between the SCHW deposit base and the premium valuation is not a straightforward exercise. The SCHW bank is low risk and provides stability to the business, but again, we’re not sure how that works into a 3.5x book equity multiple for the whole business, as shown in the chart below. Is the off-balance sheet AUM of SCHW more valuable than the huge mortgage and commercial payments float of U.S. Bancorp (USB) at 2x book value?? Source: FFIEC Liquidity: Please Sir, May We Have Some More? Despite all of this talk about banks awash in core deposit liquidity, we note with growing concern that we are repeating the scenario seen last year in the short-term money markets. Bids are adequate for overnight funds and a couple of weeks out, but there remains a reluctance to offer cash over the year-end. As the chart below from the DTCC suggests , the volumes for GCF repos of Treasury and conventional Fannie Mae and Freddie Mac collateral are falling as they did last year. Just saying. Black Friday Sale We’ll be pushing a 30% off coupon to registered readers of The Institutional Risk Analyst so that you can spend the holiday season pondering the truly extraordinary business model attributes of Citigroup (C) and Goldman Sachs (GS) . Yeah, SCHW has 3x the core deposits of GS. Think about that for a moment. Is there a correlation between strong levels of core deposits and premium equity market multiples? Maybe. And to celebrate the holiday season and shareholder value destruction, we’ve added HSBC Holdings plc (HSBC) to The IRA Bank Dead Pool , as shown in the table below. Trading on a price/book of 0.8x and a beta of 0.6, HSBC has effectively died as a stock – one of the negative side effects of macro prudential regulation. Were this $2.5 trillion asset zombie not a regulated depository, it would have been acquired and broken up years ago. But cowardly regulators refuse to break up the true zombie franchises with no hope of revival. Happy holiday. #HSBC #GS #C #DB #DarrenFonda #TelisDemos

New York | Did Goldman Sachs (GS) and Apple Inc. (AAPL) discriminate against women in the provision of credit on the new accounts for the Apple Card? Probably not deliberately, but credit scoring systems generally see women as being inferior credit risks – both internal and external to the actual underwriting process. When you apply for consumer credit, your individual score and credit utilization history are the primary criteria considered. “Several husbands — including Apple co-founder Steve Wozniak — have complained that their wives were offered dramatically lower lines of credit than they were,” reports CBS.com . Sadly, the new reports did not disclose the FICO score and credit histories of the offended spouses. A June 2018 paper by Federal Reserve Board researcher Geng Li , “Gender-Related Differences in Credit Use and Credit Scores,” outlines some of the difficulty faced when asking questions about gender bias in consumer lending. First and foremost, lenders are not permitted to gather or use gender related information, thus the public research in this area is limited. Li notes: “The Equal Opportunity Credit Act largely prohibits the use of demographic information, including gender, in credit underwriting, pricing, reporting, and scoring.4 As a result, information on credit histories and demographic characteristics has rarely been collected in the same data source, making evaluation of gender-related differences in the credit market challenging.” The mere fact that one spouse gets more credit than another does not necessarily indicate a problem in the credit scoring system. One spouse may be more active financially than the other, resulting in a higher rate of utilization of credit. Current usage of revolving credit lines such as a mortgage or a car lease is a major factor that drives credit scores and the availability of credit. Also, each bank has an internal default rate score for the “ideal” customer for a given product. As we noted in our recent profile of GS , the bank currently has about 40bp of gross defaults or just inside the breakpoint for a “BBB” portfolio default rating. Applicants below the “ideal” credit profile for a bank credit card product, for example, are likely to see lower initial credit limits or be denied credit entirely. But the real question raised by the consumer advocate wah-wah aimed at GS and AAPL is whether the lender reverse engineered the gender of the applicant during or after the underwriting process. Wall Street has for years wanted and tried to be able to track the obligor and the related assets and information in real time, particularly in areas such as mortgage lending. The early efforts backed by Buy Side hedge funds were massive, very expensive undertakings. But whereas a decade ago and more it was too laborious to manually merge credit profiles with a given individual’s personal information, today that data is commonplace and ubiquitous. Merging third-party demographic information with a loan file is a very simple matter. Indeed, some of the major consumer data repositories reportedly have begun to offer permissioned clients such as lenders and servicers secure access to merged data sets. Just imagine a confidential, non-public dashboard that merges credit, the value of the consumer’s home and behavioral data gleaned by Google and Facebook (FB) . Once a lender or investor can determine whether or not you are a single parent and a biological male or female, the credit analysis changes. Why? Because there is a correlation between gender and default probabilities. Again Li: “[S]ingle females tend to have higher installment loan balances, higher revolving credit utilization rates, and greater prevalence of delinquency and bankruptcy histories than otherwise comparable single males. Reflecting such differences in debt usage and credit history, on average, single female consumers have lower credit scores than comparable single male consumers.” Now here’s the catch. GS and other lenders don’t necessarily even need to hack your complete profile because the FICO score largely captures the gender difference. This is one reason that consumer advocates have been pushing for “competition” among credit scores. Calling for “competition” in credit scores is another way of saying that we’ll “democratize credit” and stick the losses to bond investors and the taxpayer. Just because you pay your utilities on time does not mean that you can service a 30-year mortgage. Of course, given the past track record of GS in other domains, it is easy to imagine the firm trying to limit default risk by reverse engineering the demographic attributes of their retail customers. As noted above, creating a comprehensive profile of an obligor is so easy in today’s market for behavioral data that it would almost be negligent for a lender or servicer not to have the information. And since there are any number of vendors happy to maintain such data remotely, away from the bank’s IT platform, it would be almost impossible to disprove such an allegation. So ask not whether you should be soiling your nappies because Google is caching your search results or playing with the algorithm that determines what you see online. Ask instead how you feel about unregulated third-party data providers and consumer credit repositories maintaining profiles of all of your consumer spending behavior, by name, gender and other attributes, as well as the behavior of your family. #GoldmanSachs #FICO #FederalReserveBoard #AAPL #GS #Li #SteveWozniak

