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Paris | Those of us who anticipated a quiet holiday break have been greatly disappointed. It is tempting to blame the electronic flatulence of the POTUS for the market selloff of the past few weeks, but in fact the credit for the great unwind must go to the members of the Federal Open Market Committee. First, the FOMC embraced unconventional policy after 2008, greatly expanding the liquidity in the US financial markets and thereby boosting valuations for stocks, bonds and real estate to astronomical levels. Second and most important, the FOMC lied to the American public about these policies. Specifically, by adopting a largely conventional policy narrative that ignores the real world impact of unconventional policy, the FOMC has misled the public and confused the markets. In simple terms, the FOMC refuses to accurately describe its policy for what it is – namely a reckless embrace of asset price inflation. Recall that after the 2008 liquidity crisis, when Fed Chairman Ben Bernanke wanted to call quantitative easing (QE) “large scale asset purchases,” the Fed’s Washington staff instead came up with the absurd and largely inaccurate euphemism of “quantitative easing.” QE, properly understood, was a direct violation of the legal mandate from Congress that instructed the central bank to seek “price stability.” During the period of radical FOMC policy measures like QE and Operation Twist, the US equity markets rationalized the extraordinary. Economists and Sell Side market analysts told investors that everything was fine, when in fact the FOMC was engaged in a vast and largely speculative experiment that distorted all manner of asset prices in the US and globally. Asset prices rose and investors cheered -- even as Washington's red ink became a torrent of new debt. From 2014 through the middle of 2018, the S&P 500 and DJIA rose by nearly 60% while the US economy was growing at barely 2%. Say what you want about central bank independence, at some point we need to hold members of the FOMC responsible for their policy actions. If the price of achieving full employment is to set the US economy on a course toward another asset bubble and financial crisis, then it is time for Congress to repeal the Humphrey-Hawkins Full Employment Act of 1978. Part of the reason why the FOMC finds it impossible to accurately describe its policy actions is that the second part of the mandate, namely “price stability,” has largely been discarded. Humphrey-Hawkins, let us recall, mandated zero inflation given full employment, a goal that was probably never possible. The political pressure from both national parties makes it problematic for any Fed Chairman to repeat the anti-inflation policies of former Chairman Paul Volcker in the 1970s. The demographic patterns of fifty years ago rightly put the emphasis on wage and consumer prices, this at a time when offshore capital inflows did not figure significantly in the economic equation. Today, however, the vast growth in the global use of the dollar as a means of exchange and store of value has changed the calculus for assessing “inflation” in profound ways. In the 2000s, vast capital inflows financed the US economy with the appearance of low inflation, but now the tide is going out. Of course, economists point to the heavily adjusted statistical measures of wage and price inflation as evidence that the FOMC is largely fulfilling the dual mandate. But how can any reasonable person watch annual double digit gains in stock market valuations or real estate prices and conclude that inflation is under control? We note in the most recent edition of The IRA Bank Book that inflation in real estate prices finally has skewed the net-loss given default for $2.5 trillion in bank owned 1-4 family mortgages negative in Q3 2018 (see chart below). Source: FDIC The same skew in the credit loss characteristics of 1-4 family mortgages is also visible in multi-family and commercial real estate, thus begging the question to the FOMC: Is the same volatility and price deflation now visible in US stocks eventually going to be seen in real estate as quantitative tightening (QT) proceeds with the shrinkage of the Fed’s balance sheet? Real estate markets move far more slowly than stocks, but is the same dynamic that has taken away almost half of the stock market gains since 2014 also pushing property valuations inevitably lower? A: Yes Our contributor Ralph Delguidice (" Are Leveraged Loans a Problem? Yes, and No. And YES ") reminds us that noted economist Zoltan Pozsar has long argued that QE-created bank reserves are not --and have never been --“excess.” In fact, he notes, they remain the ONLY settlement medium that can be used to meet the now binding (intra-day) liquidity requirements and all the other regulatory constraints