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San Francisco | In this issue of The Institutional Risk Analyst , we feature a conversation with David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors in Sarasota, Fl. David is a savvy investment counsellor, a keen observer of the evolving American political economy and an experienced fly fisherman. David and his colleagues at Cumberland Advisors publish commentaries on the global financial markets and the world which may be found at www.cumber.com . David Kotok and Stephen Sexauer, Paris 2014 The IRA: David in your commentary last week (“ JAY POWELL, GSIBS, CHRISTMAS EVE MASSACRE ”) you refer to December as a “massacre.” We concur. In fact, we are gathering more and more data that suggests our friends on the Federal Open Market Committee almost ran the proverbial ship aground at the end of 2018. New issuance in the bond market went close to zero for several weeks and the flow of new home mortgages also cratered and has not yet recovered as of February. There seems to be a lot of collateral damage here. Tell us what you see. Kotok: I am in agreement. What I did in the commentary last week was to go through the estimates of the “global systemically important banks” or “GSIBs,” some 29 banks. I looked at the capital cost of a prudential rule which came together with tightening monetary policy creating a perfect storm in December. Under the radar, except for those who looked for it, was a multi-hundreds of billions or even trillions of dollars in liquidity contraction. Why? Because the big banks pulled back from the markets at year-end in compliance with the GSIB rule. A mispricing of whole segments of the so-called riskless market was triggered and resulted in a massive cost to the markets that we can estimate. Trillions of dollars in meltdown of market value were triggered because of billions in reallocations. This occurred because of the cost of a rule regarding the 29 designated large banks or GSIBs. Note that this is a rule which is totally unnecessary. Fed Chairman Jay Powell has said that he is satisfied with the capital structure of the big banks. I agree with him. The IRA: Ditto. The tightening of the REPO markets was very visible in December, long before the end of the month. Customers with collateral were shunned by the big banks, benefitting the smaller desks. Kotok: The GSIB rule caused the big banks to step back from the market. On December 31st, the SOFR rate which is supposed to reflect a risk free overnight rate for funds was 60bp over referenced Treasury yields. The cost increase came because the big banks were encouraged to shrink, to convert assets into cash and other risk-free exposures. You can see the spike in REPO rates and the change in holdings. Any Bloomberg terminal demonstrates the visual spike. People who have expertise in the money markets saw it. You saw it. We saw it. But 99% of investors had no idea why the money markets were seizing up. They didn’t see that this is a temporary liquidity crunch that has nothing to do with default risk or credit risk. The risk is derived from the imposition of a rule, a regulatory provision called GSIB. But investors did not see that. They saw markets shifting violently and volatility spiking. They saw the spread on the credit default swaps (CDS) of the United States rise by 50%. They didn’t understand that CDS is hedging device used when such spikes happen. The IRA: To add another datapoint to your analysis, in Q4 2018 the securities holdings of all US banks fell modestly, but there was a huge surge in Treasury holdings roughly equal to the runoff of the Fed’s portfolio. And there was continued erosion in certain types of deposits. This may be why Chairman Powell had to back off on further shrinkage of the Fed’s balance sheet. Kotok: Individual banks around the world were acting rationally to protect their institutions. Can’t blame them for that. Collectively the 29 GSIBs imposed a temporary liquidity crunch on the entire system. And the result was that at one point the Treasury REPO rate shifted to a five hundred basis point spike. If riskless paper spikes in one day by hundreds of basis points, what is the cost? I computed what one basis point costs per trillion of market move in SOFR. The 29 GSIB banks represent hundreds of trillions of dollars in balance sheet and derivatives. And they wonder why the equity markets almost melted down? By the way, this fact may explain the bizarre December phone call that Treasury Secretary Mnuchin made to the biggest US banks. He was just "checking in to see if they were okay," according to press reports. Since the reason for his call was never fully explained, the reports of the call only worsened the market sentiment which was already based on faulty understandings. The IRA: Agreed David. We think that the accumulation of evidence suggests that the Fed and other prudential regulators came dangerously close to running the global economy aground. This is a terrible refutation of the whole idea of “macro-prudential regulation.” Monetary policy goes one way, prudential rules go another and none of the agencies involved have any idea as to the net effect on the financial markets or the economy. Kotok: Well, they sure were focused on a lighthouse or what they thought was a lighthouse but it turned out to be a pile of rocks. The IRA: We have this strange situation where the FOMC is reversing past monetary policy. The Treasury is issuing and the Fed is now buying short-term paper again, essentially unwinding “Operation Twist.” And then, on the other hand, we see prudential policies that restrict liquidity. And nobody seems to understand what it all means for the markets or the economy. When they close the door of the Fed’s boardroom, are they focused on the markets or on the DSGE models? If we cannot rely on the numbers we see on the screens every morning to govern market risk allocations, isn’t the FOMC doing more harm than good? Kotok: Yes. Those who are looking at DSGE models and those who are in the throes of the debate over whether the Phillips Curve is reliable need to answer a question. If we know that these tools are unreliable, then why are the dot plots used by the FOMC still measuring two of the main Phillips Curve components? This reminds me of the General Eisenhower story about D-Day. In January 1944, Eisenhower was planning the invasion of Europe. And he asked his staff advisors for the long range weather forecast of weather for June, 1944. The experts replied that long range weather forecasts were notoriously inaccurate. But General Eisenhower's staff insisted on a forecast because they needed it for planning purposes. We can put the Fed's "dot plots" and long range Fed forecast models in the same category. The only thing we know about dot plots is that they are wrong at the time they are created. The IRA: Since we are talking about WWII history and General Eisenhower, our next book is tentatively titled “False Mandate” and goes back to the origins of the Humphrey-Hawkins law. Do you remember Rep. Augustus Hawkins (D-CA)? He was the first African American from California in the United States Congress and co-authored the 1978 Humphrey-Hawkins Full Employment Act. Hawkins never lost an election in 58 years of public service. Rep. Maxine Waters (D-CA) inherited his seat in Congress. Speaking of long-term economic forecasts, can you tell us when the FOMC decided that zero and two are the same number when it comes to inflation? The Humphrey-Hawkins statute of 40 years ago says zero is the definition of price stability. Kotok: Ha! May I invite a corollary? Two percent inflation means that the real value of your wealth will be cut in half in forty years. A person born today under the current Fed 2% policy who inherits $1 million at birth will have a quarter million worth of buying power remaining when they die, if they fulfill their current life expectancy. If the Fed is successful with their current policy objective, they will destroy three quarters of the real wealth of the average young person living today. Sounds rather harsh doesn’t it? The IRA: No, you are quite right. The Humphrey-Hawkins statute says pursue full employment, then seek price stability which is defined as zero. Because of what has changed over the past forty years, the Fed staff in Washington has come up with this convoluted construction whereby zero = two. Two is really “price stability” because the system cannot tolerate deflation, which means that savers will never get a chance to buy a stock or distressed property and create future wealth. All of the bias of US monetary policy is on the side of the debtor (by using inflation as a hidden tax) and thus transferring wealth from savers to debtors. Certainly makes a mockery of Thomas Piketty’s assertion that the return on wealth is greater than nominal growth, yes? Kotok: Precisely. Now it would be one thing if the Fed were to say, listen, we are incapable of handling monetary policy affairs at zero. Let’s admit our frailty. And, by the way, I think this would be a fair statement. One needs only to look at the Bank of Japan and ECB to see the mess that can be created if you stay at zero long enough. And we are witnessing both the BOJ and the ECB at the point where there is zero probability of a policy change that leads to extraction. The BOJ balance sheet size is about equal to that nation's GDP. And the assets are yielding near zero percent. Imagine a Fed balance sheet of $20 trillion size. That would be a similar metaphor. The ECB will soon roll €700 billion in TLTRO . What they must wrestle with is that if, they do not increase the amount to €900 billion or €1 trillion, then they will have done zero stimulus. The IRA: Well, that is because they call QE stimulus. There are many people who see QE as and engine of market distortion and eventually deflation – unless it is made permanent and indefinite. Taking away the carry from trillions of dollars in securities around the world implies liquidation. Kotok: Of course, but whatever the impact, it will be nothing if the amount is not increased. We will have neutralized an already neutered neutrality. The IRA: Agreed. But what the FOMC has learned over the past few months is that you cannot withdraw the liquidity provided by QE without destroying the system. You can maintain neutral and have economic stagnation. But you cannot withdraw the liquidity once it is put into the system. In Europe, even the cessation of new asset purchases has put the EU economy into a tailspin. Without the constant heroin drip of QE, the enfeebled European economy has started to contract. And the US is not much better. Kotok: But we are not as bad off as the ECB or BOJ. There is still a chance in the US to get this right. The current FOMC, in my view, has ignored Chairman Ben Bernanke’s warning, which he repeated several times, that if we shrink the balance sheet we will only be taking it back up in due time. He very politely said “why shrink it?” And no one can answer that question. There is at least discussion now of a $3.5 trillion baseline for the Fed balance sheet as a target. We both have friends in the Fed System who believe that the balance sheet should be reduced back to the pre-crisis level, but that it not going to happen. In my view that would be a horrible mistake. I would size the balance sheet at close to $4trillion target to meet all upper thresholds for required reserves, survey-based (ask the banks what they want and need) desired excess reserves , Treasury operating balances, special items and currency. That mix today requires a balance sheet size of about $3.5 to $4 trillion and will require balance sheet growth of between $100 and $200 billion a year, The IRA: Our friends represent a more tradition view of the world, a more prudent view. But when the Treasury, which is the dog in this story, is borrowing $100 billion per month, traditional views about taking the Fed balance sheet down to required reserves misses the point. Once the FOMC under Bernanke made the decision to pursue QE, there was no way to take it back. Add the larger deficits to the analysis and the FOMC is clearly the tail on the doggie. So the FOMC must obviously allow the balance sheet to grow to keep pace with Treasury debt issuance. The alternative is political suicide. The Fed’s first priority is whether the Treasury issue debt tomorrow, correct? Kotok: We cannot afford anything that introduces a risk perception about the US Treasury's ability to finance itself. May I add a second priority? Can the Fed grow its balance sheet so that the Treasury may enjoy $100 billion addition each and every year in seigniorage? This keeps the US banking system stable and the lender of last resort status of the Fed intact. Can we maintain the status as the least worst major reserve currency in the world and thereby finance $1 trillion in deficits every year? That is the unspoken truth. My stump speech now has four charts that focus on what a $1 trillion deficit and a four percent unemployment rate means year after year. We are less than a decade away from a $1 trillion interest bill for the United States. The IRA: Thank you David. #Kotok #fishing #GSIB #JayPowell #FOMC #SOFR #DSGE