New York | Fed Chairman Jerome Powell confirmed this week that the FOMC is unlikely to make any further reductions in interest rates for the balance of 2019. Various market observers have offered opinions about whether the interest rate environment is good for banks and those with leverage or not. Suffice to say that the spreads between rates in dollars and different currencies – specifically euro and yen -- are more important than the notional "neutral rate” of interest in dollars that fills the imaginings of many economists. In that regard, we have posted a new assessment for Citigroup Inc. (C) in The IRA online store . Like the other members of the Bank Dead Pool, our view of the quantitative and qualitative factors affecting C is decidedly negative. Poor asset returns, expensive funding, geographic diversity in all of the wrong places, limited liquidity and the world’s biggest derivatives book somehow just doesn’t do it for us. To paraphrase Jim Grant’s observation about Fed Chairman Powell, Citigroup CEO Michael Corbat is a prisoner of history. With Citi's battered currency trading barely at par, there is nobody among large banks with stable, core deposit liquidity out there for sale at a price that Citi can pay. We write in the most recent assessment: “Unless and until the management team led by Michael Corbat finds a way to enhance the bank’s financial performance and/or funding, we expect the bank to continue to underperform its asset peers in terms of market valuations. We believe that a change in the operational path of C is unlikely to occur in the near term and is only likely to occur at all as and when regulators compel a combination with another large bank.” We compare Citigroup with JPMorgan Chase (JPM) , U.S. Bancorp (USB) , American Express Company (AXP) , Capital One Financial (COF) and the 125 largest US banks in Peer Group 1 . Suffice to say that the head-to-head with AXP, which is the best performing large bank in the US and trades over 4x book value, isn’t too pretty. Even though the smaller AXP has a higher cost of funds than C, it delivers far better asset and equity returns than the $1.9 trillion zombie bank. Source: FFIEC In other news around the financial markets, Chairman Powell appeared on Capitol Hill this week and confirmed that the FOMC has fixed the liquidity problem in the repo market, at least for now. It is no accident that the VIX and other measures of volatility have basically collapsed since the FOMC opened the monetary spigot back in September. The correlation between adverse changes in the financial market stress and the subsequent launch of a new QE program has been widely remarked, but not it seems inside the FOMC. It is pretty clear that the markets globally cannot tolerate any meaningful decrease in the Fed’s balance sheet without the short-term credit markets seizing up. From the end of 2017 to July of 2019, the Fed’s System Open Market Account (SOMA) shrank by just over $400 billion or 10% of the Fed’s total assets. Yet the impact on the financial markets was dire indeed, as shown in the chart below. Notice that liquidity related stress due to QT pushed the VIX to 35 last December. Then seasonal factors lulled us all back to sleep, even as the contraction of the SOMA continued. Over the summer, however, idiosyncratic factors combined with ebbing liquidity to cause an increase in visible volatility. The quarter-end in June, however, saw significant problems in repo land. By August, the increased perturbations in the VIX, to borrow a favorite term of our colleague Dennis Santiago, then caused the equity markets to become unstable. When the word “repo” started to appear in headlines on CNBC and in The Wall Street Journal , that signaled a change in the direction of Fed policy. When President Donald Trump gives Powell a hard time about interest rates, the Fed Chairman need only point to the VIX and the S&P 500 for the proof of the efficacy of monetary policy. But the more important point to make is that the US central bank now is in the position of defending both the bond and equity markets (and, indirectly, the dollar) by maintaining minimum levels of liquidity in the credit markets. So how does this impact banks? The good news is that the rate of increase in bank funding costs slowed after Q2 2019. Also, banks have made some progress in the past several years in getting some increase in loan spreads, but the competition for assets at all levels of the banking industry effectively caps the asset return upside. If you take the five-year Treasury less Fed funds as a surrogate for net bank loan spreads, the spread was negative from March through September, when the easing and liquidity operations of the FOMC widened spreads dramatically. But the FF-to-5s spread only just crossed back into positive territory in late October. The good news is that the direction of monetary policy or at least liquidity policy, seems to support a gradual widening of spreads. After two years of tightening during the Fed’s ill-considered balance sheet contraction, the message of the markets is that an inverted yield curve is bad. As the imperative of the Fed has shifted from stoking inflation to maintaining liquidity, the ability to tighten monetary policy at all has been lost. The public narrative from the FOMC is still a tangled confusion of econometric bullshit that has no relationship to the Fed's actions in the marketplace. The practical task facing the Fed is to defend the all-important liquidity vs VIX relationship. So long as volatility remains muted, monetary policy will remain in neutral. But when volatility starts to climb, look for more liquidity measures from the Powell FOMC. #Citigroup #AmericanExpress #USB #JPM #UBS #JeromePowell #BankDeadPool #SOMA

New York | Last week we pondered the fate of Citigroup (C) and several other global banks that have lost their raison d'être with a group of veteran treasury and operations managers. Will the bank built over the years to service the political inhabitants of the post-war Pax Americana survive another decade? Or will the relentless consolidation of the banking industry at the top continue by forcing the sale or breakup of C? During the Cold War years and after, Citi was a very convenient institution indeed, a favorite haunt for intelligence operatives and central bankers. But the fact of official support did not prevent Citibank N.A. from making some truly epic operational errors, mostly tied to exotic offshore venues where the bank chose to do business. In many ways, Citi was the successor to famed institutions such as Pakistan’s Bank of Credit and Commerce International (BCCI) . The Mexico City money laundering scandal involving Citibank Private Banking and Raul Salinas de Gortari in the late 1990s resulted in years of litigation and the eventual ouster of John Reed as head of Citigroup. The removal of Reed ushered in the era of Chuck Prince , Sandy Weill and Robert Rubin , setting the stage for Citi’s 2008 collapse and government rescue. A series of international and domestic fiascos have followed since the 1990s, including the WorldCom scandal, rigging LIBOR and various other infractions of anti-money laundering laws and regulations around the world. The incompetence and deception displayed by Citibank officials so grotesquely in Mexico in the 1990s was repeated over and over again in the US and foreign venues such as Buenos Aires, Lagos and London. The cost of these errors and omissions to C shareholders stretches into the tens of billions of dollars . As the official international support for Citibank ebbed, however, the bank’s patchwork business model began to show strain. Today, after selling its Smith Barney asset management arm to Morgan Stanley (MS) , Citi lacks a clear path for the future. The bank has limited domestic deposits to support its $2 trillion in assets and the largest OTC derivatives book of any US bank – at least in sheer dollar terms. The prize for the largest derivatives exposure of any large US bank per dollar of assets goes to Goldman Sachs (GS) . But hold that thought. We actually heard Jim Cramer last week encourage his viewers on “Mad Money” to have a look at C as an equity investment. No way Jose. With due regard to Jim, we’d say the Citi stock is toxic. We own the C TRUPs, but the common is dead money IOHO. Citi trades below book for a reason. As Dennis “Mr. Wonderful” O’Leary said this summer on CNBC’s Squawk Box about the large banks generally: “Dead Money.” Investors are not paid nearly enough to take the outsize financial and operational risk that comes along with owning the Citigroup enchilada or risk and return. Simply stated, there is a reason why this stock trades below book, while asset peers such as JPMorgan (JPM) and U.S. Bancorp (USB) trade at a premium. The chart below illustrates the fact that C actually under-performs the average of the 125 large and smaller banks above $10 billion in assets that are included in Peer Group 1. Source: FFIEC To help focus our minds on the future, below we list the initial members of The Bank Dead Pool for 2020. This new feature from The Institutional Risk Analyst is inspired by the 1998 film entitled “The Dead Pool,” an American action movie directed by Buddy Van Horn and starring Clint Eastwood as Inspector "Dirty" Harry Callahan. The banks included in The Dead Pool are large, mediocre performers with weak business models, poor disclosure of risks, feeble equity market performance and a history of outsized operational risk events. Indeed, these banks are so problematic in terms of financial performance and the frequency of idiosyncratic op-risk events as to be uninvestable, either by individual investors or another bank. Here is the initial list: Deutsche Bank AG The Goldman Sachs Group Citigroup To be in The Dead Pool does not mean that a bank is in danger of imminent failure. In today’s world, the most likely outcome of a large bank liquidity crisis is a government takeover and conservatorship by the FDIC as per Dodd-Frank. If our friends at the FDIC were not going to liquidate IndyMac in 2008, then they sure as hell aren’t going to liquidate a money center bank now. That said, the members of The IRA Bank Dead Pool are basically dead money from an investment perspective. Zombies. Muertos . 死亡證書. Without significant business model changes and/or increases in capital and liquidity, we don’t expect to see these institutions operating in their current form five years hence. The institutions in The Bank Dead Pool underperform their asset peers among global universal banks. They are unlikely to be acquired except in the context of a fire sale or government intervention. And all of these names have been given a “negative” assessment of qualitative and quantitative factors by Whalen Global Advisors LLC, using the standardized data published by the Federal Reserve Board and other agencies via the FFIEC . The first of a series of IRA Bank Profiles is available for sale in our online store . The first profile is focused on Goldman Sachs. We write: “The primary focus on the brokerage unit and on non-interest sources of income as part of the firm’s business model places GS at a distinct disadvantage compared with core deposit rich institutions like JPM and USB. Even Citigroup (C) and CapitalOne Financial (COF) , which use brokered deposits to fund their consumer loan books, have cheaper funding costs than GS.” Sure, there are other global banks that could be added to The Bank Dead Pool list. Screen for big universal banks with common shares trading at a discount to book value and little or no growth. As we go forward into 2020, we’ll be updating The Bank Dead Pool and publishing new profiles about these zombies as well as some of the exemplars among large US banks. #GoldmanSachs #DeutscheBank #Citigroup #RaulSalinas #FFIEC #JimCramer