on bank capital and assets. Pozsar wrote in his paper “ A Macro View of Shadow Banking ” (2015): “The swapping of excess reserves for reverse repos and boosting the supply of Treasury bills (whether in a reserve neutral or reserve draining fashion)… would both lead to shrinking bank balance sheets (as reserves are swapped into RRPs deposits flow out of banks to fund RRP counterparties such as money funds) as well as shrinking dealer balance sheets as more Treasury bills and RRPs offer alternatives for money funds that are safer than dealer repos. And on the flipside, reduced matched-book repo volumes mean less funding for levered bond portfolios and fewer opportunities for lending low intrinsic value securities, both of which will reduce opportunities to deliver excess returns via levered betas for pension funds and other real money accounts that struggle with structural asset-liability mismatches.” The obvious points to take from Pozsar’s work are two: First, the FOMC cannot withdraw the liquidity provided to the US financial system via QE without causing the system to implode. Chairman Jerome Powell needs to publicly state that the Bernanke-Yellen inflation in asset prices will entirely reverse as the FOMC tries to reduce “excess reserves” to pre-crisis levels. Regardless of whether the FOMC raises the Fed funds target rate or not, continuing to shrink bank reserves via QT implies a significant reduction in prices for stocks and real estate. Second and more important, Powell needs to inform Congress that so long as the Treasury intends to run trillion dollar plus annual deficits, the Fed’s balance sheet must grow rather than shrink . To have the FOMC try to follow a narrative set in place half a century ago when fiscal deficits were minuscule is obviously impossible given the Treasury’s borrowing needs. This implies that the FOMC must embrace an explicit policy of inflation that is at odds with the legal mandate enshrined in Humphrey-Hawkins. As we’ve noted previously, the POTUS is right to criticize the Fed’s policy actions, but for the wrong reasons. The fixation of markets and the financial media on whether the FOMC raises the target rate for Fed funds or not is misplaced, part of an time worn policy narrative that is completely antiquated. Since 2017, the only important trend in credit markets has been whether the Fed’s balance sheet is shrinking and at what rate. The move in credit spreads that started in August signaled that there is a growing problem with liquidity, yet the FOMC ignored the warning. Trapped in a policy path that is at odds with actual fiscal and economic realities, the FOMC is now the destabilizing factor in the markets. And remember that credit leads, equities follow. Our prediction for 2019 is that the FOMC will be forced to resume QE and again grow the System Open Market Account (SOMA) portfolio to maintain a ratio (yet to be determined) between the SOMA and the rapidly growing stock of outstanding Treasury debt. This is a pattern familiar to observers of other heavily indebted developing nations. Welcome to Brazil. #ZoltanPozsar #RalphDeguidice #FOMC #HumphreyHawkins

In this issue of The Institutional Risk Analyst, we feature a comment from our friend Ralph Delguidice, a veteran fixed income markets observer based in San Francisco. He provides important detail and context to the evolving credit dynamics of leveraged loans and collateralized loan obligations (CLOs) . San Francisco | December has been a cruel month for investors in “Leveraged Loans” as winter came in like a lion, early and cold. Primary and CLO spreads have exploded wider suddenly and loan prices have fallen below par going into the year end, stranding dozens of deals in bank warehouse lines and postponing the pricing on hundreds of other deals. This has drawn considerable media and market attention of late, as the asset class has grown to $1.1 trillion and now eclipses the high yield (HY) bond market it used to shadow. The Fed has been outspoken in their concerns as ETF and mutual fund buying has fed an insatiable demand for yield that naturally followed a decade of QE, and now with accommodation in process of being withdrawn the questions on possible systemic vulnerabilities are back front and center. The question of where and how fast this market might be going is complex to say the least, and there is room to disagree to be sure. That said, a couple of things are important to keep in mind from a MACRO and structural point of view that may hold the answers: The current correction is a natural and inevitable consequence of the widening in IG (investment grade), as the CLO markets are dispositive with respect to loan pricing and the quality of the CLO arbitrage—and expected loss adjusted returns—is a straight line-function of IG liability costs at the top of the “stack” (AAA, AA, A) that trade with corporate IG markets and FX swap costs It is not an exaggeration to point out that AAA tranches are now priced entirely in Japan by a small handful of buyers—most notably Norinchukin (a huge deposit funded agricultural co-op) many of whom were big buyers the last time around in 2008. They forgive easily. But should FX swap costs and/or alternative sovereign yields offer a more attractive option the CLO bid could close altogether. From a more MACRO point of view, the Fed hostility to leveraged loans (LLs) is actually ironic, especially given what is a clear and present intent on the part of the central bank to use the Non-banks (CLOs, hedge funds) as a loss absorbing “buffer” to protect the systemically critical GSIBs from the fallout as rates rise. This is perhaps the most important distinction of all for the asset class—as the Fed will not be quick to cut rates this time around in the face of non-continuous price discovery. It has become evident that the dramatic easing of LIBOR in 2008 and 2016 was Central Bank driven and was critical to the “out-performance” of LL’s (vis-a-vis HY) in the past. Remember, cutting LIBOR rates offers IMMEDIATE relief to FRN’s that makes refianacings unnecessary. But this time around the Fed has neither the room nor the desire to bail out the LL markets. Either way, the Fed is comfortable with credit vol. contained in the non-banks that they view as expendable (at best), and that is a BIG RED FLAG. Away from CLO’s--where volatility in the BB tranches was 8X the vol of the similarly rated loan collaterals-- the loan market has been saturated with demand from so-called SMAs (separately managed accounts). These are pension fund and family office investors who were attracted by the decade of flip-chart “out-performance” and who have joined HUNDREDS of brand-new—and totally untested—managers of hedge “credit funds” in what seemed to be an easy- Alpha trade. The question of how well (and stably) funded these SMAs and hedge funds will turn out to be--and how serious is their intent --we will see in time. But retail fund flows are already suggesting significant outflows from the ETFs and loan funds, and this is not going to be lost on those institutions, especially those who may not have fully understood what it was they were buying into. It is vital to remember that CLO deals that are half ramped (many of them) and that all own many of the same names already--are not going too be cash flowing fully to the residual (equity) tranche until they can manage to get fully loaned up. What this says about incentives (and other people’s money) as the market becomes volatile may be open to some debate, but transparency is in VERY short supply here, lags are long and management fees are, still, what they are. The FED has 2 REAL questions where systemic risk and the potential for contagion are concerned that need to be watched carefully. The first is the question of liquidity transformation where the ETFs are concerned. Loan settlements can literally take MONTHS and ETF/Fund liquidity is minute to minute. Should the BKLN or SRLN ETF see outflows that test the integrity of sponsors and force-clear pricing the rest of the credit ETF/mutual fund market—8T$ AT LEAST— will certainly be impacted. The second, and perhaps more important question (given the FED resolve in re the non-banks), is the degree to which so-called “collateral upgrades” have been done with CLO debt and LL’s themselves. In a nutshell, the now near total mandate to clear ALL interest rate and most credit swaps has created a pressing need for cash collateral to be posted at CCPs as initial margin. The BIS has estimated that swaps re-novated to CCPs have resulted in margin shortfalls are in the 4T$ range, and the primary users of swaps (insurance, hedge funds) are short of the acceptable sovereigns and cash to nearly this amount. Over the past several years the custody banks and prime brokers have quietly managed to offer the users of derivatives the ability to swap corporate securities OF ALL KINDS WITH ALL RATINGS for UST collateral that can be REPOed for cash. Of course it is hugely profitable. The problems are equally obvious, and; ironically, are a repeat of what went wrong in 2008 as REPO funding market runs suddenly become, as Vince Lombardi once said: "not just everything, but the only thing.” The above are some of the known-unknowns that LL and credit investors and will be dealing with in coming quarters. It is important to remember ALWAYS that these are specific issues that will be playing out against an economic backdrop that has become clearly hostile to credit of all kinds; and when all is said and done LL’s, CLOs and ETFs are all just different ways of packaging what is essentially raw credit risk—with few covenants and even fewer supporting market makers—into “securities” that are designed to appeal to retail investors that have been yield starved for more than a decade. If ever there was a text book smart money/stupid money trade, it is probably this market right now. Several of the MOST experienced mangers—those FEW who actually were doing the trade just 2 years ago—have started CLO funds that will offer a designed predatory flexibility to buy busted debt and collaterals from the less fortunate and prepared. Ellington and Highbridge know the risks, and they are getting ready for a GOT-style Red Wedding. My advice is don’t go -- more later. #LeveragedLoans #AAA

New York | First a safe and happy holiday to all. In this issue of The Institutional Risk Analyst , we ponder past prognostications and future risks in 2019. And we are happy to announce the publication of The IRA Bank Book for Q4 2018. For those of you who were furiously buying copies of the Q3 edition last week, for which we are most grateful, hit the download link again to get the Q4 edition. You’ll want to read about why US bank earnings growth is now 100% correlated to interest rates. FYI, new editions of The IRA Bank Book are published about two weeks after the FDIC and other regulators release their institution level and aggregate data (roughly day 60 after the quarter end) for US banks. The popular IRA Top Ten Banks usually appears after quarterly earnings are complete. And yes, to your questions, we only sell the most recent edition of each report. So what is our top concerns in 2019? First comes liquidity. For the past several weeks, US equities have fallen as the great unwind gathers speed. The same pressures that are causing the Federal Open Market Committee to consider pausing on rate hikes in 2019 are forcing stocks lower. Never mind the parade of mindless reasons for the stock market reset – trade, China or even a weak US economy – the key factor pushing markets lower is the radical tightening of credit by the FOMC. Even without a single rate hike in 2019, the tightening caused by the runoff of the Fed’s bond portfolio will continue to suck liquidity out of the financial system. And lowering the target rate for Fed funds really won’t help if markets lock up. Just as quantitative easing expanded the US liquidity base, quantitative tightening or "QT" represents a structural decrease in liquidity. As the Fed’s balance sheet contracts, there is a dollar-for-dollar decrease in liquidity because the Treasury is running a deficit. A bank deposit becomes a Treasury bill on the national balance sheet, illustrating why the Fed and Treasury are two faces of the same agency. But the key point is that QT is beginning to impact markets and credit spreads. The destruction of trillions in equity market valuation is creating a level of panic in the US markets not seen since 2016, when China fears caused the capital markets to seize up. We may be replaying that scenario again. With high yield spreads headed to the danger zone of 500bp over Treasury yields, that tells you that the policy message coming from Washington is off key. But it also means that the market for subprime debt, including leveraged loans and CLOs, is grinding to a halt. That sound you hear is Wall Street choking on conduits full of loans that cannot be sold. Feldkamp’s First Law states that when spreads widen too much, debt markets stop functioning and equity markets lose value. We talked about this in “ Financial Stability: Fraud, Confidence and the Wealth of Nations .” When the mix of policy and personalities is toxic, spreads blow out, debt markets freeze and wealth as measured by the equity markets falls. Sadly there are only a handful of people on the Street who get the joke. The majority is captive of a narrative where trade tensions are responsible for market weakness. Next on the string of worry beads is Europe. The European Central Bank just announced the end of its version of “quantitative easing” or QE, but unlike the US the ECB intends to reinvest its bond portfolio indefinitely. There will be no “quantitative tightening” in Europe by actually allowing the portfolio to run off as in the case of the US Federal Reserve. We reported this to readers after our trip to Paris last March. This past week, ECB Governor Mario Draghi confirmed our belief that EU banks cannot withstand a significant increase in rates. The list of banks in Europe that are effectively insolvent is long and growing, in part because the EU banking system is not particularly profitable. Again, as we noted in previous comments, strong banks are profitable banks. Profits allow you to build capital and deposits, and fund credit losses. For the banks of Europe and particularly nations like Italy, far too often there is little or no real profitability. This leads banks to hide credit losses and asset quality problems. We were amused to read that Qatar is considering increasing its stake in Deutsche Bank, as the newspaper Handelsblatt reported Sunday. This brings back memories of a decade ago when Korea Development Bank was touted to be looking to acquire Lehman Brothers. Then as now, the reports are not particularly helpful. What DB needs is to be recapitalized or acquired, but so far no credible investors has been willing to put new capital into this troubled bank. Merge Deutsche Bank with Citigroup (12/04/18) As we have discussed previously, the fact that insolvent Chinese aviation conglomerate HNA is selling its stake in DB means that the bank badly needs a new shareholder. And keep in mind that HNA was not a cash buyer of DB shares, but instead used leverage to fund its position. Presumably the Qataris have cash. We see the failure or restructuring of DB as a very real possibility in 2019, an event of default that will force the larger issue of bank solvency in Europe. With the bank trading below one quarter of book value, the stock of DB is not suitable as an investment. When will the EU authorities accept the fact that DB is crippled and requires state aid in order to stabilize? In the event, the mirage of German economic power in Europe will evaporate. Last comes China, both because of the growing potential for violent change and because western audiences are completely unprepared for this eventuality. Credulous western observers talk about the “long term” perspective of the Chinese Communist Party (CCP), but in fact this gang of “running dogs” to borrow the Maoist terminology is no different than western politicians. The make it up as they go. The CCP is no more able to manage a economy than is President Donald Trump. The key difference in China is mountains of debt, no real equity leverage in the economy, and a payments system that is entirely focused through the Bank of China. But the most troubling development in our view are the growing signs that the CCP and paramount leader Xi Jinping feel compelled to take more and more authoritarian measures to retain political control. The brutal rise of Xi Jinping to sole power in China is nothing if not a display of massive insecurity, starting with the elimination of all rivals and ending with the dissolution of collective leadership. Revelations that Beijing feels the need to imprison over a million Muslim Uighurs in work camps, a mere 10% of the 11 million population of Xinjiang, also suggests a very direct fear of instability. Mao Tse-Tung wrote in World Marxist Review in 1961: “A potential revolutionary situation exists in any country where the government consistently fails in its obligation to ensure a least a minimally decent standard of life for the great majority of its citizens. If there also exists even the nucleus of a revolutionary party able to supply doctrine and organization, only one ingredient is needed: the instrument for revolutionary action.” The revolutionary party is radical Islam, spilling across China’s western and southern borders. The CCP well recognizes the parallels with Chinese history. And it has happened before. Just as the Chinese nationalists and communist forces defeated the Japanese in WWII after decades of brutal occupation of China by Tokyo's fascist rulers, the CCP is now in the position of the oppressor and the Islamist “terrorists” are the liberators. No member of the CCP who understands China’s history could fail to be impressed by this parallel. Watching the liquidation of the HNA Group, a process which we now learn from Reuters is being administered by China Development Bank, you begin to appreciate just how fragile is Beijing’s control of the economy. CDB, of course, is HNA’s biggest creditor, and it in turn is an appendage of the Bank of China. When Wang Jian, the co-chairman and a co-founder of HNA Group, “accidentally” fell off a wall in Provence, France, he was atoning for creating a scheme so gigantically absurd and so heavily leveraged that it threatened the CCP. The CCP is happy to tolerate or even encourage wealth creation, but only so long as it does not become a problem. HNA’s $50 billion debt fueled shopping spree was and is still a problem for China in 2019, but only illustrates a larger issue of national economic solidity and cohesion. Westerners may need to consider the possibility of political change in China, a process that historically has come from the periphery and moved to the center in Beijing. Offshore investors who have become enamored of the illusion of political stability in China may want to recalibrate the reality gauge in 2019. #MaoTseTung #DeutscheBank #HNA #XiJinping

Charleston | In this issue of The Institutional Risk Analyst, we feature an important comment by Robert Eisenbeis, PhD., Vice Chairman & Chief Monetary Economist at Cumberland Advisors . