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New York | In May of last year, we suggested that it may be time for Elon Musk to declare victory and sell Tesla Motors (TSLA) to one of the top global auto manufacturers (“ Should Elon Musk Sell Tesla? ”). BTW, notice the nifty new search feature on the top of The IRA pages. A year later, we watch as the likes of Audi AG and Daimler AG hammer away with advertising in new and old media displaying well-executed electric car offerings. Owing to a shortage of operating cash, TSLA has no response in terms of advertising message and no retail sales network either. Under the leadership of Elon Musk, TSLA operate s in extremis for all to see. As we wrote in “ Ford Men: From Inspiration to Enterprise, ” the global auto industry is a scary proposition for even the largest and most efficient operators. TSLA has neither scale nor sufficient funding to make let alone even market its products adequately. Adequate funding, to recall the wisdom of our friend Bill Janeway, provides the opportunity to properly plan and execute a business strategy. Notice the negative market beta for TSLA in the table above c/o CapIQ. To us, Elon Musk is a really smart man who needs an exit strategy. We like to say that hope takes a stock price up, but credit concerns bring stocks down. Right now credit concerns are predominating with TSLA as it becomes clear that the company cannot spend its way to profitability. Like Uber Technologies (UBER) and so many new age ventures hatched during the irrational era of negative interest rates, TSLA’s continued existence is predicated on access to new investor cash needed to finance operating losses. There does not seem to be any possibility that TSLA can grow to sufficient size and profitability to contend with the global incumbents led by giants such as Toyota Motor and Volkswagen AG. The TSLA common is now down about 30% over the past year, a reflection of the bad boy behavior of Musk and the now explicit need for new cash -- this after months of denying that any such need existed. Indeed, TSLA's price is about where it was five years ago . When Henry Ford started to display truly idiosyncratic behavior in the 1920s and 1930s, Ford Motor was private and protected by a gang of thugs led by the infamous pugilist Harry Bennett. The company was run like a plantation, bills were paid in cash, and Ford Motor Co had no net debt. Economists and writers could make fun of Henry Ford’s increasingly bizarre public conduct and monolithic product offering, but the company was not subject to a daily auction as is the case with TSLA’s stock and debt. Despite efforts by TSLA’s board and lawyers to control Musk’s obfuscation, he continues to paint a hopeful image of the future that seems difficult to square with reality described in his public disclosure. In the April 2019 TSLA conference call, Musk stated: “We are the only Company in the world producing our own vehicles and batteries, as well as our own in-house chip for full self-driving. We're in a position unlike anyone else in the industry. And in 2020, we expect to have 1 million robotaxis on the road with the hardware necessary for full self-driving. We believe we'll have the most profitable autonomous taxi on the market and perhaps the -- yeah…. In Q1, Model 3 was yet again the best-selling premium car in the US, outselling the runner-up by almost 60%.” Due to the reluctance of mainstream auto insurers to cover the TSLA cars equipped with the wondrous self-driving feature, Musk announced during the April conference call that the company would launch its own insurer. Adam Jonas of Morgan Stanley asked Musk why he did not take TSLA private given the “alternative capital and large amounts of strategic capital that is incrementally deployed in domains where Tesla has real leadership.” Good question. Musk’s reply: “I would prefer we were private, but unfortunately, I think that ship has sailed, so... Well, I mean, being public, does feels like the sort of price of the stock is being set in kind of a manic-depressive way. And I think Warren Buffett's analogy is just like perhaps being a publicly traded company is like having someone stand at the edge of your home and just randomly yell different prices for your house every day. It's still the same house.” Well, maybe. The house Musk describes in his inflated public statements bears little resemblance to the TSLA that has debt trading at a 20% discount to par. Sadly the ship may have indeed sailed for Musk in terms of obtaining new funds or even selling the company to a larger premium marque like Daimler or Audi. When Musk himself conceded during the April conference call that “I think there is merit to the idea of raising capital at this point,” he stated the obvious. A couple of days later on May 2, Musk told investors that he was planning to raise $2 billion in capital through new common equity and convertible notes. The move came after literally months of rejecting the idea of new share issuance, including during the April 2019 conference call with investors. “I don’t think raising capital should be a substitute for making the company operate more effectively,” Musk told shareholders on the company’s quarterly conference call, reports CNBC . “I do think there is some merit to raising capital, but this is sort of probably about the right timing.” Sort of probably? It is remarkable to us that the Securities and Exchange Commission gets visibly upset about Musk’s use of Twitter for his public dissembling, for example, yet ignores the seemingly clear manipulation of investors via selective and conflicting statements regarding a future offering of securities. But those poor helpless investors do seem to have figured out the basics since the announcement of the offering several weeks ago and have pushed down the price of TSLA sharply to close at $190 on Friday. Notice that Ford Motor just announced the layoff of 10% of all salaried workers as part of the latest restructuring at the Blue Oval. Renault and Fiat Chrysler are discussing a merger, this in the wake of the palace coup launched against Carlos Ghosn by his former colleagues at Nissan. This is bad news for Nissan, of course, who must now merge with another Japanese automaker since they apparently cannot abide the idea of union with a foreign company. None of these discussions, mind you, are driven by the potential for growth in the global auto industry. Instead the imperative is to cut costs in a stagnant commodity industry that suffers from chronic overcapacity and low or no profits. A number of former supporters of TSLA have abandoned Musk since the April conference call. “Morgan Stanley threw the biggest blow, declaring that in a worst-case scenario, Tesla’s shares could sink to a shocking $10,” Bloomberg reports. “A Wedbush analyst said the carmaker is facing a “code red situation” and cast doubt on whether Tesla can sell enough of its electric cars to make a profit. And Citigroup and Robert W. Baird & Co. analysts, among others, slashed their target prices, citing concerns about cash flow and consumer demand.” We still think that Elon Musk can salvage his reputation and value for his shareholders by selling TSLA to a global manufacturing company that makes premium cars. Audi, Daimler, Honda and Toyota are all obvious suitors. And TSLA is already cooperating with Fiat Chrysler Automobiles to help reduce the Italian-US firm’s liability for emissions in the EU. Just imagine Fiat-Chrysler, Renault and Tesla under a single roof. As part of the equity offering, TSLA will no doubt receive inquiries about an acquisition from several global automakers in Europe and Japan. As we noted last year, Musk has validated the idea of electric vehicles and has also created a very valuable brand. But can this accomplished business man and technologist admit that his brilliance is wasted on making mere automobiles? We’re thinking more of the Jetsons. Flying car to LGA please Mr. Musk. A century ago, Ford, GM and other US makers could not manufacture cars fast enough to meet demand. Today the name of the game in the shrinking auto industry is alliances and consolidation. Given that large Sell Side firms like Morgan Stanley have decided to throw TSLA under the bus, maybe it’s time to think about a sale? Even a valuation near Friday’s close for TSLA would be a gift compared with the worst case scenarios making the rounds on the Street. As and when the question is asked about acquiring TSLA, will Elon Musk be smart enough to take the call? For the sake of TSLA holders, we certainly hope that the answer is yes.

New York | This week The Institutional Risk Analyst is participating at The Mortgage Bankers Association Secondary Conference, one of the most important events of the year for the housing finance industry. One topic we heard a lot about from various attendees is that the volatility seen in Q1 2019 has thankfully subsided this quarter, but the continued deterioration of the effective spread on loans and securities, and rising prepayments, are big concerns. On Sunday afternoon we heard a panel at the MBA Secondary on recent attempts to attract greater levels of private capital to the market. Eric Kaplan of Milken Institute led a discussion with Liam Sargent of J.P. Morgan (JPM), James Bennison of Arch Mortgage Insurance Company and Matthew Tomiak of Redwood Trust (RWT). Bennison noted that there is considerable pent up demand for private label mortgage exposures, but issuers must bring the right types of products to market – as in the case of the GSE risk sharing transactions. When Matt Tomiak talked about the nuances of building the RWT non-agency mortgage business since 2010, we could not help but notice again the reference to a dearth of available assets – at least at yields that made sense to these veteran loan issuers. “Our biggest competition in the jumbo mortgage space is banks at the end of the day and also insurance companies,” he observed. “Water always looks for its lowest point. Mortgage loans are always going to find their lowest cost of funding.” “My feelings are almost hurt when people say when will private capital come back to mortgages,” Tomiak added. “We’re back, we’re here and have been for a while.” His comments made us recall that credit terms for mortgage issuers are more liberal than at any time since the financial crisis, but even this considerable concession has not been enough to offset the relentless erosion of profitability thanks to the Fed’s QE. To that point, Peter Fisher wrote last year in a chapter of a timely new book edited by John Taylor, “Should the Fed ‘Stay Big’ or ‘Slim Down’,”: “My view is that QE1 (2008 to 2010) had a positive impact in liquefying the banking system during and immediately after the financial crisis and that it prevented more, and more rapid, deleveraging of the US financial system. But I am deeply skeptical about the efficacy of QE2 and QE3 (2010 to 2016) in stimulating aggregate demand.” Indeed, not only did QE and Operation Twist not help the economy, but these speculative policies by the FOMC actually did serious harm to the world of mortgage finance, the second largest market in the world after US Treasury debt. That damage is starting to emerge as one of the chief risks to the financial markets in 2019. Ralph Delguidice at Pavillion Capital wrote last week in a note entitled “Curve inversion dead ahead” that further compression of profits for leveraged players may be the next shoe to drop: “The Fed has hit the effective lower bound as the BASEL rules that de-risk the dealer banks, and the (still) contracting system balance sheet converge to constrain the supply of private short-term credit flowing into the all-important money markets. With the Fed on pause and stalling global growth, the strong USD and wide DM return differentials will pressure US term premia lower and invert the effective real-money curve. Financials—banks and especially non-banks with no deposit capacity—are ground zero, as valuations reflect the ongoing collapse of loan carry.” Even as loan spreads and comparable fixed income returns remain under downward pressure, visible default rates continue to fall. “Strong April mortgage performance pushed the national delinquency rate to a record low,” notes Black Knight. “At 3.47%, it’s now at its lowest point on record. Plus, the 5.51% M/M decline in delinquencies was the strongest single-month April improvement we’ve ever seen…. Meanwhile, low interest rates and the spring home buying season continue to push prepayment activity upward. In fact, April’s 17% increase in prepays brings the three-month aggregate increase to 67%.” So while the credit environment is benign for now, the dynamics of low profits for new loan originations and rising prepayment speeds on MBS are combining to create the perfect storm for holders of mortgage servicing assets (MSAs). The Street, after all, marks its mortgage securities and MSAs to model. Rising prepayment speeds means a commensurate decline in the modeled NPV of loans, mortgage securities and servicing assets. The table below from the Mortgage Bankers Association shows the components of gain on sale when mortgage bankers sell loans into the secondary market. Notice that the numbers are not nearly as bad as one might think looking at the aggregate profitability data. “What's interesting is that while margins were down last year, they weren't down as much as some people thought they were,” notes industry veteran Joe Garrett of Garrett, McAuley & Co. Also observe that the portion of the total gain attributable to MSAs has been rising since 2014 and jumped 10% in 2018 alone. This provides yet another data point to suggest that Fed Chairman Jay Powell is wrong when he says that asset values are not inflated. The crucial issue for the mortgage industry and especially for the specialty investment funds and REITs in this sector is whether the rise in prepayments is a temporary phenomenon associated with the rally of the 10 year Treasury and the resulting good Q1 production environment or will be confirmed by future quarters. If prepayments continue to rise, then the Street is likely to see a good bit more pain in Q2 when it comes to mark-to-model on MBS and MSAs. The good news is that the MBA refinance index has fallen significantly since the end of April, thus the mortgage bankers, REITs and other investors in RMBS may be spared drinking from the bitter cup of rising prepayments through 2019. As we’ve noted for over a year, the structural increase in funding costs described by Delguidice in the short-term money markets is also working on the US banking industry, where interest costs are galloping along at a 70% annual rate of increase. We’ll be updating our projections for 2019 when the FDIC releases the Q1 2019 aggregate data for the US banking industry. For a number of reasons, we think that for banks, REITs and other leveraged investors, the minimum floor of funding costs is rising much faster than asset returns. That is, a classical funding squeeze a la the 1980s. More Reading When will non-QM loans and HELOCs take off? National Mortgage News (May 20) Should the Fed ‘Stay Big’ or ‘Slim Down’? Peter Fisher, Hoover Institution #REIT #MBA #MSAs #Kaplan

New York | In this issue of The Institutional Risk Analyst , we speak to Michael Bright, President and CEO of the Structured Finance Industry Group (SFIG). Prior to joining SFIG, Michael was the EVP and Chief Operating Officer of the Government National Mortgage Association, or Ginnie Mae. As COO he managed all operations for Ginnie Mae’s $2.0 trillion portfolio of mortgage-backed securities. Before joining Ginnie Mae, Michael was a director at the Milken Institute’s Center for Financial Markets. In 2013 Michael was a principal staff author of S.1217, the "Corker-Warner" GSE reform bill that passed the Senate Banking Committee the following year. While in the office of U.S. Senator Bob Corker, he also advised on a range of Senate Banking Committee regulatory policy issues. The IRA: Michael, let’s start off by talking about the early part of January 2019 when you departed from Ginnie Mae to join SFIG. The markets had just been through a very tough month. A lot of securities issuance essentially went to zero. Mortgage securities had been in a slump since that September. Fortunately the markets have largely bounced back, particularly corporates and mortgages. How do you think about that period and since then as head of SFIG? Bright: I have not had a lot of folks asking about the drop off in issuance. There were a lot of factors that combined to make December a challenging month for many of our members, including the Fed reducing the size of its balance sheet and the general increase in interest rates at the end of last year. And when it comes to mortgages, there are a lot of households out there with three and four handle mortgages, so there is a limit on how much production volume that you will see even given a decline in rates. Our job at SFIG is to facilitate and coordinate the dialog about just these issues among all of the participants in structured finance. The IRA: How would you describe the mood of the structured finance community in 2019? What sort of risks or issues are top of mind for your members? Bright: I’d say the mood is cautious optimism. Default rates are low and the overall tenor of the markets is quite positive, but the thing that makes all of us take pause is the question of how long can the current cycle last? How long can interest rates stay where they are or even move lower? The narrative has changed a lot since last year, so the biggest anxiety for issuers and the professionals that advise them is really uncertainty as to the market trend and how much of a role will the Fed play in the future. We are conditioned to expect extremes in market movements, so the prolonged period of relative calm is hard for people to process one way or another because there is no clear trend in credit or interest rates. The IRA: The financial media is constantly trying to hype every market move into some sort of cataclysmic event, but we don’t actually see that in the credit markets. Credit is benign and volatility is low. Net default rates on bank 1-4s, multifamily and even construction exposures are negative, suggesting that credit has no cost. We saw this phenomenon with a few banks in the 2000s, but now its the whole sector. Bright: I think you have two issues at work here. The media is endlessly searching for the "canary in the coal mine" story, the big expose that will reveal some unknown risk. Yet at the same time, you have a financial industry that is now so well capitalized and so risk averse that at times it seems hard to imagine how we could repeat the experiences of 2008. So the media continues to pursue a narrative that says catastrophe is around the corner, but we don’t see that as an industry and we do push back against that doom and gloom narrative. The IRA: One topic that is getting a lot of attention from policymakers in Washington is leveraged loans. Congress is holding hearings on the topic and presidential aspirants such as Senator Elizabeth Warren (D-MA) have made it part of their campaign spiel. There is even some novel litigation now about whether the 1930s era securities fraud laws should apply to leveraged loans. Do you see a problem in this market in terms of risk? Bright: If you trace the history of the Fed’s quantitative easing or QE, the growth of leveraged loans tracks the Fed’s intentions to take risk free assets out of the system and force investors into riskier products. At first the worry over QE was that it would stoke inflation, but none of those concerns materialized. Around 2013 and 2014, the discussion moved to whether manipulating risk preferences would result in unintended consequences in terms of financial instability. And the Fed did not even disagree. They conceded that financial instability could be a consequence of QE. Both Chairman Ben Bernanke and Janet Yellen were asked that specific question in their congressional testimony. The response from the Fed was that financial instability is a risk but we’d rather deal with deflation now and then deal with any financial stability problems later. Loans have been made to riskier companies and this is precisely what the Fed said five years ago that they wanted to see. So there is no surprise here. The default rates on leveraged credit are still very low, and it may go higher in the future, but nobody wants