New York | The Federal Open Market Committee cut the target for short-term funds another quarter point last night, raising the question as to whether the central bank can actually defend the 1.75% upper bound of the new policy range. Fact is, demand for short-term funding is pulling rates higher as the year draws to a close. Ray's Camp, The Flowage, Princeton, Maine We got to dine with the risk committee this week, revealing new aspects of the recent repo kerfuffle that deserve mention. Chief among them was the idea of competition and, indeed, even conflict between the retail bank side of the house and the capital markets component inside the Fed’s primary dealers. It seems that when the Federal Reserve Board was caught napping in mid-September, the bank treasury side of one of the largest US banks basically took a line from the 1990 Martin Scorsese film “Goodfellas” and told the bank’s capital markets side: “ Fuck you, pay me. ” Under Regulation W, which implements what we traditionalists know as Section 23A of the Federal Reserve Act, transactions inside the bank holding co do not count against the bank’s statutory allocation for transactions with affiliates. But when market rates spiked, the retail treasury representing a very large insured depository, essentially told the traders to pound sand when it came to price. Reg W requires transactions with affiliates to be at market on an arm’s length basis, even with risk-free collateral supporting the trade. The lesson here is that regulators do not want the cash-rich retail bank to give carte blanche to the traders, either with respect to the amount of liquidity or the price. The regulatory system worked – but also caused a new problem. A rush of fully motivated capital markets banksters suddenly turned outward and sought funding in the broader market for federal funds. A squeeze ensued on or around September 16th, needless to say. Risk free collateral went begging for funding. Effective rates to finance Treasury and GNMA collateral spiked to double digits. So then, ask not whether one aspect of federal prudential regulations or another caused the liquidity squeeze seen last December and in June and later in September. Ask instead why the Fed and other regulators cannot cooperate to tweak the system and fix da plumbing. December is just a month away. The reality, as F.A. Hayek described in his classic 1988 essay “Fatal Conceit: The Errors of Socialism” (H/T Michael Lewitt ) is that fine tuning the markets is an impossibility. The Fed suffers from the “fatal conceit” that "man is able to shape the world around him according to his wishes." Happy Halloween Softbank Denies WeWork Control?? Meanwhile in the world of finance, a couple of notable events and comments occurred that deserve comment. PIMCO announced that it is reducing allocations to corporate debt, another data point on our worry beads regarding corporate credit in 2020. Our favorite was the blasé Street reaction to the announcement by Softbank that its 80% stake in the insolvent WeWork did not mean control. Hello?? Further, Masayoshi Son indicated that therefore the company would not be consolidated onto Softbank’s balance sheet. Really? If this transparent evasion of leverage disclosure does not qualify for securities fraud in the US, then we need to buy some new textbooks. Several managers, ratings firms and former shareholders complained about a “lack of controls” at Softbank in a Wall Street Journal article by Phred Dvorak and Justin Baer , but when one man is in charge is this even up for debate? We have always viewed Softbank as an investor driven Ponzi scheme, but we suspect our readers already knew that. Of note, we also were reminded over dinner that no less than Deutsche Bank AG (DB) has been the advisor and lender for much of Softbank’s issuance of securities. Would be funny were it not so very sad, especially for the credulous sovereign investors in Softbank. The whole vision thing strikes us as a grotesque speculation verging on outright fraud. On Wednesday, DB reported a third-quarter loss of $955.1 million or about 10% of total revenue, after reporting a profit in the same period a year earlier. The Softbank strategy goes like this: Give me and lend me enough capital and I will corner the market for innovation or some such version of that theme. We recall that Jim Fisk and Jay Gould attempted a similar operation in the late 1860s. Their machinations resulted in Black Friday September 24, 1869, the first modern financial crisis. Their scheme to corner the gold market – and ensnare President Ulysses Grant in the operation -- collapsed in spectacular fashion, leading the US into a credit crisis. Gold, after all, was money in those days. DOJ/HUD Accord Reached Hannah Lang of National Mortgage News reports that Department of Housing and Urban Development Secretary Ben Carson announced that HUD and the Department of Justice released a joint a memorandum of understanding, stating that HUD will deal with False Claims Act violations — involving Federal Housing Administration (FHA) lenders — mainly through administrative proceedings. This is a big deal for HUD and the mortgage industry, which has been brutally raped since 2008 to the tune of tens of billions of dollars by a succession of ambitious politicians. One of the main reasons why Senator Kamala Harris (D-CA) , who served as the state’s AG during the 2012 National Mortgage Settlement, won higher office was the billions she extracted from the shareholders of JPMorgan (JPM) , Bank America (BAC) et al. And this is why a very angry Jamie Dimon publicly took Chase out of the FHA loan market immediately after, followed by hundreds of other banks. Today only Wells Fargo & Co (WFC) and Flagstar Bank (FBC) remain as significant bank issuers and servicers of GNMA securities in the FHA/VA/USDA loan market. As former GNMA President Ted Tozer told us last week, without the bond market execution of GNMA-guaranteed securities the FHA/VA/USDA programs are moribund. We salute Secretary Carson and FHA chief Brian Montgomery for getting this interagency understanding done, but the banks won’t come back to the FHA/VA loan market until 1) the cost of servicing GNMA securities is brought into line with the GSEs Fannie Mae and Freddie Mac and 2) profitability on origination of FHA/VA loans improves a lot more. GNMA MSRs should trade even yield to conventional mortgage servicing assets. Perhaps the bigger challenge for HUD is convincing the Fed, OCC, FDIC and other prudential regulators to allow large banks to return to the FHA market. So long as the federal regulatory community sees small, low FICO, high LTV loans as being “unsafe and unsound,” the banks are unlikely to return fully to the GNMA market. Small loans are loss leaders. Would you rather service a $280,000 FHA loan for 32bs per year gross or a $3 million prime jumbo loan at 25bps per year? Further Reading The American Conservative https://www.theamericanconservative.com/author/christopherwhalen/ National Mortgage News https://www.nationalmortgagenews.com/author/christopher-whalen #MartinScorsese #Goodfellas #JPM #WFC #Softbank #WeWork #MasaSon #Ponzi #americatalyst