In this edition of The Institutional Risk Analyst , we announce the release of The IRA Bank Book for Q1 2019. We focus on some of the key financial and credit factors affecting the US banking industry. We also provide the detailed credit charts that have become one of the favorite features for readers of our publication. And with this edition of The IRA Bank Book, we include the Top Ten list of US banking organizations, this quarter selected and sorted by return on equity for the subsidiary bank. Here they are: Now the really astute members of the group will notice that none on the largest money center banks -- JPMorganChase (JPM), Bank of America (BAC), Wells Fargo & Co (WFC) or Citigroup (C) are on the list. You don't see Goldman Sachs & Co (GS) or Morgan Stanley (MS) either. In fact, U.S. Bancorp (USB) is the only large commercial lender to make the grade. The large zombie banks are just not that efficient and really are more transaction platforms than traditional lenders and depositories. The other thing to notice is that the first two banks on the Top Ten list American Express (AXP) and Discover Financial Services (DFS) are credit card specialization lenders rather than commercial banks. That's a hint. All of the banks on this list are exemplary performers and all have unique business models all their own. As our colleague Dennis Santiago at Total Bank Solutions likes to say, the banking industry is a coral reef. Just remember that the smaller fish are more nimble and better able to adjust to changing market conditions. In this issue of The IRA Bank Book for Q1 2019, we focus on some of the key trends facing the industry in 2019 and beyond, including rising funding costs, the sharp drop in securities holding by banks last year, the prospect for lending growth and securities issuance. The big question for banks and investors in 2019: Did the Federal Open Market Committee kill the market for residential mortgages and asset backed securities (ABS) with the fun and games in December? Many of our readers ask how they can support our work. The simple answer is to buy our publications. And for you institutional investors, commercial bankers and mortgage professionals looking for professional advice, please feel free to contact us at webmaster@theinstitutionalriskanalyst.com . #AXP #DFS #SIVB #EWBC #CMA #NTRS #USB #BOKF #FITB #HBAN

Scottsdale | In this issue of The Institutional Risk Analyst, Ralph Delguidice expounds on the world of leveraged investing in the post-QT markets. Suffice to say that we expect the world of leveraged loans and CLOs to be the catalyst for a larger reset in the world of fixed income. Sure there is equity underneath these deals, but with over 60% of all CLO collateral comprised of intangibles, so what? We heartily endorse those few brave souls in the ratings community who believe that post default recovery rates in late vintage corporate exposures will be far lower than the historical norms. As Tracy Alloway noted on Twitter: "CLOs are just repackaged intangible assets like goodwill & trademarks, which are tough to price, verify and sell to someone else when the company's in trouble." THE CARRY TRADE IS DEAD Ralph Delguidice The companies know it. The analysts covering the industry and working for the bankers who underwrite the deals know it. The institutions that buy the offerings on the dip, hold for a dividend and wait for retail to bid the stock back up to near book value (AKA the "zone of issuance") know it. And even the hapless dividend obsessed retail investor is starting to smell something bad in the refrigerator. The pace of the issuance is simply torrid. Mortgage REIT New Residential Investment (NRZ) has raised $1.3 billion plus with 90 Million new shares issued in just 3 months. Meanwhile little if any guidance is given on the deal calls regarding any use of proceeds, aside from vague hints about “looking to add revenue away from the portfolio of investments” and" bigger pieces of the pie" (whatever that means). And where is that next trade? It is obvious what is happening here. The likes of NRZ are raising capital BECAUSE THEY CAN, and because they know the market access window can close suddenly—and finally—at any second. The “core” business—that is the basic carry trade and NOT the way they practice non-GAAP accounting using so called “core earnings”—is in trouble. It is in trouble for the same reason banks in general are in trouble, namely a flat yield curve. The real cost of QE —a decade of FED controlled "price discovery" in the credit markets—is always visited worst on the financials when all is said and done. Inevitably it is as a totally flat “Japan-style” yield curve that offers little or no real carry, risk adjusted or otherwise. Last time the FED “paused” in the hiking cycle, in late 2015, the 2-10 spread was 250 basis points (bps). Today it is 15 bps. So much for maturity transformation. Mortgage REITs can and will try as hard as they can to throw asset mix, accounting and hedge pixie-dust complexity at the model, but at the end of the day it is matter of simple subtraction; and nothing can change the fact that there is just no there-there anymore. The carry trade described last week in The Institutional Risk Analyst in terms of cheap funding for banks is also gone. Start with the plain Agency REITs. They buy GSE paper and finance it in the REPO markets, using swaps and US Treasury hedges to minimize the duration gap between assets and funding. There are a few moving parts here, but the return—to a REIT company that is running a legacy portfolio of existing assets and swaps built over the last decade—has collapsed almost entirely. This is regardless of how “tasty” the next trade (done with incremental capital of course) is said to be. Case in point: Last year AGNC Investment Corp (AGNC) lost almost $3 per share in book value while the 10 year US Treasury —and the corresponding agency pass through securities—moved less than 15 BP. "It’s the VOLATILITY, STUPID.” Adding credit exposure to the mix (like Annaly (NLY) and others) and/or negatively convex IO’s in the form of crazy scary MSRs (like NRZ, Two Harbors (TWO) and Cherry Hill Mortgage CHMI) are REITs that “self hedge” the portfolio, which serves only to increase the raw complexity of the accounting. And while it may change the timing and recognition of the state of the basic trade, it will do little to offer any real diversity or protection in the long run given current curve environments. At the end of the day these companies were all really just a longer term trade, and not a business. The almost insatiable retail yield hunger—courtesy of the same FED that crushed their effective yield curve—has attracted too much attention; and too much capital has flowed in to these trades that are (much like getting married too young) easy to get into but incredibly hard to live with. Non REIT investors such as BlackRock (BLK) and PIMCO—who need not pay out taxable earnings—or dividends at all for that matter—and that are now happy to accept HALF the indicated returns (especially on the more esoteric asset classes) have crashed the party. MSRs are a good case in point. They have DOUBLED in price over past three years, and most of the demand has been SINCE rates peaked and began to fall again—actually undermining their hedge value. The same is true with all kinds of commercial real estate credit. As the FED-blown bubbles have exploded, cap-rates have collapsed—and of course leverage has increased to fill the holes. We have reached the point of economic no return. This is what tops look like. The story is an old one, and like every other time we have told it the end of cycle dynamics are always the same. “Yes," we hear, "the party will end someday—badly we know—but not today, right?” So let’s keep dancing. But that said, right there at the top of the long and growing list of reasons to expect the credit market eschaton in 2019 should be this insane capital raising behavior we are seeing here. It is like they teach pilots. “Climb, conserve, confess.” Have enough capital to meet the inevitable margin calls and then hunker down to wait for the OTHER GUYS FIRE SALE. Res Ipsa

New York | First a travel note. The Institutional Risk Analyst will be at the Structured Finance Industry Group (SFIG) conference in Los Vegas this week to participate in a discussion about permanent financing for MSRs. Please come say hello if you are attending this important event. And if you're really lucky, you'll meet former GNMA head and new SFIG CEO Michael Bright. We’ll also be speaking at the Docutech event at the Phoenician later in the week about the outlook for interest rates, the Federal Open Market Committee and the mortgage finance sector. Gestational REPO anyone? Look forward to the discussion with Docutech CEO Amy Brandt and Americatalyst founder Toni Moss . Last week the FDIC released the banking industry data for Q4 2018. Profits are steady, default rates are low but credit loss provisions are starting to rise. Interest expense rose 55% year-over-year to $37 billion in Q4, while income rose 14% YOY. The dollar rate of change in interest expense should catch up to income by Q2 2019. This data point regarding bank funding costs also reveals that the level of financial repression is slowly falling. The Financial Times defines the term financial repression thus: “Financial repression is a term used to describe measures sometimes used by governments to boost their coffers and/or reduce debt. These measures include the deliberate attempt to hold down interest rates to below inflation, representing a tax on savers and a transfer of benefits from lenders to borrowers.” We measure financial repression in the $17 trillion US banking sector, but you can impute a similar skewed distribution to other fixed income asset classes. The Financial Repression Index was first described in a 2018 paper (" The Financial Repression Index: U.S Banking System Since 1984" ). In Q4 '18 it fell below 80% for first time since the 2008 financial crisis. Now "only" 79% of bank interest income is going to equity holders vs a bit over 20% for creditors such as depositors, lenders and bond holders as shown in the chart below. Since the 1980s, bank depositors and investors have been the victims of significant financial repression as public sector debt balances have increased and interest rates have fallen to accommodate. Since the 1990s and particularly since the 2008 financial crisis, it is possible to precisely measure a dramatic shift in net interest income in favor of banks, their equity holders and all manner of debtors public and private. Prior to the 1990s, depositors, bond investors and lenders received the lion’s share of the interest income earned by banks, but today most of the flow is taken by equity. The biggest beneficiaries of financial repression are governments. The trend toward providing explicit subsidy to debtors and particularly sovereign nations via Quantitative Easing or “QE” is a key component of financial repression. When some observers criticize the use of cheap debt to fund share buybacks, they are also reacting unknowingly to the effect of financial repression. Thanks to the Trump tax cuts, equity investors are getting an even bigger share of the interest income dollar from all enterprises. But with the benefits of QE there are also costs beyond the permanent inflation of asset prices and lower asset returns. Though US banks and non-banks have received a significant subsidy due to financial repression, banks and other intermediaries have also suffered decreased asset returns as a result of the low interest rates policies and open market operations of the Federal Open Market Committee. The clearly demonstrated diminution of income as interest rates fall would seem to conclusively refute the idea of negative interest rates as a valid policy tool, but instead economists persist in thinking that merely lowering the cost of debt can solve the challenge of employment much less price stability. Negative interest rates of course represent the confiscation of capital by a heavily indebted administrative state. Reducing the equity stock of a the private economy to feed the indebted public sector seems completely absurd but that is the substance of US monetary policy today. At present, return on earning assets (ROEA) in US banks is moving sideways at about 83bp on $15.9 trillion in earning assets as shown in the chart below. This may be the peak in ROEA for this cycle. Notice that the ROEA was low during the inflationary period of the 1980s, then spiked to over 1% in the 1990s, but today is a good 20bp below the average peak earnings on the 1990s through 2008 period. Of course, the same market dynamic that reduces income to depositors and bond holders also reduces the gross spread on loans, encouraging the use of leverage in all manner of asset classes. When you consider the clustering of investment grade rated issuers around the “BBB” cliff edge, it is pretty clear that monetary policies such as QE and negative interest rates are in direct conflict with the legal responsibility of the central bank to ensure the safety and soundness of banks and non-banks alike. Just how does one ensure financial stability while pouring gasoline on the fires of asset price inflation? In the next issue of The Institutional Risk Analyst, Ralph Delguidice will be talking about the end of the carry trade and what it implies for the leveraged mortgage sector. Also, the next issue of The IRA Bank Book will be out in March, including the most recent IRA Top Ten list of banks, ranked by equity returns. * * * #financialrepressionindex #returnonearningassets #SFIG