to be the one who misses the next big risk. The IRA: Well Chairman Jay Powell says that asset prices are not inflated, but you could make the case that the Fed wanted to inflate asset prices to counter the deflationary tendency cause by the massive accumulation of debt in the system. Given the relatively tranquil credit environment that we’ve discussed, what is on top of your agenda at SFIG? Bright: Our agenda at SFIG is to foster a dialog between the structured finance industry and policy makers. We have a unique position in the US because we have a structured finance market that allows lenders to create secured assets, finance this production and eventually sell those assets to end investors. This is an incredibly valuable asset for the people of the United States and has a big role to play in fostering and sustaining economic growth. But with the benefits of structured finance also come responsibilities. People in our industry know that getting it wrong on risk has real world consequences that can endanger financial institutions, markets and the entire economic equation. Educating policy makers about the benefits and potential risk is our job at SFIG. The IRA: The arbitrage in the financial markets post 2008 has been to move into asset classes that were not center stage in the last crisis. Commercial real estate, leveraged loans, collateralized debt obligations, auto loans have all grown significantly over the past decade. Issuers of leveraged loans, for example, have taken the position that the securities fraud laws from the 1930s don’t apply to these assets and therefore all bets are off when it comes to protecting investors. Do you worry that this sort of regulatory arbitrage may conceal risks that are significant to the industry and policy makers both? Bright: As an organization, SFIG has both the issuers and the investors under the same tent, so we are very focused on enabling precisely the sort of discussion that helps our community understand these issues and any attendant risks. We don’t just advocate for issuers. There is an important ongoing conversation between investors and issuers on topics such as loan covenants and other protections. One of the great things about my job is that our chief goal is to bring all of our members together to discuss these issues on a continuing basis. Do we worry about these issues? Of course, that is our job. The IRA: Going back to your days at Ginnie Mae, one of the big questions on the table is what happens to Fannie Mae and Freddie Mac once they exit federal conservatorship. The new head of the Federal Housing Finance Administration, Mark Calabria, has said that the GSEs need more capital to exit conservatorship. There are people in Washington who seem to believe that the GSEs can operate as they do today without a federal credit wrapper. Do you worry about what happens to the mortgage market if the political sound bite about “protecting taxpayers” becomes an end of credit support for Fannie Mae and Freddie Mac? Bright: There are two outcomes for the GSEs that are unambiguously safe for the financial markets. The first is conservatorship. The markets understand conservatorship and accept that the Treasury is backing both GSEs. Ginnie Mae paper trades at a slight premium to the GSEs, but they are close enough. The market also understands a congressionally authorized credit wrapper as is the case with Ginnie Mae explicitly. Those are the two extremes that the markets understands. This is why foreign central banks are comfortable with Ginnie Mae because the governmental wrap is clear and unambiguous. The middle ground is quite unclear in terms of market acceptance. The idea that there is some amount of private capital that gets you to the same market acceptance as either conservatorship or an explicit guarantee from Treasury strikes me as wishful thinking. Any outcome that does not involve explicit credit support for the GSEs runs the risk that markets and particularly global investors will not accept it. The IRA: Thanks for your time Michael #MichaelBright #risk #leveragedloans #elizabethwarren #SFIG #MarkCalabria

New York | In this issue of The Institutional Risk Analyst, we feature a market comment from Robert Eisenbeis, Vice Chairman & Chief Monetary Economist at Cumberland Advisors . Dr. Eisenbeis asks: Why is the stock market showing more volatility than bonds? Why indeed. He concludes with a typically concise summation: "The lesson here for stock market investors is that hoping for a rate hike as a substitute for considered analysis is not a good strategy." On Wednesday, the FOMC left its policy stance unchanged. This decision was consistent with the message sent after the previous meeting and was not contradicted by speeches given by FOMC participants in the intermeeting period. This action was also consistent with the consensus view of economists who follow the Fed. Indeed, of the 39 economists responding to the April 23–25 Bloomberg poll, only two had forecast a rate cut in 2019 while the rest had the funds rate target steady through 2020.[1] Despite this data, the stock market declined after the FOMC statement was released, indicating that a rate reduction had been expected but not delivered. The market continued to decline over the next two days. In contrast, on Wednesday, May 1, the ten-year Treasury rate rose at about 10 AM and then jumped even higher just before the release of the FOMC statement at 2 PM, then dipped slightly before the meeting, as the Bloomberg chart below indicates. It then recovered to pre-10 o’clock announcement levels after Chairman Powell’s press conference. How can we explain these reactions to the information flowing from the FOMC meeting? Why was the stock market’s reaction more prolonged than the Treasury market’s was? Source: Bloomberg In the case of the stock market, rhetoric from some politicians and even a now-former Fed nominee argued that the FOMC had made a mistake in raising rates in December 2018 and that time was ripe for a rate cut. Economic growth appeared to be slowing through 2018, with Q3 growth below Q2 growth while Q4, at 2.2%, was below Q3’s 3.2%. Participants were expecting a modest number for Q1 2019, especially since first-quarter growth had been slow for the past five years and we had a full government shutdown for a full one third of the quarter. Everyone expected the shutdown to subtract from Q1 growth. Finally, in addition to expected slow growth, part of the rationale on the part of those expecting a possible rate reduction lay in the fact that inflation had been running persistently below the FOMC’s 2% target, and thus at some point a rate cut would be necessary to further stimulate inflation via extraordinary monetary accommodation until the target was achieved. Of course, we learned that this scenario did not match the view of the FOMC. Chairman Powell, in his press conference, countered the idea that inflation was “persistently below target” when he stated that the decline in inflation in 2019 was not only expected but also was viewed as being due to “some transitory factors.”[2] If markets had assumed that inflation below target was persistent and hence would soon require a rate increase – especially if the FOMC was as committed to its inflation objective as it was to the other leg of its dual mandate – then Chairman Powell, when questioned by an astute reporter, effectively shut down the possibility of a near-term rate cut to achieve the FOMC’s inflation objective. Nancy Marshall-Genzer asked, “You were saying if inflation does stay low and these low inflation rates are not transient, you said a couple of times you’ll take that into account with monetary policy. How, specifically, will you take that into account?” Chairman Powell’s response was extremely vague. He stated, “It’s hard to say, because there’s so many other variables. Ultimately, there are many variables to be taken into account at any given time, but that’s part of our mandate. Stable prices is half of our mandate and we’ve defined that as 2 percent, so we’d be concerned and we’d take it into account.” The reporter pushed further asking whether an interest-rate cut would be possible, and Powell responded that he could not be more specific. That interchange, combined with Powell’s use of the word transient, was interpreted by markets as indicating – as the economists’ Bloomberg predictions had implied – that policy was on hold for the foreseeable future. There would be no rate cuts to satisfy stock market investors’ desire for more stimulus; and as far as the Treasury market was concerned, the meeting was a blip, as it returned to its pre-meeting position. If there was any doubt, the 3.2% Q1 preliminary growth estimate, coupled with Friday’s CES report of a 3.6% unemployment rate and over 263,000 jobs created in April, clinched the fact that no rate cuts are on the horizon. Interestingly, if the FOMC meeting had been a week later, there would have been no shock to the stock market. The lesson here for stock market investors is that hoping for a rate hike as a substitute for considered analysis is not a good strategy. [1] https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20190501.pdf [2] https://www.bloomberg.com/news/articles/2019-04-26/economists-see-fed-on-hold-through-2020-with-no-rate-cut-survey #Eisenbeis #Cumberland #FOMC #JayPowell

New York | In this issue of The Institutional Risk Analyst , we talk to our friend Hans-Joachim (Achim) Dübel of FINPOLCONSULT in Berlin to provide some context for the latest troubles affecting Deutsche Bank AG (DB) and the German banking system more broadly. Dübel is one of those rare independent analysts of the banking sector in the EU and has worked on a number of internal and external debt restructurings. But first we need to comment on the end of Q1 2019 earnings and, with it, the top of the rally in the bond market. Since October the Street has been rotating out of risk assets such as collateralized loan obligations (CLOs) and into safer corporate paper, causing a short term rally in both the bonds and related spreads. The policy pivot by the Federal Open Market Committee, however, has interrupted a large asset allocation shift, leaving managers around the world wondering: What the do I do now? Managers of mortgage assets are asking the same question, especially as prepayments rise and loan retention, when homeowners refinance their mortgage, is falling. “In Q1 2019, fewer than one in five homeowners remained with their prior mortgage servicer after refinancing their first lien,” said Black Knight’s (BKI) Data & Analytics Division President Ben Graboske. He adds: “That is the lowest retention rate we’ve seen since Black Knight began tracking the metric in 2005. Anyone in this industry can tell you that customer retention is key – not only to success, but to survival. The challenge is that everyone is competing for a piece of a shrinking refinance market, the size of which is incredibly rate-sensitive, and therefore volatile in its make-up.” The Q1 rally in the bond market pretty much stopped at the end of April, concluding the bull case both for mortgage finance and bonds. A number of more astute players have rightly taken the Q1 bond market rally as a “transient” phenomenon, to borrow the words of Fed Chairman Jerome Powell regarding inflation, and took the gains off the table. Have a look at the 10-Q for New Residential Investments (NRZ) is this regard. The big question that faces owners of mortgage assets as well as bonds is do we hedge and which way do we lean? Chairman Powell’s comments about asset prices not being “inflated” certainly does not add to the FOMCs credibility when it comes to providing guidance or managing soft landings. The big losers in the proverbial policy mix seem to be weaker credits that need to raise capital, but sadly the market already has moved away. The science project/automaker known as Tesla (TSLA), for example, has suddenly reversed previous public statements and now is in the market with a $2 billion capital raise. Of course the true believers in the audience pushed the share price up after the announcement, but TSLA is still down 25% for the past year. The challenging situation facing Elon Musk’s love object TSLA is as nothing, however, compared to the task facing Deutsche Bank, which has been trying to raise new capital for years without success. With the failure of merger talks with Commerzbank AG (CBK), the lack of progress at Deutsche Bank presents a growing risk to the global financial system. In our conversation, Dübel reminds us of the obvious, namely that the largest “bank” in Germany is not really a bank at all when compared with US institutions. Even the $2 trillion asset JPMorgan Chase (JPM) is still more than half core deposit funded and boasts a significant loan book focused on small and medium size enterprises (SMEs). A fatal flaw in the business model of Deutsche and many other private German lenders has led to the present juncture. Deutsche seems so toxic due to bad loans and inadequate disclosure that it cannot raise new equity capital or combine with another institution. “In a nutshell, German (and Japanese) banks are traditionally bond buyers and not lenders, notes Duebel. “All of them, not just Deutsche and Commerzbank AG. Germany doesn’t have a pension system, so much of our surplus has to go through bank deposits and bonds bought by banks.” He notes some of the structural differences between banks in Germany and the US, but cautions that these disparities are not sufficient to explain the decline of German banks. “Structurally they didn’t build up international retail and SME lending as opposed to, for example, BNP Paribas (BNP). As their corporate client base increasingly became banks themselves, Deutsche thought they could compensate through trading income,” he notes. “Of course the strong cooperative and public banking system made the domestic retail/SME market difficult, but that is no excuse. Consider the international success of BNP or Société General (SG) against strong domestic co-operative bank competition. German banks used to be internationally strong in Latin America, Russia and the Middle East, these markets are history today.” Once the focus on traditional corporate and SME lending started to fade, Deutsche Bank and others were lured by the big returns of global investment banking, notes Dübel. “Being securities-overweight, they jumped into extremely crowded investment banking, where banking is dominated by the soccer model (most profits end up with staff, not shareholders),” he relates. Dübel notes that Deutsche and other German banks reaped a large share of their profits from taking market as opposed to credit risk, which is extremely curve- and volatility-sensitive. In addition, due to weak regulations, the German banks pushed up risk levels across their portfolio, with disastrous results. “Where they ventured into credit risk especially,” Dübel notes, “Deutsche focused on the synthetic market where it didn’t have a natural hedge due to the absence of a real credit portfolio. They ran into legal troubles when seeking those opportunities in local governments, retail investors, etc. They were brutally hit by adverse selection in bonds from Anglo investment banks during the crisis. And they contributed to inflating the economy of our neighbors and the U.S. via the bond markets. With ZIRP and only low-yield alternatives in the bond market, Deutsche effectively was bailed out by American and German governments without any consequences.” Dübel believes that the key issue as first mentioned is the unhealthy structural development, that is, management mistakes at Deutsche. “Achleitner (Allianz, Goldman) fired Cryan because he wanted to correct the investment banking bias. Now he trapped himself into something worse,” says Dübel. “I believe in contrast that the money laundering allegations against Deutsche Bank are mostly politically driven. Look who is talking. Details are very hard to verify.” Dübel adds: “Also let us not forget that international banking is as brutal as international oil. German banks were strong for example in Russia and Iran – these countries were lost as clients due to political pressure. One serious mistake they made is to leave everything in between Central/Eastern Europe to Italian and Austrian banks. So bizarrely, today Unicredit (CRIN) of Italy is a more serious contender for a Commerzbank takeover today than Deutsche.” As we’ve noted in The IRA previously, Deutsche has been struggling to make a bad business model work for over a decade. Faced with the fatal structural flaws in the business, the bank has drifted without clear direction from its board of directors and management. German pride makes it impossible for the government of Chancellor Angela Merkel to admit the obvious, namely that Deutsche Bank needs to be wound down and sold. And the public anger at big banks makes it politically impossible for the German government to take an example from Italy and lead this process. Thus we wait to see a solution to the financial and operations problems at Deutsche Bank as the moral hazard risk facing the markets grows. More Reading Can we privatize Fannie Mae and Freddie Mac? Really? https://www.nationalmortgagenews.com/opinion/can-we-privatize-fannie-mae-and-freddie-mac-really? When Deutsche Bank’s Crisis Becomes Our Crisis https://www.theamericanconservative.com/articles/when-deutsche-banks-crisis-becomes-our-crisis/ #DeutscheBank #Dübel

“Stock prices have reached what looks like a permanently high plateau.” Irving Fisher Autumn 1929 New York | Is the free ride over for financials? For the past decade, banks and other leveraged players have basked in the warm embrace of artificially low interest rates and not quite so low yields on various asset classes. The just completed cycle of Q1 2019 earnings for public companies suggest that the outlook for financials may be a good bit less accommodating than the recent past. One trend we note in the latest earnings cycle was the number of US banks that were explicitly guiding down investor expectations with respect to future net interest margin or NIM. The state of confusion with respect to interest rates and yields seems to have thrown a spanner into the proverbial gearbox of Wall Street hyperbole. Our survey of bank earnings suggests that the year-over-year change in funding costs in Q1 may exceed the 70% rate of change in Q4 2018. Just about everywhere you look, one chart seems to describe whatever asset class is under examination. A typical example is the chart below which shows the S&P 500 (SPX) over the past year. Notice the yawning crevasse where we all stood in late December of 2018, when securities issuance in the United States nearly stopped. Looking at U.S. Bancorp (USB) , for instance, which we own and is among the better performers among the largest banks, the market value of the common equity has not quite returned to the levels seen around Halloween. With most financials, we’ve basically waltzed sideways over the past 12 months, albeit with lots of volatility to amuse everyone. Looking at large cap financials as a group, we’re basically back to where we stood in October of last year. The December massacre engineered by Chairman Jay Powell and his colleagues on the Federal Open Market Committee left an impression on just about every asset class we surveil. Could it be that our colleagues among the ranks of bank analysts have finally figured out that the wind has shifted when it comes to NIM for banks and non-banks alike? Looking at the world of leveraged loans, for example, the volumes have not returned to this once toni neighborhood in the world of junk credit. Joe Rennison writes in The Financial Times that the “rout” in leveraged loans continues, driven in part by falling interest rates of all things. He notes that total outflows from the sector reached $26 billion since November, when the wheels began to seriously fall of the cart in the world of credit. “The long stretch of outflows has dented the assets of some of the biggest loan fund managers,” notes Rennison, but adds optimistically that “loan prices have recovered from a sell-off in the fourth quarter of 2018.” One of the great things about watching monetary economists try to “fine tune” monetary policy, an idiocy we today refer to as macroprudential policy, is that it creates great trading opportunities for those with strong constitutions and the ability rationalize the nonsensical. Thus we lightened up on mortgage exposures in December, believing the proverbial credit bottom in that asset class is nigh, but loaded up on USB common and preferred, and even some Citigroup (C) preferred as well. Of course the precursor to the December massacre was seen in August of 2018, when credit spreads began to move. By October, high yield spreads set a trough of sorts around 325 bp over the curve and started to move higher, peaking just shy of 550 bp over on January 3, 2019. As Feldkamp’s first rule states, when bond credit spreads widen, wealth is destroyed and economic growth suffers accordingly. The chart below shows high yield and investment grade spreads. Spreads have come back strongly since January, one reason why stock prices have recovered and even hit new highs. If you want to pick two indicators to watch as a general guide to market moves, credit spreads and the SPX are probably the two best broad indicators around. As we noted in Financial Stability (2014) : “Understanding what moves credit spreads allows us to construct and test policies that allow the United States to create and sustain financial stability.” What concerns us about the present day is the widely held assumption that the artificial increase in asset prices engineered by the FOMC since 2010 is permanent, a view we ourselves have advanced with respect to residential real estate. But maybe not. Could it be that bank credit costs are set to rise after years of artificially low levels of loss? Economists of a century ago were perhaps too involved in the euphoria of the markets, as in 1929 when Irving Fisher uttered his now infamous phrase about stock prices. Yet today’s economists are entirely divorced from the markets, surrounded by the conflicts cordon that encases all government officials in a sterile void. Financial breaks like 1907 or 1929 or 2008 are long in the making, however, and usually start from the periphery of the financial markets and then work towards the center. The Great Crashes of 1929 and 2008 both were preceded by a decade of boom and bust in sectors of the real economy far from lower Manhattan. Thus when we see growing deceleration in once red hot real estate markets around the country, we do start to wonder. Images of the great Florida real estate boom of the mid-1902s come to mind. As John Kenneth Galbraith wrote in “ A Short History of Financial Euphoria ,” the boom of the mid-1920s started in the Sunshine State: “And present also was leverage; lots could be purchased for a cash payment of around 10 percent. Each wave of purchases then justified itself and stimulated the next. As the speculation got fully under way in 1924 and 1925, prices could be expected to double in a matter of weeks. Who need worry about a debt that would so quickly be extinguished?” Kinda sounds like the leveraged loan market, does it not? As we’ve noted over the past many months, credit risk in bank 1-4 portfolios have been negative for several quarters now. Yet if the prices of more expensive residences are now under pressure, can higher bank credit costs be far behind? The chart below is from Weiss Analytics (Note: Whalen Global Advisors LLC is a shareholder in WA) shows the percentage of houses falling in value in various markets around the US. Suffice to say that high end home prices are decelerating in some of the most desirable areas. The WA home price index includes more than 80 million residential homes. Source: Weiss Analytics Keep in mind that in many of the hottest markets around the US, there were virtually no homes falling in price three years ago. The picture has changed rather significantly over the past 18 months. If the falling home price trend described in the chart above is confirmed, then we would expect to see increased pressure on net default rates across the mortgage sector. As we’ve noted before, low interest rates and tight spreads have the benefit of concealing credit risk for a time, but eventually the proverbial trend line reverts to the mean. Loss given default for bank owned 1-4 family mortgages is currently negative, but the 40-year average loss is over 60% of the loan balance. If home prices fall significantly, defaults will rise – and this will occur just as bank funding costs will have fully normalized. For these and several other reasons, the free ride in financials c/o the FOMC may truly be over. As Galbraith wrote: "Financial genius is before the fall." #NIM #Galbraith #Financials

New York | Last week the Mortgage Bankers Association released their annual production report for 2018. It is not a pretty picture. The Federal Open Market Committee has supposedly been “helping” the housing finance sector for years by purchasing long-dated securities, yet mortgage lenders have turned in their worst performance in decade. The MBA estimates total residential mortgage production volume at $1.64 trillion in 2018, down almost 7% from $1.76 trillion in 2017. “In basis points, the average production profit (net production income) was 14 basis points in 2018, compared to 31 basis points in 2017. In the first half of 2018, net production income averaged 18 basis points, then dropped to 9 basis points in the second half of 2018,” reports Marina Walsh of the MBA. “Since the inception of the Annual Performance Report in 2008, net production income by year has averaged 49 bps ($1,020 per loan).” The good news for the mortgage industry is that, since December when the FOMC did a double pirouette and stopped hiking interest rates, long-term bond yields have fallen and lending volumes have picked up. While increased lending results did not show up in the Q1 earnings for the largest banks, there was clearly a surge of activity in the first three months of 2019. Joel Kan, MBA's Associate Vice President of Economic and Industry Forecasting opined: "Purchase activity remained strong and increased slightly, reaching its highest level since April 2010. The spring buying season continues to be robust, with activity more than 7 percent higher than a year ago and up year-over-year for the ninth straight week." Could it be that after years of monetary chemotherapy the housing sector is recovering of its own accord, despite the “help” from the FOMC? The answer is yes. The smart leaders in the industry are positioning for stronger volumes down the road and lower interest rates. Unlike heavily regulated commercial banks, mortgage firms tend to be quite nimble and highly sensitive to changes in the sales cycle caused by interest rate movements, prepayment rates and other factors. Of note, after peaking around Thanksgiving 2018, interest rates seemed to bottom at the end of March and have risen in the first half of April. But the big obstacle to profitability for independent mortgage banks remains the cost to originate or acquire a loan. The MBA reports that total loan production expenses - commissions, compensation, occupancy, equipment, and other production expenses and corporate allocations - increased to $8,278 per loan in 2018, up from $8,082 in 2017. Excessive regulation at the state and federal level is a big component of higher loan production costs. Another recurring theme is a scarcity of mortgage related assets, which like houses are being produced in too little quantity for meet market demand. The result is a price war among the major residential loan aggregators, but you won’t read about it in the financial media. Suffice to say the falling volumes put increased upward pressure on secondary loan prices. Many banks and other owners of 1-4s simply keep the assets in portfolio instead of selling them. The chart below from SIFMA shows that many asset classes and especially mortgages and CLOs have not yet recovered from Q4 2018. Having spent the past two weeks on the road attending mortgage events on both coasts, we have a pretty good view of the state of the mortgage sector and where things are headed. As in 2018, liquidity remains the big concern in the industry, in large part due to paltry profits but also because of the absolute increase in funding costs. Credit concerns are there, but so far the numbers related to credit costs remain very muted and, indeed, extraordinary. Credit costs for bank owned 1-4s remain negative at the end of Q1 2019, for example, with serious delinquency rates at just 2% (200bp) and charge-offs of just 30bp. We heard Mark Fleming, Chief Economist at First American, talk about whether 2019 is the year that the housing market turns and ends it’s 7-year bull run. The good news is that the number of households is finally starting to grow, but supply remains the key constraint. And many households are moving from expensive coastal markets and into more affordable markets such as NC, TX, IN, CO and OH. This is bad news for states like NY, CT and NJ, where an exodus of affluent homeowners to other states is finally forcing sellers to capitulate in the high end suburban markets. San Khater, Chief Economist at Freddie Mac, likewise confirmed that a larger cohort of younger buyers is entering the market and that first time buyers are being forced to move further from the city center to find affordable housing. With the median age of the first time home buyer in the early 30s, Khater sees an increase in younger buyers looking for their first house. Of note today’s mortgage production is pristine in terms of delinquency compared with 2008-2014 mortgage loan vintages. While high-end home prices may be softening, home price appreciation remains robust at the lower end of the price scale, according to Laurie Goodman, Co-Director, Housing Finance Policy Center at Urban Institute. Significantly, Laurie believes that we currently have a 330k deficit in terms of the number of new homes being constructed vs new households created. Whereas the supply of new homes exceeded demand in the 2000s, today the opposite is the case due to soaring land prices and restrictions on new home construction. A scarcity of assets is not just visible in the market for homes and the secondary market for residential loans. Mortgage servicing rights or MSRs continue to trade at record multiples, this even after the bond market rally in Q1 2019 and the related downward marks on MSRs recorded in earnings for many large cap financials. Note that banks now own less than half of the $110 billion or so in total residential MSRs, as shown in the chart below. As and when default rates rise, the bull market in MSRs will end. Levered investors will flee the cost of default servicing. MSRs are naturally occurring negative duration assets, the polar opposite of a loan or a fixed income security, but with a short credit put position attached. Yet in a stable housing market with falling loan volumes and rising asset prices, MSRs are trading at premium prices. In the financial hunger winter engineered by the FOMC under Ben Bernanke and Janet Yellen, MSRs were the best performing fixed income asset class. Will this be the case in 2019 and beyond? Or will winter finally arrive for home prices in 2020? Our view is that home prices are unlikely to fall significantly. Scarcity of assets, soft volumes and low profits are and will be the watchwords in the residential housing sector for 2019.

Orlando | This week The Institutional Risk Analyst is participating in the Information Exchange sponsored by Black Knight, Inc. (BKI), the premier provider of integrated technology, data and analytics for mortgage lenders. We'll be joining Laurie Goodman of Urban Institute, Chris Flanagan of Bank of America, Sam Khater of Freddie Mac and Ed Pinto of American Enterprise Institute for a Super Session on the housing economy. With long-term interest rates falling, the mood in the mortgage industry is much improved and lending volumes are rising. Will profitability return in the yield spread famine created by the central bankers? Maybe. Sadly short-term interest rates remain elevated, held up by the errant policies of the Federal Open Market Committee. Significantly, even as the 10 year Treasury note sits at 2.5%, short-term interest rates are fundamentally linked to funding costs for banks and other leveraged investors. Source: US Treasury Last week Wells Fargo & Co (WFC) and JPMorgan Chase (JPM) reported earnings, in both cases exceeding Street expectations. But the results from both WFC and JPM confirm our expectations with respect to rising funding costs, which continue to grow by mid- to high-double digit rates or roughly 4x the rate of increase in bank asset returns. In the case of JPM, interest expense rose 70% year-over-year from $4.4 billion in Q1 2018 to almost $7.5 billion in Q1 2019. By Q1 2020, we expect to see quarterly interest expense for JPM over $12 billion. To give you some context, JPM’s net interest income was $14.5 billion in Q1 2019. While JPM is guiding investors to higher earnings, nobody expects the House of Morgan to grow asset returns by $5 billion in the next three quarters. For WFC, total interest expense rose 50% from $3.1 billion in Q1 2018 to $4.7 billion in Q1 2019. By Q1 2020, we expect to see WFC’s funding costs rise to something over $7 billion. To compare, WFC’s net interest income was $12.3 billion in Q1 2019. WFC has provided guidance to the Street for declining earnings and revenue through the end of 2019. Even were interest rates to remain unchanged over the next year, the cost of funds for the US banking industry is likely to continue increasing as bank deposit and debt costs normalize. Whereas in the period between 2008 and 2014 funding costs fell faster than bank asset returns, now the opposite is the case as we discussed on BNN last week. Bank funding costs are rising 3-4x asset returns as interest expense normalizes back to the $70-80 billion range. At Q4 2018, total funding costs for the banking industry were just shy of $40 billion. As noted in a previous comment, we expect quarterly bank funding costs to be over $60 billion by year-end 2019. To provide some perspective, the net income of the entire US banking industry was $59 billion in Q4 2018. Since 2014 when bank funding costs troughed at $11 billion per quarter, interest expense has grown four fold and at an accelerating rate. Source: FDIC Since much of the growth in bank interest income is due to balance sheet growth, the cost of funds for the industry is likely to stabilize well above $100 billion per quarter vs the pre-2008 levels of $80 billion. Total assets of the banking industry was $13.8 trillion at the end of 2008 vs $17.9 trillion at the end of 2018, a 30% increase. This is one reason why we believe that net interest income is likely to flatten and start to decline this year and beyond, as shown in the chart below. Source: FDIC, Whalen Global Advisors LLC James Grant writes in Barron’s this week: “Radical monetary policy, and the interest rates that go with it, advantage some, punish others. Speculators gain, savers lose. The rich do better than the poor. On balance, has the decadelong experiment in interest-rate suppression yielded the expected net benefit? The answer—'no’ — is best explained by the first economist who uttered the five wise words. ‘There ain’t no free lunch.’” Between 2008 and 2014, the FOMC subsidized the US banking sector to the tune of tens of billions per quarter in incremental income. Now as the financial markets slowly claw their way back to normal, banks and leveraged investors are entering a dangerous period of falling margins over funding and uncertainty about the future direction of interest rates. Without a complete capitulation by the FOMC and short-term rate cuts, we see no avenue for bank's to avoid a squeeze on net interest income in coming quarters. Yes, President Trump and Larry Kudlow are right about the Fed and interest rates. This novel and ultimately deflationary situation facing investors is entirely the fault of the FOMC and other central banks, which persist in thinking that negative interest rates are somehow helpful in terms of encouraging economic growth. But in fact savers, bond holders and now financial institutions are paying a very high price for the speculative fancy of global central bankers. As Warren Buffett told Yahoo Finance’s editor-in-chief, Andy Serwer : “I think, now, there’s still $11 trillion, at least, of government debt around the world that’s at a negative rate. So we’ve never seen it before.” No indeed. #BlackKnight #BKFS #JPM #WFC #WarrenBuffett #JimGrants

La Jolla | This week The Institutional Risk Analyst is in La Jolla for The Chairman's Conference of The California Mortgage Bankers Association. Click here to download our keynote presentation. Last Friday we got to talk banks with Brian Sullivan on CNBC . We noted that investors need to forget everything they were told in 2018 about rising interest rates. Many investors got killed last year positioning for rate increases in 2019. Hint: When your prime desk coverage is selling the short bond/long rate trade, look the other way before crossing the street. The folks on the Federal Open Market Committee may be clueless on rates, but your friends on the Sell Side are most definitely not. Banks and nonbank financials are being whipsawed by falling market yields. Look for negative marks on mortgage servicing rights (MSRs), TBA exposures, and rate hedge desks in Q1 earnings. But don’t worry, the Sell Side desks did just fine. And behind the scenes, funding costs continue to rise for US banks regardless of the moves in market rates. The relentless increase in funding costs will take a bite out of bank earnings as net interest income growth flattens out and even declines. Last month we put out a call on NIM flattening for US banks in 2019. We discuss the dynamics driving up the cost of funds for US banks in the most recent issue of The IRA Bank Book . https://www.theinstitutionalriskanalyst.com/single-post/2019/03/24/Bank-Earnings-and-QEQT China, trade, etc is all fun to talk about, but we remain in a sellers market for securities even as market yields decline. Quality issuance is getting snapped up aggressively by global funds and public sector agencies. This impacts financials because the competition between lenders and bond market execution and private equity is intense. They are all fighting over the same pool of assets, a big bucket of duration that has been rendered inadequate by the reckless actions of the Fed and other central banks. Just as the FOMC has been unable to achieve a certain level of inflation, neither can they engineer rising interest rates. This is one of the unanticipated side effects of "quantitative easing" or QE. Bank loan spreads and bond yields remain biased ON THE DOWNSIDE despite the yada, yada from the FOMC and allied media about rising interest rates. Since December, in fact, the FOMC has been rudely reminded that it only controls the short-end of the Treasury yield curve and then just barely. Steve Moore, Larry Kudlow and POTUS all are right about rates and markets, BTW. The folks on the FOMC ignored market indicators from September onward, ignored the fact that high yield credit spreads were blowing out by T-Day, and almost ran the ship aground in December. Herman Cain on the FOMC? Yes please. We need more non-economists sitting at the Fed table. Some say the Fed's independence would be hurt by having Cain or Moore on the Fed. But independence from what exactly? Remember December 2018? Wells Fargo & Co Our upbeat comment on Wells Fargo & Co (WFC) last week generated a lot of comments, but the reality is that it will take a long time for the basic operational quality inside the bank to see premium valuations. We have all witnessed a huge screw-up by the WFC board, management, and regulators. If Fed/OCC had forced CSUITE changes two years ago, then WFC would be in far better shape today. https://www.theinstitutionalriskanalyst.com/single-post/2019/03/31/Is-there-a-bull-case-for-Wells-Fargo-Co The moral of the story: regulators need to use the power that they already possess to enforce change at banks with weak internal systems and controls. The Street has negative estimates on revenue and earnings growth for WFC, in part because bank lending volumes across the industry are slowing. As we said last week, WFC balance sheet definitely gets smaller in 2019 if they continue dividend payouts at current levels. JPMorgan Chase & Co The Street has small earnings growth in Q1 for JPMorgan Chase (JPM), then the proverbial hockey stick for full year. Big question for JPM is how December massacre in fixed income and falloff in securities issuance volumes in Q1 will impact capital markets and investment banking results. Can't wait to see the March data on securities issuance from SIFMA. Of course Jamie Dimon will exceed the Street's modest estimates for earnings growth in 2019. Housing Redux? Finally, it is notable that mortgage-refinance applications were up 39% last week. An index that measures refi applications hit its highest level since November 2016. The welcome surge in volumes has brightened the outlook for the entire mortgage finance sector. Real question is whether these “green shoots” will give the industry a shot in the arm in terms of both volumes and profits after the worst year in decades. The good news is that 30 year mortgage rates have followed the 10-year Treasury note down a point in yield since last November. The bad news is that home prices have been pushed out of reach for many Americans. The inflation in home prices that occurred during and after the Fed purchase of trillions in government securities and RMBS under QE has permanently raised the price of housing in many parts of the country, preventing millions of young families from purchasing a first home. Former Fed Chair Janet Yellen confesses to be “perplexed” by the dearth of home purchases by young families, but she and the other advocates of inflation on the FOMC are the cause of this malady. Unless and until the FOMC figures out a way to gently let some of the air out of the housing bubble, low rates may not be sufficient to boost annual lending volumes back over $2 trillion annually. And without a significant increase in lending volumes, profitability is likely to be elusive in the mortgage sector -- even with lower interest rates. ♦ #WFC #JPM #Moore #Cain

New York | Last week Senator Elizabeth Warren (D-MA) finally got her scalp. Tim Sloan, CEO of Wells Fargo & Co (WFC) resigned, part of the blood letting demanded by progressive politicians in recompense for the bank’s numerous acts of fraud, stupidity and malfeasance. WFC shareholders are paying for these sins and omissions in a number of different ways. As usual, the officers and directors are largely unscathed. "Impacted consumers" are not really being made whole in any meaningful fashion. But the lawyers, politicos and regulators thrive. Once the stellar performer among the nation's four largest banks, WFC is now sidelined in terms of growth and overall performance under regulatory sanctions. These facts and the attendant media noise relegate the bank to a subordinate number three position beneath JPMorganChase (JPM) and U.S. Bancorp (USB) in terms of book value multiple of the equity shares. So here’s the question: Is there a bull case for Wells Fargo & Co? The bank’s performance is actually still quite strong despite its self-inflicted legal and reputational wounds. Indeed, we’d contend that most of the market's discount from the near 2x LT book value once enjoyed by WFC is due to operational errors and the resulting negative media coverage, regulatory actions and political noise. The bank’s financial performance has clearly slowed and capital is down, but WFC is still a peer performer compared to its largest competitors. Can WFC regain its past glory and specifically trade closer to 2x book? Maybe. Brand destruction is tough to reverse. A lot depends on who ends up running this now $1.9 trillion asset behemoth and how long the Fed and OCC keep the bank in the supervisory penalty box. But at the end of the day, as with George Gleason at Bank OZK (OZK), WFC will regain the confidence of investors and thereby regain a premium valuation by delivering earnings and otherwise being vewy, vewy quiet, to recall the advice of duck hunter Elmer Fudd. On Friday, WFC closed at 1.3x book, hardly cheap for a commercial bank and below the comparable multiple for JPM and valuation leader USB. Bank America (BAC) and Citigroup (C) trade at a book value discount to WFC of 1.2x and 0.8x, respectively. But looking at the performance reports for year-end 2018 prepared by the FFIEC , WFC has diminished in terms of size and other key performance metrics. Even with that said, WFC remains a reasonable peer of the other four largest money center banks as measured by price to book value and average market volatility (beta). Source: Capital IQ In terms of net income to average assets, for example, a key measure of any lender’s core profitability, over the past five years WFC has fallen from the top 20% of large banks to the bottom of Peer Group 1, is defined by the FFIEC and includes the 118 largest depositories in the US. At the end of 2018, the San Francisco-based bank was in the bottom quarter of all banks in net interest income vs average assets as well, whereas in the previous four years WFC was closer to the center of the pack. Likewise interest income as a percentage of earning assets puts WFC in the bottom 20% of the group. Of course, the smallest banks in Peer Group 1 tend to be the best performers, thus the peer average is well-above the average asset returns reported by the top four "zombie" banks. One interesting comparison for WFC and the other top banks is loan pricing. If you look at the top five commercial banks, WFC is doing pretty well in terms of pricing for new loans. Yet the top performer by far is Citigroup followed by JPM. And C has the lowest equity market valuation and highest beta of the top four. What gives? In simple terms, both the yield on loans and leases and the default rate at C are much higher than its large bank peers and, indeed, all of Peer Group 1. Citigroup is in a different business than the other banks, a subprime consumer lending business that is seen by investors as having greater risk financially and in terms of reputation. The bank has lower risk adjusted returns and gets a lower equity market valuation as a consequence. Remember, the only good credit comp for Citigroup is credit card monoline Capital One Financial (COF). Source: FFIEC Pricing on WFC’s loans was 20bp below peer at the end of 2018, a reflection of the competition among the largest banks for equally large assets. Smaller banks tend to get far better pricing on smaller loans. Of note, in terms of credit performance, WFC has been pretty stable over the past five years including the period of trouble due to the bank’s actions. Like most of the large banks in the US, provisions for future loan and lease losses have been trending lower at WFC as defaults have fallen. Obviously the balance sheet of WFC has been getting smaller, down 3% in 2018. Last year the bank’s capital position also fell to the lowest level since 2014 due to the high (42%) dividend payout vs net income. The Tier 1 