New York | In the last issue of The Institutional Risk Analyst , " Elizabeth Warren Wants to Crash the Global Financial Markets ," we talked with Ralph Delguidice about why the spread differential between the dollar markets and other liquid offshore markets is thwarting efforts by the Federal Open Market Committee to restore liquidity in domestic money markets. When the New York Fed provides liquidity to the primary dealers, that cash does not necessarily “trickle down” to the rest of the money markets. Indeed, a good bit of it goes offshore seeking to maximize yield. One example from our discussion last week is the vast offshore market in dollar lending by non-US banks and governments, lending that is largely unreported. Horn , Reinhart and Trebesch note in their must-read paper for NBER, “China's Overseas Lending” (2019) : “[T]he government of China holds more than five trillion USD of debt towards the rest of the world (6% of world GDP), up from less than 500 billion in the early 2000s (1% of world GDP)… China’s total financial claims abroad amount to more than 8% of world GDP in 2017. This dramatic increase in Chinese official lending and investment is almost unprecedented in peacetime history, being only comparable to the rise of US lending in the wake of WWI and WWII (Horn et al. forthcoming). Indeed, the rapid growth of claims have transformed the Chinese government into the world’s largest official creditor (the largest overall creditor remains the United States). Despite these developments, however, we know strikingly little about China’s capital exports and their global implications.” The chart below shows LIBOR interest rates for dollars, yen and euros. The rest of the interest rate complex denominated in the three largest global currencies rests upon these basic short-term rates. It does not take much time to see that a Chinese bank able to borrow at a negative yield in euros or yen and swap the debt payments into dollars has enormous arbitrage opportunities. The fact that the members of the FOMC actually believed they could raise short-term interest rates anywhere close to 3% is entirely ridiculous in view of the spread differentials shown above. More than half a century since Bretton Woods, the community of economists in the US, including the members of the FOMC and the Fed’s staff, still tend to think about monetary policy in purely domestic terms. Most economists ignore the impact of interest rate differentials and how these spread relationships can impact the demand for dollars and short-term interest rates. The funny part is that American economists can prattle endlessly about the “special” attributes of the dollar as a reserve currency, yet somehow miss the impact of this fact on the interest rates that prevail in domestic US markets. The fact of low or even negative rates in Japan and the EU is driving demand for dollars, which non-US banks and governments use to make loans. Even at just 1.7% this AM for overnight forward Treasury repo transactions, zero risk dollar assets are extremely attractive for offshore investors. The short-dollar overhang in the offshore Eurodollar market is a key factor behind the dollar’s strength -- and has been for 75 years. Many US economists take comfort in the special relationship of the dollar as a “reserve currency,” but totally miss the other side of the coin – namely that the end of that special status implies disaster for the US economy. As the former Chairman of the Joint Chiefs of Staff Michael Mullen warned in 2011: “I believe the single, biggest threat to our national security is debt.” Growing debt is certainly a threat to the role of the dollar as a reserve currency, but the debt also provides the liquidity that makes the dollar market function as the world's prefered means of exchange. The greenback accounts for something like three quarters of global commercial and financial transactions, especially when you factor in currency swaps and hidden debt described by Reinhart et al and the Bank for International Settlements we discussed last week. For the US central bank, offshore demand for dollars makes calibrating policy to achieve the entirely domestic mandate in the Humphrey-Hawkins law increasingly difficult. Since the end of WWII, nations around the globe have used dollars as both a means of exchange in trade and as a store of value for central bank reserves. Even large nations such as the EU today remain chronically short dollars, an important fact that is often ignored by US policy makers. Without a steady supply of fiat paper dollars, the global economy would essentially come to a halt. But the flip side of that coin is that short-term interest rates in the US must be measured against the interest rates prevailing in other major nations if US monetary policy is to be effective. How do we shake the FOMC and the wider economics profession from their domestically focused lethargy when it comes to understanding (or better, remembering) the global dimension of the dollar system? Richard Gardener in his classic book "Sterling Dollar Diplomacy" (1956) described the creation of the dollar system after WWII. He ends the work with these lines from John Maynard Keynes classic essay on "National Self-Sufficiency" (1935): "Words ought to be a little wild, for they are an assault of thought upon the unthinking. But when the seats of power and authority have been attained, there should be no more poetic license.... When a doctrinaire proceeds to action, he must, so to speak, forget his doctrine. For those who in action remember the letter will probably lose what they are seeking." Further Reading The American Conservative https://www.theamericanconservative.com/author/christopherwhalen/ National Mortgage News https://www.nationalmortgagenews.com/author/christopher-whalen

Ft. Myers | Sisyphus is a figure from Greek mythology. For sins in mortal life, he was punished by Zeus to forever roll a boulder up a hill in the depths of Hades, only to see it to roll down again. The Federal Open Market Committee is essentially trapped in the torment of Sisyphus. They keep trying to add liquidity to the domestic US money markets, only to see it leak out into the vast offshore market for dollar funding. This week the FOMC announced that the minimum size of its overnight repurchase-agreement operations will rise to $120 billion , from what had been at least $75 billion. Long-term repo operations will rise from a minimum daily offering size of $35 billion and go up to $45 billion in interventions scheduled for Thursday and Oct. 29. The longer-term repo operations are scheduled to carry over into November, but you can expect the operations to be extended into next year. Trouble is that these larger operations are unlikely to be effective. Why? Because the US and foreign banks that hold liquidity have no incentive to make this liquidity available to domestic borrowers in the US. Indeed, the entire intellectual construct that