Washington | Consider the irony of the American housing sector. In the District of Columbia, various pundits, market retreads and spin-meisters (many employed by hedge funds) obsessively focus on "reforming" the government sponsored enterprises known as Fannie Mae and Freddie Mac, together the “GSEs.” The third and largest GSE, the Federal Home Loan Banks, along with the fourth, the Government National Mortgage Association or Ginnie Mae, are also included in the prospective policy mix. None of these agencies are in distress or in need of financial assistance, but no matter. Meanwhile, the US mortgage sector is undergoing a massive and truly terrible period of restructuring that conjures up biblical images of the apocalypse. Literally dozens of private mortgage firms are for sale or simply shutting down. As we have long anticipated, Ditech Holdings was forced to again file for bankruptcy protection last week. The company and its creditors are seeking bids to buy some or all of the business, but it remains to be seen whether there is any value in the remaining assets. The big question: who will buy the Ditech reverse mortgage business, Reverse Mortgage Solutions. RMS is consuming cash to such an extent that the company’s DIP lenders had to allocate a big portion of resources -- $1 billion in working capital – to RMS as part of the bankruptcy filing. As we’ve noted in the past, Ginnie Mae as the guarantor of the bonds that hold the reverse mortgage loans, is on the hook in the event that the business is abandoned in bankruptcy. But hold that thought. All this talk of doom and destruction in mortgage finance may come as a surprise to some readers of The Institutional Risk Analyst. After all, aren’t home prices near record levels? Loan trading in the secondary market is brisk and mortgage servicing rights or MSRs are likewise trading at all time high multiples of cash flow, around 6x annual servicing income or 6-7% yields. What’s the problem? In a word, government. And in several words, the Federal Open Market Committee. As we noted last week , sales of mortgage loans into residential mortgage backed securities or RMBS plummeted in the fourth quarter, reflecting the difficulty faced by mortgage banks in pricing loans during the market volatility seen in November and December. And as we noted in our previous missive, new issuance of mortgage RMBS has fallen by nearly 40% since the end of September last year. In fact, the happy campers on the FOMC came awfully close to running the good ship lollipop aground in December 2018. New securities issuance activity across many sectors basically went to zero and mortgage lending volumes fell to levels not seen in decades. After almost touching 5% in mid-November, the 30-year fixed rate mortgage has since fallen to 4.4%, this as the yield on the 10-year Treasury note has rallied to 2.6% from a high of 3.25%. If you see Fed Chairman Jerome Powell in the hallway, please tell him that this sort of roller-coaster in terms of gyrating benchmark interest rates is not particularly helpful. The estimates from the Mortgage Bankers Association released last week still show Q4 2018 coming it at just shy of $400 billion in total purchase and refinance originations, but based upon what we are hearing from the origination channel we’d be surprised if the actuals are not lower. See chart below showing the actuals and projections. Source: MBA Now of course the mortgage origination estimates from the MBA assume that interest rates are rising . Yes, rising. The most recent projections show the 30-year mortgage at 4.8% and the 10-year Treasury note at 3%. But what if the bullish assumptions about the US economy are wrong? What if we are in fact headed into a recession or at least a period of economic stagnation? Keep in mind that the near-5% print for the 30-year fixed rate mortgage back in November 2018 was close to the 10-year high for that key benchmark. The RESI market prices off the 10-year Treasury because it is close to the double digit average life in many pools, as shown in the chart from FRED below. Should the FOMC actually end the runoff of the system open market account (SOMA) portfolio later this year, then assumptions about rising interest rates may need to be recalibrated. “Federal Reserve governor Lael Brainard said she expected the central bank could end the runoff of its asset portfolio later this year,” reports Nick Timiraos at The Wall Street Journa l. “Ms. Brainard said she is comfortable ending the balance sheet runoff this year because she favors an operational system with a much larger level of reserves than before the financial crisis.” Brainard’s comment confirms our suspicion that the economist-led FOMC and, more specifically, the Fed Board of Governors, has decided to permanently nationalize the short-term money markets in the US. In effect, the Fed is discarding any hope of restoring private function and particularly unsecured lending in the US. The decision to again grow the portfolio is being made without the advice and consent of Congress and carries with it profound implications for mortgage lenders, the REPO market and investors. But the reason for the decision obviously is the accelerating fiscal deficits of the United States. By manipulating all manner of asset valuations, the FOMC has created two very specific risks for holders of mortgages and MSRs that are not well understood in the equity or debt markets. First, by gunning prices for homes, mortgage loans and MSRs to ridiculous levels, the FOMC has essentially created a short-put position for holders of mortgage credit and servicing exposures. Once the FOMC resumes net purchases of government securities, long-term interest rates will fall under the dual pressure of investor demand and the artificial asset shortage that is the essence of “quantitative easing.” Like shooting heroin, once a central bank gets onto the QE habit, it is impossible to stop without deflating the financial markets. And since the Dow Jones Industrial Average and S&P 500 are the benchmarks for the political class, no deflation will be tolerated. Second, using the forward TBA market to hedge this “SOMA Risk” may not be entirely effective because of the absurd “fair value” accounting rules brought to us by the happy squirrels at the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission. Tell us again why we need to value cash flow generating "intangibles" like MSRs every quarter please? These same folks at FASB are responsible for the new idiocy known as Current Expected Credit Loss or “CECL,” whereby owners of 1-4 family loans have to guess the probability of default over the full life of a 30-year mortgage. Obviously such a task is impossible, but don’t tell that to the FASB and the SEC. As benchmark interest rates fall, the modeled prepayment speeds for mortgage exposures will accelerate, this on the assumption that mortgage refinancing activity will increase -- maybe. Holders of MSRs, specifically, will be forced to take “fair value” non-cash losses on their mortgage exposures, even if they are running aggressive hedge positions. Should the 10-year note continue to rally and perhaps get back down to a low 2% or even a 1% handle, for example, those 6x annual cash flow multiples that we see in the MSR market today will evaporate overnight. And the next shoe to drop, of course, will be credit risk, a currently unrecognized danger that is not really priced into asset valuations or the calculations of the FOMC. Ralph Delguidice noted recently (“ Bigger Balance Sheet Bullish? Really? ”) that an increase in the SOMA portfolio may not actually be “stimulative” to the economy. In fact, the embedded credit risk in all of the 1-4 family mortgages that were originated during QE 1-3 may start to emerge in the next 18-24 months, pushing up the cost of servicing for holders of MSRs. If you own the servicing asset, then you are responsible for the capital cost of resolving a distressed mortgage. “A report released… by the Federal Reserve Bank of New York revealed that the rate of delinquencies was steady at 4.65% in the last quarter, but Moody’s says this is a cycle low that will change in the coming quarters as loosening underwriting standards and rising interest rates impact loan performance,” reports HousingWire . The default and past due rates for the $2.5 trillion in prime bank-owned 1-4 family mortgages are shown below. Source: FDIC Assuming that Governor Brainard’s pontification about the imminent resumption of QE is correct, operators and investors in the world of mortgage finance need to take notice. With MSR valuations under the twin pressure of again falling long-term interest rates and rising capital costs of default servicing, investors could see the double digit gains in the best performing asset class in the fixed income market suddenly reversed, with catastrophic consequences for the mortgage market and certain publicly traded mortgage REITs. Given the impending resumption of QE, investors who are long servicing need to take pause. MSRs carry both interest risk and, as many have forgotten, default risk garnished with reputational hazard. As John Dizard wrote in The Financial Times on December 16, 2018: “If the homeowner defaults, it is up to the servicing company, i.e. the MSR holder or a sub-servicer they contract with, to persuade the homeowner to pay up, to restructure the mortgage if the original terms are too burdensome, or, if necessary, to carry out a foreclosure. You can see where MSRs can become an unromantic asset.” So what is an independent mortgage banker to do? Lenders who are owners of MSRs need to seriously consider the following trade: 1) sell the mortgage servicing asset at the record multiples now available in the market to some willing, leveraged financial investor and 2) purchase a federally insured depository from which to safely operate a lending and mortgage sub-servicing business. Go long a bank charter and short the capital risk in the MSR to a friendly mortgage REIT. Trade the haphazard and at times arbitrary regulation by the 50 states for the kind supervision of the Fed and FDIC. And the best part is that when defaults rise and prepayment rates accelerate, you'll be able to buy the servicing asset back at a lower valuation if you want. But we'd argue that the risk adjusted equity returns of sub-servicer + depository are superior to owning the actual MSR asset. If our suspicions are correct that long-term interest rates are headed for another down leg, then holders of MSRs may be facing a considerable “emerging risk” to paraphrase our contributor Ralph Delguidice. They don’t teach you about such risks in the textbooks, but suffice to say that in the age of QE we might as well just throw the old corporate finance books into the trash. If you have been thinking about going short residential mortgage default risk and long a federally insured depository, then do give us a call. Mo' Reading Moody's: Mortgage delinquencies are on the rise https://www.housingwire.com/articles/48175-moodys-mortgage-delinquencies-are-on-the-rise Fed’s Brainard Says Balance-Sheet Runoff Should Probably End This Year https://www.wsj.com/articles/feds-brainard-says-balance-sheet-runoff-should-probably-end-this-year-11550159755 #JohnDizard #MSR #servicing #yellen #bernanke #QE #bank #REIT #NRZ #Ditech #freddiemercury