leverage ratio of WFC is just barely 9% after a 5.1% decline in 2018, almost three quarters of a point below 2014 levels. This suggests a smaller balance sheet is likely in future quarters. Net loans and leases and non-core funding also declined, an indication that the bank is allowing its loan book to run off compared to the 7.7% loan growth rate reported by all large banks in Q4 2018. One troubling factor to consider for the future is that as WFC allows assets to decline, it is forced to also trim debt, deposits and other sources of funding. WFC is one of the most leveraged large bank holding companies in the US, in the 92nd percentile of its peer group for debt as a percentage of equity capital. WFC carries long-term debt equal to 65% of the bank’s equity capital vs the peer group average of just 13%. Back in 2014, the same LT debt/equity metric for WFC was in the 40s. To be fair, all of the larger bank holding companies have levered up again since 2008, generally with bloat in the form of derivatives and other non-loan asset types. At the end of the day, WFC is a bank that is essentially coasting along, allowing its assets to run off. Pricing for WFC loans is in the bottom decile of large banks but still quite good compared with the top four banks, admittedly a less challenging hurdle. The yield on total earning assets for the bank was just 3.77% at the end of 2018 vs 4.20% for all large banks in the US above $10 billion in total assets. And in terms of all interest bearing funds, WFC’s cost is dead center of the peer group vs the bottom quartile in 2014, when WFC had one of the lowest funding costs of any large bank. Source: FFIEC WFC is the laggard among the larger banks compared with Peer Group 1, but the asset return performance of JPM is even worse owing to the fact that less than half of JPM’s balance sheet is actually deployed in lending. Like JPM, BAC is likewise not a great performer measured by asset returns. Of note, Citigroup is actually the best performer among the top five commercial banks based on nominal asset returns, this because of its subprime consumer loan portfolio. The pricing of Citi’s non-consumer, commercial loan book is poor, however, dragging down the bank’s overall gross loan yield before funding costs. U.S. Bancorp, however, is the best performer overall based upon risk-adjusted returns and equity market valuation. The chart below shows returns on all earning assets, including loans, securities and deposits with other banks and excess reserves at the Federal Reserve. Source: FFIEC Under new leadership, WFC could be turned around very quickly in financial terms, but again, we believe that the reputational and regulatory problems are chiefly responsible for the present equity market discount. And we’ll still take USB over any of the top five banks. All that said, WFC offers an opportunity, Avi Salzman writes in Barron’s this week. Ditto. But having to spend several more years in regulatory purgatory is unlikely to help the bank’s financial or equity market performance, again illustrating how shareholders are paying the tab for the grotesque failures of management and the board of directors. Even with all of the regulatory lapses and adverse public attention, WFC in financial terms still is performing better than JPM and BAC. WFC trades at a premium to book value and above the relative equity market valuation of BAC and C. Clearly there are some investors who still find WFC a compelling value, if not now then in anticipation of better times in the future. For us, however, the bank’s performance is average compared to the 118 largest banks in the US banking industry and is likely to stay that way for the next couple of years. And we expect to see a smaller balance sheet at WFC in coming years. Once the legal and regulatory issues are fixed and the signal in terms of earnings performance again is louder than the political and media noise, then we believe that WFC can eventually resume its position at the highest valuation among the top four US banks by assets. ♦

New York | In the most recent edition of The IRA Bank Book , we note that the rate of increase in funding costs for US banks in 2018 was a bit over 70% year-over year. The rate of change in this key component of bank earnings is not particularly correlated to the broad swings in market interest rates and, by implication, investor confidence. But the normalization of bank funding costs is relentless. As we describe in some detail in the IRA Bank Book for Q1 2019 , rising bank interest expense is a structural trend that heralds the end of extraordinary monetary policy, at least for now. Whereas the quarterly cost of funding for all US commercial banks was just shy of $40 billion at the end of 2018, by the end of 2019 funding costs for the $17 trillion in US bank assets should be closer to $70 billion, especially for the larger banks. Asset earnings are rising at one quarter of the rate of funding expenses, BTW, the result of a continued sellers market in collateralized loan obligations (CLOs) and straight debt. At year end 2018, the average cost of funds was well over 1.3% for large banks such as Citigroup (1.27% Q4’18) but the average for the top 100 banks is still below 1%. Despite the full stop retreat by the Federal Open Market Committee, the impact on the bank earnings is likely to be negative, albeit gradually. The fact of a flat yield curve and continued downward pressure on yields for loans and securities is not particularly helpful when it comes to keeping asset returns even with increase funding costs. The chart below shows our projections for bank interest income and expense from Q1 2019 through Q4 2019. Note that we see net interest income stop growing in Q1’19 and begin to shrink in dollar terms as the year continues. We currently project that US bank funding costs will exceed $70 billion per quarter by year-end 2019. Source: FDIC/WGA LLC "[T]he Fed already seems to have embraced the idea that inflation should be allowed to exceed 2% without immediately triggering a tightening," notes Nouriel Roubini over the weekend in Project Syndicate . Roubini correctly notes that with the addition of Governor Richard Clarida on the FOMC has the effect of “tipping the balance of the FOMC in a more dovish direction.” Additional evidence of the change in the Fed's policy orientation toward greater intervention is found in the March 20, 2019 document released by the FOMC entitled “Balance Sheet Normalization Principles and Plans.” The FOMC has slowed the rate of decrease in the central bank’s balance sheet. Specifically: The Committee intends to slow the reduction of its holdings of Treasury securities by reducing the cap on monthly redemptions from the current level of $30 billion to $15 billion beginning in May 2019. The Committee intends to conclude the reduction of its aggregate securities holdings in the System Open Market Account (SOMA) at the end of September 2019. The Committee intends to continue to allow its holdings of agency debt and agency mortgage-backed securities (MBS) to decline, consistent with the aim of holding primarily Treasury securities in the longer run. In addition, the increasingly dovish FOMC is going to continue reinvesting in both long-dated Treasury securities and agency RMBS. Again, the FOMC: Beginning in October 2019, principal payments received from agency debt and agency MBS will be reinvested in Treasury securities subject to a maximum amount of $20 billion per month; any principal payments in excess of that maximum will continue to be reinvested in agency MBS. Principal payments from agency debt and agency MBS below the $20 billion maximum will initially be invested in Treasury securities across a range of maturities to roughly match the maturity composition of Treasury securities outstanding; the Committee will revisit this reinvestment plan in connection with its deliberations regarding the longer-run composition of the SOMA portfolio. The upshot of all this is that the FOMC is going to continue the ill-advised policy of Operation Twist, buying long dated securities as part of the asset mix. It is not clear, for example, how the FOMC will reinvest MBS in Treasury securities. By purchasing long duration paper for the system open market account (SOMA), the FOMC directly contributes to the further flattening of the yield curve and maintains an effective cap on bank asset returns. This is why we see bank industry NIM growth going negative after Q1 2019. Yet of note, in the very same document, the FOMC states: “It continues to be the Committee's view that limited sales of agency MBS might be warranted in the longer run (emphasis added) to reduce or eliminate residual holdings. The timing and pace of any sales would be communicated to the public well in advance.” That's nice. Meanwhile, even a relatively modest $15 billion per month in net runoff from the SOMA will still squeeze overall liquidity in the system. As George Selgin at Cato Institute noted back in 2016 ( citing Walter and Courtois ) once the Fed started paying interest on excess reserves (IOER) banks “would be more willing to hold on to excess reserves instead of attempting to purge them from their balance sheets via loans made in the fed funds market." But the level of excess reserves in aggregate is still a function of the size of the Fed's securities portfolio. The decision to slow (and eventually reverse) the rate of SOMA portfolio shrinkage indicates that the more dovish FOMC has decided to make permanent the nationalization of the short-term money market in the United States. The FOMC accomplishes this end by continuing the reverse repo approach to managing interest rates and dealing with a larger number of potential non-bank counterparties, such as money market mutual funds. Why bother with those messy private markets, eh? As with IOER, the Fed is subsuming the functioning of private unsecured markets for cash onto its own federal balance sheet. When the FOMC mechanically reduces excess reserves by allowing the SOMA securities portfolio to shrink, the big banks will return to private markets and bid more aggressively for REPO and other low-risk capital weight substitutes, driving yields down. As we noted last week, the FOMC’s plan to maintain a “ceiling” on short-term rates via IOER may be doomed to the same fate as the Fed’s plan of a year ago to reduce the size of the balance sheet. In a market where the 10-year Treasury note already is trading below 2.5% yield, a ceiling may become a floor very quickly. Markets are likely to be a bit sloppy this week as investors digest the latest statements from the FOMC. Of course, the FOMC under Chairman Jay Powell is committed to full and complete public disclosure. But the markets may not care for the message – especially as the decidedly mixed outlook for financials become more apparent. Thus the markets will tighten and yields will fall, as started in earnest in December 2018 and has continued since then. But bank funding costs will continue to rise. #IOER #Selgin #FOMC #NIM #Earnings #Bank #SOMA #MBS

New York | We had a great trip last week, participating in Ellie Mae’s (ELLI) Experience 2019 and surveying the rich (and water sodden) agricultural sector due north of the Golden Gate Bridge. You may have seen the announcement that ELLI has agreed to a buy-out led by Thoma Brava for $99 per share. Suffice to say the valuation is well-above the 50-60% of book value that most of ELLI’s customers in the world of mortgage lending enjoy. That is, the few that are actually publicly listed. Q: Why is a non-QM mortgage loan like a corporate bond on transformational REPO? Hold that thought. One of the key topics of discussion at the ELLI event was the long-awaited growth of the market for non-qualified (QM), non-conforming, non-government loans that don’t qualify for guarantees or credit “wrappers” from Fannie, Freddie or Ginnie Mae. Today the non-QM market is limited to a few industry pioneers like Citadel Servicing Corp. of Irvine CA, the self-proclaimed “leader in Non-QM/Non-Prime Wholesale and Correspondent Lending products.” Camp Kotok -- June 2019 Subscribers to The Institutional Risk Analyst interested in possibly joining June Camp Kotok 2019 Maine fishing trip should email via www.rcwhalen.com . Four days of the best small mouth bass fishing in North America, and discussion of markets and the world. Citadel originates the non-QM paper and retains the servicing, and earns an appropriate return for the risk. But the basic problem with non-QM lending is that outside of the prime market for jumbo loans dominated by banks, non-QM lending is limited to a few highly specialized non-bank lenders, industry veterans who hand-underwrite these loans much like a serious garage in southern California builds race cars. Non-QM lenders have cash capital and an audience of hard money investors to “take out” the loan from the underwriter. Each non-QM loan is different – even more so than with your typical conventional loan. Each has a story and all have limited liquidity in terms of short- and long-term financing. Whereas you can finance a QM loan that has received an agency endorsement like a T-bill and get execution over par and with no margin on the security, for non-QM loans financing is far more costly. Thus we speak about “specified pools” of hand picked loans that have characteristics such as credit or geography. The same financing cost barrier that inhibits the growth of non-QM lending, especially by non-bank lenders, also is an effective obstacle for an important subset of the non-QM universe, namely home equity lines of credit (HELOCs). There was a lot of discussion at the ELLI conference about the impending return of HELOCs as an asset class for 2019-2020. Some even see HELOCs as a potential replacement for reverse mortgages. Not on both counts. And why not? Three reasons: Home equity loans or HELOCs are a traditional bank product that is frequently treated as an unsecured, 100% risk weight loan by regulators and are typically held in portfolio and serviced by the lender Non-banks are ill-equipped to originate HELOCs because of funding costs and the lack of liquidity in terms of a natural take out by end investors Investors dislike the attributes of HELOCs which are priced against 1st liens and do not reflect the credit and prepayment risk of the asset With the rare exceptions of banks and non-bank firms such as Citadel or Angel Oak Mortgage , the non-QM and HELOC markets are owned by banks and really are a product meant to be retained in portfolio and serviced by a bank lender. Large banks have a cost of funds averaging 1.25% as of year end or 3-4 points below the cost to a non-bank. Small banks fund even lower, closer to 50bps than 1%. The larger banks such as JPMorgan Chase (JPM), Wells Fargo (WFC) and Bank America (BAC) will aggressively bid for large prime jumbo loans which are non-QM mostly due to size, whether as first liens or HELOCs. Yet overall the banking industry’s portfolio of HELOCs has been steadily shrinking for the past decade. Source: FDIC So the big obstacle to the growth in non-QM loans and also HELOCs can be summarized in three factors: 1) high funding costs for non-bank originators, 2) crazy high pricing/low yields due to the bid from the larger banks and 3) end-investor reluctance to take default risk on a non-QM loan with no guarantee from Uncle. The fact of government guarantee on agency mortgages and regulatory requirements for banks, insurers and pensions has made Buy Side investors lazy over the years. Letting Uncle Sam subsidize the default risk on residential (or even multifamily) mortgages is much easier than paying for the servicing and loss mitigation. Indeed, were the true credit costs born by investors in agency RMBS the real returns would be negative by several points, an illustration of the huge subsidy that the federal government provides to the US housing finance sector. Imagine the coupon on current FHA production sans the credit loss cover from Uncle Sam. Double the coupon and keep going. While the federal government subsidizes some sectors, it acts as a brake on others, specifically in the way that regulation post 2008 limits liquidity and risk taking. Last week in our discussion with David Kotok of Cumberland Advisors , we spoke about how the rules for demonstrating liquidity imposed upon the 29 largest banks, the supposed “globally systemically important banks” or GSIBs, almost caused a market meltdown in December. But there are many other areas where global regulators have changed the rules in such as way as to make the financial system more, not less, fragile. Such an area is the wild and woolly world of “repo collateral transformation” used to finance trading in over-the-counter (OTC) derivatives. Collateral Transformation So we asked above why the world of non-QM lending is like a corporate bond? Answer is collateral, namely non-agency, non-US Treasury risk that is subject to haircuts when used as security to raise cash. "Collateral upgrades" is another possibility suggested by Ralph Del Guidice. Just as a non-bank lender often lacks the collateral to finance its business effectively, non-bank funds and financial firms operating in the OTC derivatives markets now face even higher capital requirements as a result of the post-2008 regulatory onslaught. The Dodd-Frank law and various regulations since adopted required many changes in the world of finance, particularly derivatives. Both the Dodd Frank Act and the European Market Infrastructure Regulation (EMIR) mandated that all eligible OTC swaps traded by Swap Dealers (SDs) and Major Swap Participants (MSPs) be cleared centrally with central counterparties (CCPs). In theory, this meant that the good old days of the prime brokerage desk trading OTC swaps with non-bank clients with little or no collateral were over. But think again. While some of the larger Buy Side firms became actual clearing members of the major exchanges post 2008, most non-banks remain dependent upon banks for financing and, in some cases, collateral finance. How does this work? Say you are a non-bank with little working capital outside of your warehouse for non-QM loans or a fund invested in barely or even non-investment grade corporate debt. Your friendly securities firm takes your corporate bond paper, does a repo transaction to raise cash, and uses that cash to cover the margin on your derivatives trades. The dealer bank trades corporate debt for cash (for a fee), but uses its own government or agency collateral to meet the margin call for the customer. Thus the bank holds the crap and all of the risk – sometimes for its own book, sometimes for clients. Tales of MF Global. Recall that the margin rules in Dodd-Frank and other laws and regulations around the world are meant to increase the proverbial “skin in da game” for swaps customers, especially the non-bank customers of banks. Since most of these Buy Side customers did not have the capital to actually meet the new margin requirements, the Sell Side of the Street had to come up with a solution to circumvent the true intent of the new rules. The alternative would be to limit client positions as intended by Dodd-Frank and greatly reduce the fee income to the largest Wall Street banks. Keep in mind that in the world of actual securities, the rules on cash margin are set in stone. Only is the magical world of OTC derivatives are large banks allowed to explicitly evade margin requirements in such a reckless fashion. Back in 2013, the folks at Sapient Capital Markets asked some obvious questions about collateral transformation. We provide our answer . Will there be unintended consequences for putting the repo market between the buy side and CCPs? A: Yes How will collateral transformation react in a stressed market? A: Badly What is the potential for liquidity risk and rehypothecation? A: Depends how quickly the old plunge protection team can fix the contagion What are the dangers in the new OTC landscape? A: Numerous and growing Now of course, in a stressed scenario, a non-bank mortgage lender can liquidate a pipeline of fully government guaranteed agency loans within a day, posing little risk for the firm or the fully secured warehouse lender. The portfolio is essentially self liquidating. Even a portfolio of low-LTV non-QM loans would be reasonably easy to sell, remembering that this is a first lien claim on a real asset. But in a transformational repo trade, the bank is exchanging corporate for risk free exposures, this to guarantee a margin call of OTC derivatives. Kinda makes us feel a bit queasy. Bank of New York Mellon (BK) noted in a June 2017 presentation ominously entitled “Collateral: The New Performance Driver.” “Over 90% of participants noted a direct impact on their collateral obligations due to regulations such as OTC uncleared margin requirements. Both the demand for high-quality collateral and the frequency of margin calls have increased for almost all participants.” Indeed, it is fair to say that today most of the major banks and non-bank dealers offer some sort of transformational repo product. The rub is that there are so many companies clustered around the neutral zone between investment grade and junk that we can see ratings volatility figure prominently in the forward analysis of value-at-risk (VAR). And we have not even talked about the leverage coming from the particular derivatives trade. To us, the risk on a fully secured first lien mortgage loan, qualified or not, is an order of magnitude lower than leveraging selected portfolio assets to finance the margin on a derivatives trade – especially to the futures commission merchant is not affiliated with BK, JPM, WFC, etc. And we’re pretty sure that the intent of Congress when Dodd-Frank was passed in 2010 was that “skin in the game” was meant to be cash equity available to absorb first loss. Using borrowed money to finance a margin call in transformational repo seems almost absurd, but perhaps this is just a sign of the times, an environment where market behavior is increasingly distorted by well-intentioned regulations and open market operations. Should we be more critical of the over-aggressive FCM financing a non-bank’s junk corporate bond collateral or the mortgage servicer or REIT that leverages capital invested in a servicing asset to generate free cash to finance new lending or acquisitions? Fortunately we don't need to answer that question. The Federal Reserve Board is proceeding apace with the nationalization of the US money markets. And it seems pretty clear reading the proverbial tea leaves that the central bank stands ready to buy all of the detritus of Wall Street as and when the markets go through the next tantrum. "Minutes from recent FOMC meetings suggest the Fed is exploring an O/N repo facility, which could potentially replace the pre-crisis era temporary open market operations used to target the fed funds rate," notes Goldman Sachs (GS) in a research report appropriately entitled: "Global Rates Insights: From leaky floors to leaky ceilings." GS continues: "How such a facility is implemented can have material consequences for market functioning. In this report, we explore the design choices for such a facility, along with market implications of these choices. Our analysis suggests that the Fed can continue to effectively control unsecured overnight rates using IOER adjustments, especially given the Fed's signals that it intends to stop balance sheet reduction early." Reading List Investors should encourage a resurgence of local community banking CNBC Don’t Assume That the Fed Is Done Raising Rates William Dudley, Bloomberg Worried about next downturn? U.S. credit funds may offer early clues David Henry, Reuters #elliemay #kotok #HELOC #transformationREPO #JPM #GS #BK #WFC #BAC