allowed the FOMC to think in 2018 that they could actually raise interest rates is shown to be a complete fallacy. “Everyone in the markets focused on repo problem as technical, given the competition for funding from T-bills/reserves,” notes Ralph Delguidice at Pavilion Global Markets . “The Fed asset swap, which is ‘not QE’ you understand, is designed to force cash out of T-bills into general collateral (GC), but is now failing as sellers of those bills (foreign official mostly) park cash in reverse repurchase (RRPs) instead. But problem isn’t cash not flowing UP to repo, it is cash not flowing DOWN to repo.” A number of analysts such as George Selgin at Cato Institute have rightly focused on the “leakage” in the Fed’s “floor” system for fed funds , but the offshore dimension may be a more significant factor thwarting the efficacy of Fed policy. It's about the spread everybody. Duh. The fact that regulatory policies such as Dodd-Frank and Basel III are blocking the movement of funding is easily understood by the markets (but not Massachusetts Senator Elizabeth Warren, it seems). Most of the TBTF/G-SIB banks must shrink going into year end to avoid a G-SIB capital surcharge penalty. Last December’s liquidity crisis was a function of JPMorgan (JPM) and other large banks backing away from the short-term markets. Thanks Elizabeth! With the level of bank reserves now lower than a year ago, the rocks in the proverbial stream are starting to appear. The Fed is trying to address their error by dumping more reserves back into the system via QE and repo, but the “liquidity” is running out of a hole in the bucket thanks to the spread between what a cash provider earns on repo – say +75bps over LIBOR in Treasury and agency repo – and the higher yields available in the $10 trillion market for currency swaps. Call the hypothetical offshore spread 2% over funding. Delguidice believes that as US interest rates have risen, demand in the $10 trillion market for currency swaps (aka “Eurodollars”) has soared, proving an impossible situation for the Fed as it tries to manage the 1.75-2.0% target range for Fed funds. “FX-swaps are a ten trillion-dollar market and are functionally equivalent to a repo to lenders of USD (most of the time), only with higher rates reflected by the basis,” says Delguidice. “They also receive derivative treatment on balance sheets, unlike repo, so dealers would MUCH rather do them. You only have count MTMs in the capital charge, but unlike repo they MUST be physically settled when they mature. They cannot just be rolled over.” Many sellers of T-bills are non-US banks. Many of these then take the cash and go into the RRP market away from the Fed. These banks get Treasury collateral that they can hypothecate to, you guessed it, access dollar liquidity. Many of these non-US banks in China and other Asian nations are profoundly short-dollars and hold trillions in dollar loan assets. Important, you cannot hypothecate the RRPs at the Fed. See BIS paper below on the "missing debt" parked offshore for your happy reading this weekend. https://www.bis.org/publ/qtrpdf/r_qt1709e.pdf Bottom line is that the rate paid and earned for RPs and RRPs is important, but the actual flow of cash vs "excess reserves" measured by our friends at the Fed is another matter. The Fed is uniquely ill-equipped to deal with such tactical issues. The Fed's balance sheet may grow, but the supply of cash liquidity in the broad market may not. The liquidity that the Fed is adding may not "trickle down" to the GCF and fed funds markets outside the primary dealers. Indeed, each day there is a 20-30 basis point differential between what the Fed charges primary dealers (~1.85% today and the rest of the market (~2.05%). This effective rate differential is likely to widen as the year comes to a close. Truth is, not only has the FOMC lost control of the Fed’s balance sheet to the financial markets, but the offshore Eurodollar market may force the FOMC to collapse US rates to eliminate the rate differential or "spread" between domestic fed funds and repo and the effective negative cost of funds offshore. The Fed and prudential regulators could take a lot of pressure off the money markets by adjusting the G-SIB capital surcharge and a couple of other relatively minor tweaks to the bank regulatory environment, but Senator Warren is having none of it. So now the worst single thing that can possibly happen has happened. Elizabeth Warren wants to complicate what could have been a simple and straightforward hostage negotiation with JPM’s Jamie Dimon over regulatory relief and the eventual Fed acquisition of the UST he is having increasing difficulty funding in the GC markets on his balance sheet. Remember, the TBTF/G-SIBs will again be shrinking their balance sheets going into year-end thanks to Basel III/IV and Dodd-Frank. Now you understand why the Fed just doubled down on adding repo liquidity to the markets, but it may not work. And a socialist presidential candidate named Elizabeth Warren is perfectly willing to crash the US financial markets to advance her never ending quest for celebrity and fame. Fed Chairman Jay Powell is Sisyphus. Elizabeth Warren thinks she is Zeus. This will not end well. Good weekend. #PavilionGlobal #GSIB #Sisyphus #ElizabethWarren

New York | This week in The Institutional Risk Analyst, we feature a discussion with Ted Tozer, former President of Ginnie Mae (2010-2017) and veteran mortgage banker. He is a Senior Fellow with the Milken Institute. The IRA: Thanks for talking the time to catch up Ted. First, let’s start by talking about what it was like to take over GNMA in 2010, which was a very tough year in the mortgage industry and for financials generally. Can you give us a sense for your priorities when you took that job a decade ago? Tozer: I was somewhat prepared for the task because of running capital markets for National City Mortgage, which was a top ten originator at that time. We saw the shift from Fannie Mae and Freddie Mac product to FHA product that occurred after 2008 as the credit climate changed. I knew the shift to FHA was going to occur, but I also recognized the potential that GNMA had to serve as a backstop for the industry and the US economy. We needed to leverage and improve our technology and the effectiveness of our people to really make a difference for consumers, so I made customer service for our issuers and our investors the priority. The IRA: That’s a radical concept for Washington, especially when aspiring politicians like to portray mortgage lenders as the enemy. How did you reorient the culture at GNMA to focus more on being customer centric? Tozer: When I got to GNMA, we had good people, but they were like all government employees, focused on the job instead of the customer. We had to change from merely offering a product to being concerned about making the GNMA market attractive to lenders and investors. We needed to focus on service to all of our constituencies if GNMA was going to position itself to help the industry recover. GNMA provides the liquidity that makes the FHA, VA and USDA programs possible. We had to focus on improving the capital markets execution of GNMA. A lot of veterans at FHA saw their loan guarantee program as the only concern, but I made the argument that the combination with GNMA was powerful and really essential to our being able to serve the industry’s needs. The IRA: How was the reception to that message? Tozer: It was very positive. National City was the largest GNMA issuer in the US in 2007 and 2008, so I knew the GNMA staff well. We had worked together for years so that set me up to help the organization get through some tough years after the financial crisis. I really focused on conveying to my colleagues at GNMA, FHA and HUD how important we were to supporting the industry in those years. I also tried to educate people about the VA program and why that program was also crucially important. We had all of these veterans coming back from Afghanistan and Iraq that had an important benefit in the VA loan program, but many did not use it. Promoting the VA program was another way to support the mortgage industry and the US economy. The IRA: People forget that in 2010 many investors, especially offshore sovereigns like the Bank of Japan and Norinchukin Bank, had backed away from the GSE debt market, leaving GNMA as the only mortgage asset class they would buy. The market for smaller, low-FICO loans had essentially disappeared when the banks and even GSEs backed away. Did you and your colleagues at GNMA feel like you were catching the falling knife in the housing sector in those dark years before residential assets truly recovered in 2012 and thereafter? Tozer: There was certainly a sense of mission, but fortunately both the FHA and GNMA were well-positioned to play a counter-cyclical role in the housing sector. We were in a unique situation because GNMA had gotten so small during the 2000s. Most of the GNMA servicing was being done by Bank of America (BAC) , Wells Fargo (WFC) , JPMorganChase (JPM) , and U.S. Bancorp (USB), strong financial institutions that minimized Ginnie Mae’s counterparty risk. This left us free to focus on the future and what we needed to accomplish to better support the industry. Unlike the GSEs, which as issuers of MBS with pre-crisis loans had to deal with the problems of legacy subprime mortgages, our servicing was being done by large banks. But we also put out the welcome mat to attract new non-bank issuers into the GNMA market. Had we merely focused on working with the large banks as before, would have dramatically slowed the housing recovery. The IRA: After BAC closed the Countrywide acquisition, they shut down their correspondent channel. Cost BAC shareholders billions in lost revenue. But good timing on your part to pivot back to the non-banks as the commercial banks were leaving the FHA market. We always laugh when researchers fret about the rise of the non-banks, when in fact it was the return of the non-banks going back to the S&Ls of the 1980s. In this cycle, much of that distressed FHA loan product was eventually transferred from BAC, JPM et al. to high touch non-bank servicers and at the insistence of prudential regulators and state AGs. Tozer: A lot of the correspondent people at Bank of America came to GNMA. And non-banks strengthened the agency and helped us build a business with new issuers like Quicken, Penny Mac (PMT) , Freedom and Caliber. There were also some significant new high touch distressed servicers like Mr. Cooper (COOP) , Ocwen (OCN) and Carrington, who processed huge volumes of troubled loans and made many thousands of FHA loan modifications. Carrington was a great example because they were set up to clean up the private label mortgage market, so they had the people and systems to handle distressed FHA loans very effectively. The IRA: What was the biggest challenge during your time at GNMA? Tozer: Throughout Washington, whether you are talking about HUD or Capitol Hill or other agencies outside the mortgage complex, there is little real awareness about how mortgage finance works in practical terms and GNMA specifically. The IRA: One of the more amusing things about housing reform is to see how few people understand that GNMA is a guarantor only, with bank and non-bank issuers handling the bond issuance and servicing, while the GSEs are issuers themselves, guarantors and the owners of servicing. How do we bridge the enormous chasm of understanding? Tozer: At the start of my tenure, very few people at Treasury or the other parts of government knew what GNMA did or what we accomplished by enabling the FHA and other programs. When I explained it to people at the White House, they were actually shocked. I am not being critical here, but housing finance is a specialized niche. There were a lot of very smart financial people and politicians I met over the years who did not understand GNMA’s role and our potential to drive recovery in the housing market. And this is the same challenge with housing finance reform, because so few people understand the complexity and nuances of housing finance. The IRA: Even with the growth in FHA lending and RMBS issuance at $2.1 trillion, today GNMA is less than 20% of the total residential housing market. The large banks are the top of the food chain with $2.5 trillion of mostly large, prime, non-FHA loans, the GSEs currently occupy the big middle of $5.5 trillion or so, and the non-agency private loan market makes up the rest. So when we read the Trump Administration proposal to downsize the FHA, we wonder if they understand that there is no other practical market for small, lower FICO loans? Tozer: Reading the Administration proposal, the first thing that jumps out at me is the huge growth in GNMA were it to provide the credit wrap for the existing GSE securities as part of the re-privatization of Fannie Mae and Freddie Mac. Under the proposal, GNMA would become a monster guarantor for three quarters of the mortgage bond market. Operationally Ginnie Mae could support the growth because of the hundreds of millions of dollars Ginnie Mae spent to modernize its infrastructure. FHA has actually been a very successful program in a sense that they capped market share by limiting the size of the loans, but they took such a broad swath of the market that the credit loss performance was fine. By undercutting private issuers and taking a broad cross section of the credit spectrum in smaller loans, you did not need risk-based pricing. The good loans balanced out the bad in terms of risk. When the subprime issuers that underpriced the credit risk arrived from Wall Street, however, that threw off the entire system through FHA being adversely selected. But the basic FHA model actually worked quite well. The IRA: During the period before 2007, the large banks were pushing the GSEs out of the way to acquire residential collateral for private label securitization deals. Investors clamored for more deals. How did that surge of demand affect FHA and GNMA? Tozer: The Wall Street banks cherry picked the better loans out of the market and left the FHA with the poorest quality subprime product. Now that we have restored the balance in the FHA and other programs, however, we don’t really need risk-based pricing to do a good job for our issuers and investors, and thereby protect the taxpayer. If we coordinate the demarcation between GSE execution and FHA, the program is quite stable and could return to the type of operating performance we saw before 2008. In the early 2000s, the FHA was so well capitalized that it actually waived premiums for some low-income borrowers. I’d like to get back to that situation. The IRA: So will banks come back to the FHA market? Prudential regulators have told banks to avoid smaller loans due to reputational risk. Tozer When the DOJ and FHA took the pound of flesh from banks large and small after the 2008 financial crisis, they ensured that banks would exit FHA lending and not return. The big public banks don’t want the reputational risk and the smaller banks don’t want to put capital at risk with the DOJ. You can’t force people to make FHA loans. If you have a limited number of people that want to make FHA loans, then the program will be offered on a limited basis. This capacity issue should become apparent in the next economic cycle. The punitive aspect of the DOJ and FHA approach, where they went back years to penalize technical deficiencies in loans, defects that will not affect the loan’s performance, burned the bridge with the depositories. This has important effects because it essentially makes the FHA a procyclical program. That scares me. When we had the large bank issuers, they could lean into a receding market as a countercyclical resource and help to support lending during a recession as in 2010 onward. But not anymore. The IRA: The smaller non-banks in the GNMA market clearly face a funding challenge in a moderate to severe loss cycle. Yet in retrospect, the FHA and GNMA were fortunate that the non-banks came into the government market, cleaned up the subprime mess and then replaced the banks in the role of GNMA issuers. Clearly a depository is a superior model for the GNMA market because of the large escrow balances. But speaking of non-bank issuers, what would you say about the White House proposal prohibiting refinance of FHA loans? We discussed same in National Mortgage News ( "Trump's housing plan attacks the FHA mortgage market" ). Tozer: Many borrowers in the FHA market would not be able to refinance out of the FHA market because of needing to get private mortgage insurance on the GSE loan. I do agree that a GSE loan should not be refinance by the FHA, because that suggests that the FHA is again going to be getting the problem loans. I don’t see the issue of an FHA refinance into another FHA loan. FHA already owns the risk, so lowering the payment for a borrower is good for the FHA and the consumer both. The IRA: Precisely. Most of the product being written in 2019 is rate product, not cash out loans as in 2018. Responsible FHA and VA lenders will lower the cost to the borrower and keep the loan amount stable. Speaking about risk-based pricing, if we take Fannie and Freddie out of conservatorship without a legislative fix that provides for GNMA guaranteeing the existing securities, what happens? Do Washington folks understand that the GSEs are issuers, and also need to fund bond payments and have the liquidity to fund advances? Tozer: Fannie and Freddie are like CapitalOne (COF) before they bought Chevy Chase and MBNA before they got bought by Bank of America. These monoline non-bank credit card issuers had a very tough time funding their businesses without access to government guaranteed debt (bank deposits). None of them were really able to make it because of the cost of financing. I think the cost of financing for Fannie and Freddie will become prohibitive to them if their debt is no longer guaranteed by the Treasury. The IRA: The discussions about GSE reform make us recall the warnings from Dave Stephens when he was head of the Mortgage Bankers Association. He said that when Mel Watt left the Federal Housing Finance Administration, things would change. And they certainly have. Mark Calabria seems to think that private capital is enough to support the GSEs, but most of our colleagues inside the enterprises suggest otherwise. Even a change in funding costs of as little as 20% to reflect the difference between GNMA at zero risk weight and Fannie/Freddie at 20% for Basel III would be intolerable. Warren Kornfeld of Moody’s wrote that: “Reducing Freddie and Fannie’s footprint would be credit negative for GSEs,” but increased funding costs are even more problematic. What would happen to FHA flows if the GSEs were really privatized without a federal guarantee for the bonds or the issuers? Say the GSEs ended up as “A” credits c/o Moody’s. Tozer: Well, first off, the UMBS would become next to impossible to administer. The GSE MBS would become the obligations of the issuers that were no longer obligations guaranteed by the United States. MBS investors would have limits on how much exposure they would have to each GSE. The GSEs would be joint and severally liable for the other GSE MBS that were included in their mega or giant pools. For example, the only reason they are allowing other issuers to sell production into mega pools is that there is a government guarantee. If they are guaranteeing the other agencies securities, then they have the counterparty risk as well. I don’t think that people in Washington understand all of the moving parts involved with the GSEs operationally. You miss one moving part and the whole operation falls apart. You can tinker on the edges, but you cannot make wholesale changes without destabilizing the conventional market. That is why unless Congress acts to guarantee the securities issued by the GSEs, I do not see how they will be able to leave conservatorship. The IRA: Thanks Ted. See you in Dallas next year at Americatalyst 2020 .