New York | This week in The Institutional Risk Analyst , we note a couple of reader comments. First, we’ve been accused of having a fixation on the insolvent Chinese aviation conglomerate HNA. Another reader claims we have a CLO fetish in the wake of several posts on the subject. Guilty on both counts. And it was suggested by a reader that we don’t give leveraged loans sufficient credit for the equity cushion included in the capital stack. Sure we do. But since the median debt levels of non-financial companies relative to earnings now exceed levels seen before the last financial crisis, this according to the Standard & Poor’s rating agency, we’ll stand our ground. When it comes to risk management, watching the fastest changing datapoint on the proverbial dashboard is usually a good practice. HNA fits that description and is a modern day Icarus, an archetype for the crazy rich Asian business model so prevalent in China prior to the political crackdown by paramount leader Xi Jinping. Then there are CLOs, our favorite asset type and the driver of the bull market in equities. The November 2018 Financial Stability report published by the Federal Reserve Board tries to spin the central bank's culpability in boosting asset prices since 2010. Notice in the table below the astronomical growth of CLOs as well as the 3x inflation rate of growth in real estate. Why the eye-popping growth rate for leverage loans, the asset class du jour of the global speculative classes in this cycle? Low rates of course. And strangely, the figures for “real” annual price growth for commercial and residential real estate seem to be a tad low. Maybe the Board is using real inflation data to deflate the surreal real estate valuations caused by QE? Sad to say for millions of young American families, the Bernanke-Yellen asset price inflation in commercial and residential real estate may be largely permanent, depriving a whole generation the opportunity to own a home or build wealth by investing in distressed properties. But meanwhile mortgage lending and sales volumes are in the proverbial dumper. The FRB noted last year: “Asset valuations appear high relative to their historical ranges in several major markets, suggesting that investor appetite for risk is elevated. Spreads on high-yield corporate bonds and leveraged loans over benchmark rates are near the low ends of their ranges since the financial crisis. Equity price-to-earnings ratios have been trending up since 2012 and are generally above their median values over the past 30 years despite recent price declines. Commercial real estate (CRE) prices have been growing faster than rents for several years, and, as a result, commercial property capitalization rates relative to Treasury securities are near the bottom of their post-crisis range. While farmland values have fallen in recent years, they remain very high by historical standards. Residential real estate price-to-rent ratios have generally been rising since 2012 and are now a bit higher than estimates of their long-run trend.” Long run trend. That’s great. Now a cynic might argue that the collapse of the CLO market in the fourth quarter and with it the larger high yield debt market was the catalyst for the latest dovish turn in the Federal Open Market Committee. We seriously doubt anyone on the FOMC actually worries about a precipitous drop in something as banal as mortgage lending, but now would be a good time to pay attention. In particular, looking at the total issuance data from SIFMA, Q4 ’18 was a particularly bad quarter for CLOs but also saw a marked slump in issuance of all types of mortgage-backed paper as well as asset-backed securities. Could this be a sign from on high? Source: SIFMA The US has seen a ~ 40% decrease in issuance of mortgage backed securities since the end of September 2018, certainly reason for alarm in our book. The US residential mortgage industry is looking at doing a lot less than $1.5 trillion in new mortgage origination volumes in 2018. This slump in activity is due to the volatility in the markets, which makes it impossible to accumulate and hedge new residential and commercial mortgage backed securities (CMBS) deals. Recall Q1-Q2 of 2016. Market factors aside, the slump in residential lending volumes is more of the same, premium pricing for loans killing profitability for aggregators and banks, which are bidding points through the curve to buy larger jumbo assets for portfolio. Smaller retail lenders are dying due to high origination and funding costs. And even though rates have fallen since December, better yielding refinancing volumes are not yet returning. But hope remains: Several operators in mortgage land tell The IRA that January will be a great month. BBT + STI: "Big Deal" or Not? Listening to some analysts and members of the media waxing effusive about the merger of BB&T (BBT) and SunTrust (STI) last week, as in the union of two strong residential mortgage businesses, sure makes us wonder. Some 55% of BBT’s loan book is real estate loans, but the gross spread before funding and SG&A is just 440bp. At STI, real estate exposures are 40% of the loan book with a 390bp gross spread. When you subtract the cost of funding (~1.2%), commissions to the loan officer and overhead and compliance, there is not much left. Risk-adjusted returns are negative of course. Remember that banks generally don’t care about high LTV loans with borrowers below 700 FICO, so the competition for prime mortgages is intense. The crazy high bid for mortgage assets, even as volumes drop, is why valuations for mortgage servicing rights (MSRs) are being "pulled" up to meet the execution in the secondary loan market. The result is nosebleed 6x annual cash flow MSR multiples that cannot be validated vs, say, mainstream prepayment assumptions from the major third party advisors. And this "execution" ripples through all of the fair value MSR valuations models of the major banks. Again, special thanks and big kisses to Chairs Ben and Janet. When investors ask if the BBT + STI combo will lead to more deals, the answer provided to the FT by no less than Rodgin Cohen at Sullivan and Cromwell pretty much sums it up. He told Robert Armstrong and Laura Noonan that the tie-up would cause “acceleration of thinking about deals, and accelerate conversations, but whether it leads to actual deals we will have to see.” He might also have said that merging two medium sized banks together at a premium to book value in an all-stock deal is hardly reason for great excitement. A few years back, when we'd drop off documents at Sullivan & Cromwell on the way home from the Federal Reserve Bank of New York, banks did not trade much above book value. The reason for this, quite simply, is that well run banks have low double digit equity returns, but that it about it. At present BBT’s cost of funds is about 1.4% vs 1.5% for Peer Group One, which includes all 120 banks in the US above $10 billion in assets. BBT’s gross spread on total loans and leases was just 4.69% at the end of Q3 2018, according to the FFIEC. This is just below the peer average. In other words, BBT and STI are middle of the fairway performers, consistent earners and with strong capital, but not great sources of alpha. Together these banks are not worth much more than the current 1.4x book value. Net loan and lease growth for BBT over the past five years is modest at best, begging the question as to why certain analysts are getting so excited about “the biggest bank deal since 2008.” To be fair, the larger banks are even worse in terms of risk adjusted returns on real estate loans. JPMorgan Chase (JPM), has 42% of total loans in real estate loans for a gross spread of 384bp. That includes both residential and commercial exposures. Bank of America (BAC) has a third of its loan book in real estate loans and is working for a whole 386bp gross, before funding costs or sales costs or overhead expenses. Layer on a charge for the reputation risk element of facing consumers and the equity returns on residential mortgages quickly go negative. H/T to Liz Warren and Kamala Harris. We might have been tempted to own BBT prior to the transaction, but adding STI to the mix does not make us want to own the post-merger bank. Much rather add to the position in U.S. Bancorp (USB), which has lower funding costs and a more diverse revenue mix. And even after the market volatility seen that the end of 2018, the financials as a group are not particularly cheap. Just remember that in a ranking of large US banks based upon equity returns, USB is the only bank in the top 10 by assets that makes that illustrious list of exemplars in terms of equity returns. Of course, for all of you who still think that rising rates are good for banks, the fact that the 10-year Treasury note has rallied since last Thanksgiving is probably not welcome news. And the bond market rally is unlikely to slow the "normalization" of bank interest expense, which has seen the cost of funds for the industry rise 75bp in 2018 by our calculations. Indeed, after almost touching 5% around turkey day, the 30-year fixed rate mortgage has fallen below 4.5% and seems to be following the surging T-note lower in yield. Since early January, high yield spreads have taken their queue from the equity markets and rallied more than a point in yield. Option-adjusted spreads have essentially collapsed. Indeed, just about every bank asset class we can think of from loans to securities and mortgage servicing rights are surging higher, buoyed by "the new confidence." Echoing ECB head Mario Draghi, the FOMC will do whatever it takes to keep the world safe for heavily indebted corporations, Italian banks and anyone else with the slightest potential for causing a deflationary market event. Have a great week. Extra Reading The Vice President’s Men Seymour M. Hersh The London Review of Books , 24 January 2019 https://www.lrb.co.uk/v41/n02/seymour-m-hersh/the-vice-presidents-men Jim Grant on the Bond Market’s 35-Year Bull Run Barron's , February 1, 2019 https://www.barrons.com/articles/sizing-up-the-bond-market-51549050648 The Fed's Killing Floor Zero Hedge , 2/6/19 https://www.zerohedge.com/news/2019-02-06/feds-killing-floor #BBT #STI #JPM #Noonan #FT

New York | This week in The Institutional Risk Analyst, contributor Ralph Delguidice ponders the aftermath of the retreat last week by the Federal Open Market Committee following the latest market volatility tantrum. Suffice to say that the FOMC has no stomach for deflation of any duration, thus we see the magical appearance of the "Powell Put" in financial commentaries. But riddle us this: When is easing really tightening? First the Fed backed off further rate hikes, now we are talking about resuming asset purchases for the system open market account or SOMA. Sadly, the impact of renewed “quantitative easing” will be a further tightening of private credit as the FOMC does what is does best, namely caters to the debt issuance needs of the US Treasury. None of these developments are a surprise to readers of The Institutional Risk Analyst and illustrate the growing conflict between prudential rules meant to ensure liquidity in banks and the voracious cash needs of Washington. Last week's events illustrate that the FOMC cannot pursue price stability in the face of $1 trillion annual deficits. A Bigger Balance Sheet? (careful what you wish for) By Ralph Delguidice The credit-cartel-consensus has concluded that the Fed has made up its mind to end the balance sheet roll-off “early;” whatever that means. Chairman Jerome Powell suggested a near term equilibrium where reserves are “plentiful,” and that may indeed mean soon; but on closer examination it may surprise many and turn out to imply TIGHTER credit in the hard money markets where real companies fund and leverage on a secured basis. A larger balance sheet—with all of the associated moving parts like currency demand and the Treasury General Account (TGA)—will mean more reserves for banks to use to satisfy the Liquidity Coverage Ratio (LCR) and Resolution Liquidity Adequacy and Positioning (RLAP) requirements that already see Fed reserves as BY FAR the most efficient of all qualifying assets. In fact, for global systemically important banks (G-SIBs), RLAP is calculated intra-day and that leaves ONLY Fed reserves as effective. With more bank assets tied up in Fed reserves—and more “sponsored REPO” giving Money Market Funds and CCPs direct access to the Fed as a counter-party to REPO sellers-- the supply of credit that can flow into private REPO markets will fall all else equal. This will be coming at the same time that VASTLY increased US Treasury (UST) issuance will need to be cleared into the private bond markets. The Treasury Borrowing Advisory Committee Members (TBAC) report last week was VERY clear that much more US savings were going to be needed go forward as foreign demand for UST could not be counted on. With rates where they are these UST positions will increasingly need to be financed—either by intermediary dealers or end users--, and this turns banks that were SELLERS of REPO into BUYERS of REPO. Yesterday was month end, and we saw UST GC printing at 2.90% Source: Scott Skyrm Yes, it was one day. But the quarter end spikes are higher and last longer, and the Year End is flat out crazy. Remember that this is all the time when then SOMA balance sheet roll-off was intact (it still is, of course) and the Fed was encouraging dealer banks to lend back into the private money markets. AKA: “normalization.” Now stop the run-off music and tell the banks to hold more reserves at the Fed, what do we think happens? Policy honchos need to ponder the conflict of LCR/G-SIB rules with monetary policy. Isn’t that called “macropru”? Bottom line here is that the global money markets are a complex cascade of arbitrage that recent history shows can-- and certainly will —amplify any changes to the Fed footprint in reserve demand in uncertain and sometimes counter-intuitive ways. As BAML said in a recent piece on the possible need for a Fed Backstop the REPO market: “has become increasingly fragile and sensitive to shifting behavior of key market participants, especially banks and dealers, the strategists wrote.” https://www.reuters.com/article/us-usa-repos/u-s-federal-reserve-may-need-to-backstop-repo-market-baml-idUSKCN1P5273 Chris Whalen wrote recently in The IRA that the Fed wanted to “nationalize” the money markets once and for all as a way to ensure financial stability. This rings increasingly true as we get visibility into the eventual size, tenor and composition of the SOMA account, and buyers of financial stocks would do well to remember that structural changes to the money markets that involve a permanent Fed presence may change the REPO alchemy (Hey!! it’s a loan AND a sale!!) that they have taken for granted for all these many years. Just Sayin', #Delguidice #PowellPut

“How did you go bankrupt?” “Two ways. Gradually, then suddenly.” Ernest Hemingway, "The Sun Also Rises" New York | Last week the Federal Open Market Committee under Chairman Jerome Powell blinked, again. Last week, The Wall Street Journal reported what bond traders and the readers of The Institutional Risk Analyst have known for months. Rate hikes are on hold and the FOMC is preparing to end the shrinkage of the Fed’s system open market account (SOMA) portfolio. With the financial economy slowing and housing in a swoon, there may be no rate hikes at all in 2019 and maybe even a resumption of quantitative easing (QE). But no surprise. The post 2008 world has seen the death of many long-held beliefs, in particular the idea that the US central bank is here to fight inflation. Jim Cramer of CNBC hit the proverbial nail on the head last November when he questioned how the Fed can talk about “normal” when things are decidedly not normal at all and largely as a result of FOMC policy actions. Bernanke likes to pretend that he saved the world following 2008, yet in fact he actually sacrificed any notion of Fed credibility with respect to inflation for another experiment with -- wait for it -- the wealth effect. This widely discredited notion remains today the key driver of FOMC policy actions. “While critics may dispute the wealth effect’s magnitude, few have challenged its conceptual soundness,” notes Christopher Casey of Mises Institute . “The wealth effect is but a mantra without merit.” Ben Bernanke noted in 2010 that “higher equity prices will boost consumer wealth and help increase confidence, which can spur spending.” The Fed's fixation with perception rather than data is illustrated by the way in which former Fed Chairs Bernanke and Yellen deliberate chose to inflate the value of financial and real assets to "stimulate" the economy. The WSJ’s Nick Timiraos reported last week: “Former Fed Chairman Ben Bernanke often argued that it was the maturity and risk-profile of the Fed’s holdings, not the overall size of its reserves or securities portfolio, that determined how much it stimulated markets and the economy.” The Fed’s dual mandate from Congress includes full employment and price stability. But to look at recent policy suggests members of the FOMC cannot read federal statute or do simple sums. Causing asset prices to soar by double digit rates is not price stability – it is inflation, plain and simple. Please, Chairman Bernanke, do show us where it says in the Federal Reserve Act that the FOMC is allowed to employ asset price inflation as a policy choice. In the Orwellian newspeak of the Federal Reserve System, inflating the value of stocks, bonds and real estate to absurd levels is a form of economic “stimulus.” Never mind that this vast act of asset price inflation did not help the majority of Americans. Indeed, the biggest impact of the Bernanke/Yellen asset inflation seems to be preventing a whole generation of younger Americans from buying a new home. As you read these words, real estate markets around the US are starting to revert to the mean, suggesting that the great Bernanke experiment with the wealth effect is ending. Mind you, the adjustment in real estate markets is not happening gradually, but all of a sudden to paraphrase Hemingway. Similar to the volatility seen in debt and equity markets, the price discovery pattern visible in many heretofore red hot residential housing markets is similar to recent equity market volatility – huge downward spikes in home price sales volumes. Prices will eventually follow when sellers capitulate. One large market caught in the downdraft is Chicago, a sleepy Midwest MSA that only started to see home price appreciation relatively late in the game. Markets such as Southern California and Florida started to rebound even before 2012, but Chicago was essentially dead until 2013 but then began to climb steadily. Since then, the index value for homes in Chicago has risen 25 points, according to Weiss Analytics (WA) home price index. Note: WGA LLC is a shareholder in WA. In the 12 months through October 2018, residential home prices rose 3.6% and condos by better than 5%. In the past three months, however, prices have begun to collapse in Chicago as volumes have disappeared. So, Chairman Bernanke, is this an example of “price stability?” Nope. Let’s go east to New York City, where prices along Billionaire’s Row on Central Park South are down single digits in the past year after rising 30% over the past decade. Indeed, condo prices along CPS have been falling since 2016. As in Chicago, sales volumes in NYC's more toni areas have dried up as the gap between buyers and sellers has widened. Of note, single family residential homes in the greater New York MSA have barely moved in the past decade, but are expected to increase a couple of percent on average even as prices in New York City’s most desirable areas sag. Of course, housing price charts are great fun, but the truly scary chart is the one that also remains our favorite, namely loss given default (LGD) on the $2.5 trillion in single family mortgages owned in portfolio by US banks. In Q3 2018, the LGD or net credit cost on this portfolio, which represents one quarter of all mortgages in the US, was negative by almost 16%. This means that, on average for every mortgage that defaulted, the bank make a profit after repaying the loan in full. Source: FDIC Think about how much the prices for homes backing the average bank owned mortgage had to rise to generate such a result as shown in the chart above. Again, Chairman Bernanke, is this sort of behavior in asset prices consistent with “price stability?” Nope. Did this enormous skew in home prices caused by QE and “Operation Twist” help Americans create jobs, or build or buy a home? Nope. We generated a lot of real estate commissions, but much of the benefits, at least for now, have gone to the banks and investors who own residential credit risk. As US home prices revert to the long-term mean, the key question that arises in the minds of many risk managers is when will loan default rates start to rise? Even if the FOMC does not raise the target for Federal Funds or ends the runoff of the Fed portfolio earlier than expected by investors, the pace of Treasury debt issuance will continue to drain liquidity from the credit markets and force rates higher. Source: FDIC Indeed, as we’ve stated previously, we full expect the Fed to reverse course entirely, end rate increases and start growing the SOMA portfolio to keep pace with US government debt issuance. But none of these expedients are likely to prevent the repricing of the US housing market, which after half a decade of irrational exuberance c/o the FOMC is falling back to earth due to a lack of customers. Look for housing credit costs to rise significantly by the 2020 general election. Meanwhile next door in the leverage loan space, the modest rebound in January 2019 has only taken some of the pain away from the slaughter that occurred in November and December, when dozens of loan conduits were caught off base holding loans for collateralized loan obligations (CLOs). The same weakening macro market dynamic that is causing home prices to slum is prompting investors to flee this asset class. The astute folks at TCW describe the carnage: “As risk sold off globally, retail funds recorded record outflows. At the same time, CLO liabilities widened. As CLOs ceased to be manufactured due to liability costs, demand for loans became negative as retail funds were forced to sell positions to raise cash and meet redemptions. There is a unique component of this weakness: Investment bank trading desks have much smaller balance sheets than they had prior to 2009. Therefore, as CLOs stopped buying and retail funds began selling – there were few investors left to take the other side of the trade.” The CLO market, for the record, saw its largest ever issuance in 2018. As in Q1 2016, when China concerns killed the ABS market for six months, the Street is crossing its collective fingers, hoping that spreads will narrow so that some of these deals will get priced. Don’t hold your breath. Institutional new issuance of CLOs declined in December to $3.9 billion, which was the lowest institutional issuance in 2018. The liquidity that has exited the sector since Thanksgiving is unlikely to return. And again, as with residential credit exposures, the key question in the minds of CLO investors is this: When will default rates start to rise significantly? Nobody has the precise answer to that question, but a reasonable assumption is that the volatility of the change in default rates will be markedly higher than in previous credit cycles thanks to QE and "operation twist." Stay tuned. #BenBernanke #Cramer #wealtheffect #housing

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Citigroup CEO Chuck Prince (2007) New York | Earnings have turned out to be a snoozer rather than the recession step down some gloomy souls predicted. Even if the economy is slowing, does it matter for earnings, which keep rising ever higher as net revenues stagnate? Our big takeaway from last week was the remarkable consistency in the big banks missing estimates for trading revenue, even as the Street saw higher volumes across many desks. And no surprise that securities underwriting revenue evaporated with the closure of the high-yield market in Q4 and a tedious equity pipeline. Markets seem to be moving sideways, albeit with lots of hyperventilation from the analyst community. But that does not mean there is no news. First, kudos to George Gleason at Bank OZK for turning in strong Q4 numbers. OZK remains under suspicion, though, due to its role as a benchmark for commercial real estate lending. Likewise regards to the bankers at Goldman Sachs (GS), who supplanted the traders for the first time in a decade in the only measure that matters, namely gross revenue. Of note, OZK outperformed GS last week , with the common of these two very different banks up 21% and 14% respectively -- this after OZK spiked 12% in a matter of hours after earnings were released. And, Lord be praised, both names are now trading just above book value. A year ago, OZK traded at 1.8x book value. Them were the days. Meanwhile in the automotive sector, Elon Musk and his Tesla Motors (TSLA) science project are grappling with the reality of being the most flashy, high cost member of a commodity industry. The latest TSLA announcement of layoffs took the stock down a notch and suggests evidence of liquidity stress to us, but the forgiving narrative in the financial media is that the heroic Musk wants to make money selling his mid-side Tesla 3 sedan. Never mind that consumers don’t want sedans or that the midsize slot in the global auto industry is basically a break-even proposition. Of note, TSLA is trying to squeeze every last penny out of the proverbial lithium nugget by raising the cost of ownership for Model 3 in ways beside an increase in the sticker price. For example, Tesla is officially ending any type of free Supercharging program, a surprise increase in the cost of the affordable Tesla 3. The drastic increase of Supercharging prices around the world is the latest shock for loyal TSLA owners and prospects, but also reveals the financial stress operating inside this still tiny manufacturer of electric cars. As we note in “Ford Men: From Inspiration to Enterprise” the global auto industry is a break even prospect nominally and consumes capital in terms of risk adjusted results. The advertised $35k price tag for a Model 3 is too low to be profitable in the current market. Compare the Tesla 3 with an Audi A-4 starting around $37k or an S-4 starting at $50k. Frankly the highly differentiated Tesla brand ought to be focused on a hybrid SUV that is higher in price than the premium manufacturers. Yet Musk has decided to follow the example of Henry Ford and compete on a lower price in a market that is largely consolidated and financially integrated. Good news for TSLA shareholders, of course, is that the stock is basically unchanged over the past year at about 3x sales, but what a wild ride it has been. To our astonishment, TSLA has a beta of 0.6, meaning far less volatile than the broad markets. But the credit spreads tell the tale. The TSLA 5.3s of 08/25 closed Friday at $87.75 at a weak “B” credit spread with a yield to worst of 7.71% (+500bp over 5 year Treasury debt). Compare to General Motors (GM) 5.1s of 5/25 at +260bp to the Treasury curve and Ford Motor Credit (F) 5.96s of 01/22 at +282bp to the curve. Source: US Treasury Meanwhile in mortgage land, the misery continues. Even though the spread between the benchmark 10-year Treasury note and the 30-year fixed rate mortgage has widened considerably and, indeed, is near the 2016 wide of 209 bp, profits remain elusive. We note, for example, that Ditech Holding Corporation (DHCP), which emerged from bankruptcy less than a year ago, just missed a debt payment and saw its COO depart . Read the latest DHCP 10-Q for a fascinating discussion of ties to other mortgage firms. Despite a lending profit uptick in Q2 as reported by our friends at the Mortgage Bankers Association, both bank and non-bank loan originators are still losing money on a large portion of their new residential mortgage production. The wise in the industry warn that this earnings winter could last for several more years . This raises very specific questions of survival for some industry players if the anticipated arrival of the Army of the Dead (aka rising loan defaults) occurs before lending profits recover. Source: MBA But the Creator does have a sense of humor. In December the Federal Housing Finance Agency, which regulates the three GSEs (Fannie, Freddie and the FHLBs), issued new rules for lenders regarding the use of credit scores in loan underwriting. “Chief among those rules is a provision that would prohibit the government-sponsored enterprises from using the VantageScore credit scoring model because of conflicts of interest with the company’s backers,” reports Housing Wire. Suffice to say that former agency head Mel Watt had his revenge upon the three credit repositories – Experian, TransUnion (TRU) and Equifax (EFX). See our 2017 comment, " Experian, Equifax & TransUnion want to sell you new mortgage credit scores. " This odious triopoly has poured hundreds of millions of dollars into pushing their own consumer credit measure -- Vantage Score -- in Washington. Now that FHFA has spoken, will the big three in the consumer data triopoly be forced to quietly euthanize Vantage Score? More, will the big three be forced to take a write-down of their investment in Vantage Score? Sure looks like a goose egg to us. To add insult to injury, the big three consumer data repositories must now contend with a revivified FICO, which finally realized that incorporating the non-mortgage data components pushed by the Housing Affordability mafia in Washington into the existing FICO benchmark solves the proverbial problem. Viola! Truth to tell, the key constituency in this discussion, namely global bond investors and the credit rating agencies, were never asked and did not care at all about replacing the familiar FICO credit scores. Another recent victim amidst the sideways shuttling financial market is the notion of green investing in big power. The bankruptcy of electric utility PG&E in the aftermath of the California wildfires basically suggests that providing electricity in CA may be an entirely uneconomic proposition, begging the question as to policy driven green investments. “[T]he California political class has been trying to find some way for every stakeholder group (except the shareholders) to remain intact. I would not bet on magic here.... The group's crash is becoming the failure of a model – that of private equity financed green infrastructure based upon notionally permanent fully prices contracts,” writes John Dizard in his must read column in the Financial Times . “[T]he current system of green finance has probably suffered a near-mortal blow.” So even though global equity markets are essentially moving sideways, don’t think there aren’t lots of important and even amusing things going on away from the TV cameras in the world of credit and risk. With the S&P 500 still down single digits vs a year ago, and financial bellwethers like JPMorganChase (JPM) lingering in the red by a like margin vs the exuberant valuations of last January, the global equity markets still have a long way to go before reaching solid ground. Adjusting to a world with no Fed bond market intervention and a very ambitious forward Treasury borrowing calendar will take a great deal of time. We suspect that the real test of the present market stability will come when China starts to aggressively sell dollars to prop up its sagging currency. Notice in the Treasury yield curve chart above that short-term T-bills out to 6 months are still rallying, but the rest of the complex is moving higher in yield/lower in price. Remembering that former Fed Chairs Bernanke/Yellen et al dispensed with the inverse relationship between stocks and bonds as a result of QE, the next surge for the exit may look different from December. When we see all of the yields on the Treasury curve heading higher, this under the dead weight of new issuance, then the great unwind in equities may also accelerate. Reading Martin Luther King: Notes on American Capitalism https://kinginstitute.stanford.edu/king-papers/documents/notes-american-capitalism Jim Dorn: Irving Fisher's Search for Stable Money: What We Can Learn https://www.alt-m.org/2019/01/17/irving-fishers-search-for-stable-money-what-we-can-learn/

New York | Once again it is time for earnings in the world of financials. Go back and compare the Sell Side view of financials at the end of Q2 ’18 with the narrative today. What you see is that the group basically has gone sideways for the past year. Peak gains for sector leaders like JPMorgan Chase (JPM) and U.S. Bancorp (USB) were about 5%, but both are down more than that amount since the great slide began in earnest in December. We can blame the sudden downdraft on various externalities and global trade yada yada, but the simple fact is that financials were very fully valued at the end of June. They are less so today. Is this the signal to run back into the water with the Meg? Yes and no, depending on whether you are buying quality exposures for the medium term or merely seeking a quick flip. As the recently released 2013 FOMC transcripts confirm , unwinding the great Bernanke/Yellen asset bubble means above-normal market volatility going forward. Thoughts: * There are some relative values in the financials compared with 6 months ago, but we would be cautious as the "great unwind" of the Fed balance sheet is going to continue to put pressure on valuations generally and also spreads, regardless of whether the FOMC raises interest rate targets for Fed funds. The easy days of up, up and away c/o quantitative easing are over for stocks. * To us, the sensible risk position is to stay away from complexity and "high beta" plays, but look for bargains among the low beta exemplars. The upside optionality we all thought was free a year ago now has a cost as does short-term funding. Spreads were widening as the year closed, killing HY issuance in December, but now spreads are going the other way . We believe that the real storm in terms of credit is still 12-18 months away, but equity markets are already discounting that reality. * We were a seller of PMT and NRZ going into year-end. Mortgage exposures are going to become more influenced in '19 and '20 by credit concerns. We've been a buyer of USB common and preferred because 1.7x book seems relatively cheap for the best performer of the top five banks. The USB common yields 3.25% and preferred is over 5%. LOW BETA. We like other boring, consistent names like BBT, STI and KEY for same reasons. * We are not impressed by JPM at 1.4x book or BAC at 1x. Same with Citi and Capital One (COF) at a 25% discount to par value. These last two are subprime shops and thus trade at a discount to book, period. Different business model than JPM or USB. Likewise don't like Deutsche Bank (DB) or Goldman Sachs (GS) because of the multiplicity of "known unknowns," namely continuing fears of further operational risk surprises from these investment banks. Sad to say, we still believe GS CEO David Solomon may need to fall on his sword in order to settle the 1MDB mess. Goldman Sachs is accused of facilitating fraudulent securities offerings that were ostensibly for Malaysia, but the proceeds were then stolen by various parties -- people that GS thought were clients. The Malaysians are seeking the return of the full amount of the bogus offerings plus fees, some $7 billion or thereabouts. As we noted last month, the big issue facing GS may be with US regulators and the bank's internal systems and controls. Saying that the firm was deceived by its investment bankers is not the right answer, for example, if you are speaking to the Federal Reserve Board. "I don't want to touch Goldman Sachs," analyst Dick Bove said on CNBC's "Trading Nation" last Wednesday. "People really don't understand what the issue is concerning Goldman Sachs. It's that they were involved in this huge scandal related to Malaysia. It's the fact that their compliance operations internally seem to have broken down." Ditto. The market volatility in December was good for volumes at many dealers, but not so much for clients. We could see an upside surprise from GS, Morgan Stanley (MS) and Citi as a result of the December tumult. That said, Citigroup is showing 2% sales growth for the full year 2018 and 2019 as well, but 21% plus earnings growth in Q4 ’18 and the full year. The C common is down 21% for the year vs just -11% for JPM, but if you consider the greater enterprise risk that comes with Citi that valuation differential seems about right. Consider that C has a market beta of 1.6 vs 1.1 for JPM. As we noted in the latest issue of The IRA Bank Book , the key issue facing banks in 2019 will be whether the rate of increase in funding costs – roughly 60% year-over-year – continues even as the FOMC shows signs of pulling up in terms of further increases in the target rate for Fed funds. The runoff of the Fed’s system open market account or SOMA is going to continue to tighten the US domestic deposit base regardless of whether the FOMC takes any further action in 2019. A pickup in capital markets volume, regardless of the reason, would be a nice surprise. More important, the debt issuance by the US Treasury will be an even greater weight on short-term funding costs – this as the 10 and 30- year Treasury bonds rally while high yield spreads are falling. Thus funding costs for banks and non-banks are rising, but the investor exodus from the equity markets is driving long-term bond yields and credit spreads lower. In normal times, such bullish bond market indicators like falling yields and credit spreads might suggest a substantial leg up awaits in the equity markets. Today, however, the market indicators are muddied by the side effects of QE, making traditional indicators less useful than ever. Then-Fed governor Jerome Powell said in the FOMC deliberations in January 2013: “Although it doesn’t show up yet in the dealer survey, some investors are saying that they sense the end of quantitative easing over the horizon, and as a result, there’s a sense of a rotation into equities and away from the safety of Treasuries, which accounts for some of the very large increase in the yield on the 10-year. And we should welcome all of that and consider whether our statements and actions reinforce or restrain the positive feelings that are out there.” As Powell predicted, the US equity markets delivered a stunning performance since 2014, with stock market valuations increasing by several orders of magnitude above the rate of US economic growth – what we lovingly refer to as the Bernanke/Yellen inflation. Now, however, with the Fed’s balance sheet shrinking and the fiscal deficits soaring, investors are seeing a sharp and somewhat contradictory pattern in the markets that was predicted by Chairman Powell in 2013. He said: “While financial conditions are a net positive, there’s also reason to be concerned about the growing market distortions created by our continuing asset purchases… Many fixed-income securities are now trading well above fundamental value, and the eventual correction could be large and dynamic. You hear that all the time now in the fixed income markets—and in the media, for that matter, which actually may suggest that it won’t happen, of course. But you hear it all the time; we all do. The leveraged finance markets are a particular concern. Rates are low; spreads are not that low yet, but they’re definitely tightening; and terms are deteriorating rapidly. There are many examples of bubble-like terms, which we can talk about at the next meeting. The Dell leveraged buyout, if it does happen, may be very prolific in that theater. I don’t think there’s an imminent crash coming. I do think that the incentives will rule in the end, and the incentive structure that we put in place with the asset purchases, is driving securities above fundamental values. So there is every reason to expect a sharp and painful correction.” Although the 2013 FOMC transcripts make clear that Chairman Powell was leading the charge against the Bernanke/Yellen tendency when it came to the scale and duration of SOMA asset purchases under QE, the markets still don’t seem to get the joke. Unwinding the Fed's asset price bubble is going to be a long and painful process. For financials in Q4 2018 and beyond into 2019, look for rising funding costs and still tough pricing for assets on the one hand, and lots of volatility on the trading book – good and bad. #BenBernanke #JanetYellen #JeromePowell #QE #SOMA

Richmond | The 10 year Treasury bond peaked in yield at just shy of 3.25% around Thanksgiving. Since then, the world’s most important interest rate benchmark has rallied, pushing yields back down to just shy of 2.55%. Most of this move is probably due to the exodus of investors from equity markets, but even with a stable dollar and relative market calm the 10 year continues to climb in price/fall in yield. QE and a lot of talk aside, deflation remains the dominant underlying tendency in US markets. So is now the time to pick up exposure to US financials? Maybe. Will refinance volumes return to the US mortgage sector? Deo volente . Bank OZK? Thinking (see below). Readers of The Institutional Risk Analyst know that credit metrics for all manner of bank real estate exposures are dramatically skewed in the too-good to be true direction. When will the proverbial pendulum swing the other way? Ralph Delguidice puts the opportunity into sharp focus in a missive this week: “The banks will present a GENERATIONAL buying opportunity in due time, when the FED has tightened financial conditions to deflate what is clearly a systemic bubble in COMMERCIAL REAL ESTATE (CRE) and, to a lesser extent, corporate loans. CRE and LL fundamentals can be debated to be sure, but the securitization bid is the CORNERSTONE of valuations in credit and it is never easy to ‘make the water fall up these ABS structures.’ Zero loss assumptions have been baked into the equity residual math for almost a decade, and there just isn’t room for ANY error. Like the equities, there is just too much asymmetry of return here. Eventually-- yes to the banks. In the meantime, the flat curve is going to make them too hard to own.” Ralph’s observations from the credit channel touch on a point we have long noted, namely that the monetary excess of the Federal Open Market Committee has made credit markets flaccid, now grown accustomed to zero or even negative net loss. As and when credit ratings for leveraged loans and related ABS start to slip below investment grade, the whole game will stop and “investment grade” assets that were liquid six months ago will be no bid. That’s what happens when you fall off the edge of the ratings table. Now if you ask former Fed Chairmen like Ben Bernanke or Janet Yellen, they will tell you that default rate expectations are low because the system is less risky. Yellen said back in 2016: “One reason that risk premiums may be low is precisely because the environment is less risky... The Fed has long focused on ensuring that banks hold adequate capital and that they carefully monitor and manage risks. As a consequence, banks are well-positioned to weather the financial turmoil.” The magical mystery tour of self-congratulation featuring Ben and Janet made an appearance last week, joining Fed Chairman Jerome Powell for a round robin session of carefully curated yet mindless nonsense on national television. For the record, Chairman Powell knows better. But their statements are important for investors because they illustrate just how far down the rabbit hole of economics are the internal discussions at the Fed and other agencies. The idiotic “capital will make us safer” view that underlies much of official thinking on the question of market risk sets the stage for a perfect systemic surprise. Ponder the views of Prerequisite Capital in Australia: “Ironically, when most investors study the top 15 global banks in the world ‘in isolation’ of the interrelationships and issues that arise when you take a broader look at the complex global system – you will hear them mistakenly talk about the improved ‘capital’ positions of these banks, thereby implying the relative ‘safety’ or strength of the banks globally. However, when you step back and ‘take into account larger and larger numbers of interactions as an issue is being studied. [...You are led to] strikingly different conclusions than those generated by traditional forms of analysis’ ... you start to realize that the banking and financial system globally is more (not less) fragile than it was in 2007.” The more capital = less risk construct that has become the intellectual foundation of prudential regulation in the US is a perfect analog to the Maginot Line of WWII. After WWI, the French built fixed fortifications along the eastern border with Germany in the hope that these extended castles would protect them from attack. It’s like the French version of China’s Great Wall. But the key failure of the Maginot Line was that it was an incomplete solution to a public problem, both physically and in a technological sense. George Ball wrote in The New York Review of Books in 1984: "Contrary to myth, the Maginot Line was, as far as it went, quite effective in blocking a German attack. France’s failing was that it had not finished the line and extended it to the sea or modernized its army units on the left flank.” We can think of capital in major global banks as a Maginot Line type of linear, static defense. But what was needed to counter the blitzkrieg warfare of the Nazi armies was a mobile, flexible defense comprised of tanks, infantry, and mobile artillery combined with close air support. The Allies did not have these tools or tactics and early on almost lost the war. In rare cases such as General George Patton, a horse cavalry soldier who became one of the fathers of modern mobile warfare, there was understanding, but not yet broad acceptance among US military leaders. Because the Maginot Line ended at the Luxembourg border, the Germans simply drove their Panzers around it via Belgium and the Ardennes Forrest. To apply the metaphor to finance, capital is fine, but regulators and officials responsible for monetary policy need to think about risk dynamically, especially when that market risk is the result of extreme forms of monetary policy. As curves flatten and funding costs soar, the possibility of contagion rises exponentially and regardless of capital – because liquidity ultimately is about confidence. Think about the fact that the 10 year T-bond has rallied three quarters of a point since November at a time when the Treasury is borrowing record amounts. The unwind of the Fed’s extraordinary policy is causing asset classes to correlate and other distortions in both demand for duration and funding. Any pretense at making rational investment decisions in such a muddled environment seems to stretch credulity to the breaking point. But life continues, in defiance of the apocalyptic. Bank OZK Let’s take a case in point, Bank OZK (formerly known as Bank of the Ozarks). Long one of the performance darlings in the US banking industry, OZK was known for being a well-run regional bank from Little Rock that had a big footprint in CRE lending nationwide. The common is off 50% over the past year, a reflection of some credit write downs that we not well handled with investors and an expensive name change and corporate name change and restructuring effort that leaves many puzzled. When you look at the available disclosure on OZK , which is greatly reduced since the bank dissolved its parent holding company and became a unitary state-chartered non-member bank, the numbers look fine. Strong capital, low credit losses. BTW, a great resource when you need to follow the growing number of publicly traded unitary banks is the TBS Bank Monitor (see below), which scored OZK an “A+” in Q3 2018. Ping Dennis Santiago at TBS for more information. Source: TBS/FDIC After cratering to down 60% YOY on Christmas Eve, OZK rebounded 10% in the past month. Do you go in and start to increase exposure to this tainted dove, this one time exemplar of the CRE syndication world that now trades at a discount to subprime players like Citigroup (C) at 0.75 x book value? Not to mention U.S. Bancorp (USB) at 1.75 x book? The answer to that question depends on your view of risk and particularly unexpected risk. We could spend a fine evening debating where that floor, that average equity market volatility rate, really ought to be for OZK given the perceived embedded risk. But looking at larger comps, the market swings of the past six weeks confirm that change is underway. The high volatility players such as Goldman Sachs (GS), Deutsche Bank (DB) and Citi all trade at a discount to book because of the potential for large operational risk events. You could argue that GS wishes for a higher beta. All of these stocks reflect a lack of visibility on future risks, something the folks at Wells Fargo (WFC) also learned about over the past several years. OZK with a beta of 1.8 is twice as volatile as GS at about 1 beta or roughly in line with market volatility. OZK at 0.89 book value is down 50% from a year ago, but since the unexpected credit write downs and the other fumbling around, the bank has lost that special bond with investors. Based on the historical performance, we want and expect to see OZK deliver solid earnings and strong credit, quarter after quarter. But once you start to lose confidence in bank management and start to think about unexpected risk events, then that premium valuation goes out the window. The fact that OZK is head-to-head in CRE lending with some of the largest banks in major metros is not exactly a cause for confidence given loan pricing. The point of the story is that consistency pays big dividends, but once you introduce the risk of uncertainty into the equation, investors quickly forget past performance and start to discount the promised outcome no matter the historical track record. Will the once premier names of WFC and OZK return to that premium pricing band above 1.5x book value? Yes, but it may take years to happen. Credit spreads have widened considerably and given the softening of collateral values in residential and commercial real estate, worry about the unknown is certainly going to dominate financials going forward. The key question for the future is when will actual default rates follow spreads and how rapidly. Further Reading: China's Stability Is at Risk The National Interest The Interview: George Gleason, Bank of the Ozarks The Institutional Risk Analyst #OZK #Capital #Maginot #RalpDeguidice #WFC

Paris | In this issue of The Institutional Risk Analyst, we feature a timely comment from Robert Eiesenbeis, Vice Chairman & Chief Monetary Economist at Cumberland Advisors in Sarasota, FL . Dr. Eisenbeis was formerly Executive Vice-President and Director of Research at the Federal Reserve Bank of Atlanta. While explaining the market mechanics of the Fed's balance sheet manipulations over the past few years, he makes a key point, namely that the increase in the federal deficit is the main driver of rising interest rates and widening credit spreads. "Treasury is the driver here and all the had wringing about shrinkage in the Fed’s balance sheet is missing the gorilla in the room," he opines. Perhaps President Donald Trump should stop criticizing Federal Reserve Chairman Jerome Powell and start to focus on raising revenue and/or cutting federal spending. Meanwhile, yields on fixed income benchmarks such as the 10-Year Treasury bond and 30-year mortgage rate have been falling since mid-November. Yogi Berra, the Fed’s Balance Sheet, and Liquidity January 1, 2019 The story is that the Fed’s quantitative easing program injected large amounts of liquidity into financial markets, causing bond rates to fall and stock prices to accelerate. Consequently, the argument goes that, the shrinking of the Fed’s balance sheet through maturity runoff will cause bond rates to increase and, presumably, stock prices to retreat. But what are the essential mechanics of Federal Reserve asset purchases, and how might they affect liquidity in the market? When the Federal Reserve began its quantitative easing program, it purchased Treasury obligations in the marketplace through the primary dealer facility and paid for those securities by writing up the reserve accounts of the sellers’ banks, simultaneously increasing the sellers’ bank deposits.[1] Effectively, the Fed created money in the purchase transactions, but as far as the public’s asset position is concerned, the purchases substituted demand liabilities for Treasury obligations. The sellers received deposits; their banks’ reserves increased by the same amount; and the sellers’ Treasury holdings were reduced. From the perspective of the consolidated government balance, Treasuries were removed from the public; and on-demand Fed liabilities were substituted in their place, bearing a lower interest cost than the Treasuries they replaced.[2] One form of very liquid asset (Treasury securities) was replaced by another (reserve deposits at the Fed, with corresponding deposits held by the public in its bank). The Fed’s purchasing Treasuries bid up bond prices and put downward pressure on interest rates. One of the main effects of QE was to redistribute the ownership both of Treasuries and of bank reserves and their associated deposits. We can’t quantify or identify the sellers of securities, but we do know that a large portion of the excess reserves associated with those purchases ended up with US affiliates and subsidiaries of foreign banks. Presumably sellers were institutional investors, hedge funds, and money market mutual funds but could also include individuals.[3] Foreign banks’ share of reserves peaked at about 50% in the fall of 2014 and is presently about 35%. Those excess reserves in US and foreign subsidiaries were potentially available to generate a large increase in bank loans and the money supply. A dollar of excess reserves would support an estimated $20 increase in credit and the money supply if it were converted to required reserves as part of the bank credit creation process.[4] But this obviously didn’t happen. Indeed, the ratio of bank loans and leases to bank reserves in Oct 2008 was 26.0, whereas that same ratio as of October 31, 2018, was only 5.6; so bank credit did not expand nearly to the same degree that bank reserves expanded. Interestingly, despite the series of QE experiments, in September 2014 a dollar of reserves was associated with only 2.9 dollars of bank loans and leases right before the Fed stopped adding to its portfolio in October 2014.[5] In short, the degree of stimulus, as far as bank lending was concerned, was muted. In fairness, business investment demand for credit was not great. The NFIB (National Federation of Independent Businesses) reported in March 2014 that 53% of its respondents indicated no need for a loan. Only 2% reported that financing was a major problem; and only 30% reported borrowing on a regular basis, a near-record low. One of the reasons was pessimism about investment and expansion prospects. The report stated that “The small business sector remains in maintenance mode, no expansion beyond a few firm starts in response to regional population growth.”[6] In December 2016 the Fed began a series of 25 bp increases in its target rate for federal funds, and in October of 2017 it began the process of shrinking its balance sheet by letting assets mature and run off naturally. As of December 19, 2018, the Fed’s balance sheet stood at $4.084 trillion, down from its peak of $4.5 trillion on October 14, 2015. Critics have complained that the balance sheet shrinkage process has contributed to a liquidity shortage; but they have not defined exactly what the nature of liquidity problem is, who is or is not constrained, and how that constraint is manifested. The size of the Fed’s balance sheet is determined by the outstanding reserve balances (both required and excess reserves), the volume of currency in circulation (which is of course the most liquid of assets), the volume of funds in the Treasury’s account with the Fed, the volume of reverse repo transactions outstanding, deposits in foreign official accounts, and of course capital. The only way the Fed’s balance sheet can shrink in size is if outstanding currency declines, bank loans shrink, Treasury or other official balances decline, or assets are allowed to mature, in which case the Fed’s liability to the Treasury declines, offsetting the maturing assets. Several factors have actually put upward pressure on the size of the Fed’s balance sheet since October 2014, including an increase of $330 billion in Treasury balances, an increase of $314 billion in added currency outstanding, and an increase of $82 million in foreign official and other deposits. This increase was offset by a decline of $1.07 trillion in bank reserves. How can we explain the drop in reserves if other factors seem to be pointing to an increase in the balance sheet? The source of Treasury balances is tax revenues that are deposited in Treasury tax and loan accounts at commercial banks. When the Treasury transfers funds from those accounts, the reserve accounts at the affected commercial banks are drawn down. So, in fact, the increase in the Fed’s liability to the Treasury is offset by a decrease in the reserves of the tax and loan account banks. Similarly, when bank customers withdraw funds in the form of currency, currency demand increases. That currency is obtained from the Fed in exchange for a reduction in banks’ reserve accounts. So again, rather than actually increasing the size of the Fed’s balance sheet, the composition of its liabilities is changed – currency outstanding is increased, and bank reserves are decreased. Of the $1.07 trillion decline in bank reserves, there was a corresponding increase in Federal Reserve liabilities to the Treasury and the increase in currency outstanding together accounted for $653 billion of the decline. The remainder is largely associated with the runoff and shrinkage of the Fed’s asset holdings.[7] It is important to note that when the Fed engages in what it calls reverse repo transactions, the securities sold remain on the Fed’s balance sheet. Bank reserves are temporarily reduced, but corresponding liabilities to banks under the account “reverse repurchase agreements” are increased. The composition of Fed liabilities changes but the volume does not. When the repo transaction is reversed, bank reserves go up and “reverse repurchase agreements” are reduced. The bottom line is that the apparent decline in bank reserves, far in excess of the change in the decline of the Federal Reserve’s balance sheet, is offset by changes in the other factors absorbing reserve funds, which simply represent a reallocation of the ownership of Federal Reserve liabilities. In the case of the Treasury, it accumulates funds to spend on entitlements, purchases, salaries, etc., which when paid reduce Treasury balances but reappear as an offsetting increase in bank reserves when the funds are deposited with the banking system. As for the notion that the Fed’s reducing its balance sheet holdings of Treasuries contributes to a so-called liquidity problem, again the mechanics are not clear, especially when we consider what has happened to Treasury debt issuance. To be sure, the Fed’s portfolio of Treasuries fell by $213 billion since the decision to let maturing issues run off, while MBS holdings declined by $132 billion.[8] Treasury debt held by the public increased by $956 billion through the end of the third quarter of 2018 as the Fed’s portfolio began to run off. But the actual net issuance of Treasury debt is even greater than that because the Fed’s portfolio is treated from an accounting perspective as part of the public’s ownership of the debt. Since the Fed’s ownership declined by $213 billion, the Treasury securities owned by the public, not including the Fed, increased by $1.169 trillion. This issuance dwarfs the rundown in the Fed’s portfolio and its potential impacts on securities markets. The decrease in the Fed’s marginal demand for Treasuries is far offset by the increase in supply. That supply, depending upon the maturity structure of the Treasury’s refunding, puts downward pressure on rates across the Treasury curve relative to the impact that the FOMC’s rate increases have had on short-term rates. This issuance pattern probably is the major explanation for the overall upward shift in the yield curve that we have experienced since the Fed began letting its portfolio run off. In the meanwhile, more liquid assets are now in the marketplace as a result of the increase in currency outstanding and the increased supply of outstanding Treasuries, and banks still have a huge volume of liquid reserves. Note that, like cash and bank reserves, Treasuries satisfy the banking regulatory agencies’ liquidity requirements, so it isn’t clear what the nature of the claimed liquidity problem is or who is experiencing problems.[9] Liquid assets are supposedly those that can be sold with little or no impact on their price. But we must be mindful that in order for an asset other than cash or deposits at the Fed to be liquid, there must be a buyer on the other side. If there is no buyer, then assets that were thought to be liquid suddenly are not. Indeed, the Fed in essence became the buyer-of-last-resort during the financial crisis. If Yogi Berra were asked to define liquidity, he might have said the following: “Liquidity is what you have when you don’t need it; but when you need it, you don’t have it.” [1] The following discussion of asset purchases and sales omits much of the institutional detail and mechanics behind the transactions and focuses instead on the key results. [2] We have noted before that the Treasury pays the Fed interest on its Treasury holdings, and the Fed pays interest on reserves out of those proceeds (as well as covering its other operating costs) and remits the remainder back to the Treasury. The effect is that the Treasury’s financing cost on the Fed’s Treasury portfolio is the cost of interest on reserves and not the interest payments on the Treasuries themselves. [3] Foreigners and foreign institutions own about 50% of the outstanding debt held by the public. [4] Author’s estimates [5] Source: FRED FRB St Louis [6] See http://www.nfib.com/Portals/0/PDF/sbet/sbet201403.pdf. [7] It is important to note that when the Fed engages in what it calls its reverse repo transactions, the securities sold remain on the Fed’s balance sheet, and bank reserves are temporarily reduced, but liabilities to banks under reverse repos are increased. The composition of Fed liabilities changes, but the volume does not. When the repo transaction is reversed, bank reserves go up. [8] Data from Oct 2017 through December 19, 2018 [9] If Secretary Mnuchin understood banking, the last institutions he would have called to inquire about liquidity problems would have been the nation’s largest banks, which hold the bulk of the excess reserves and have ample liquidity.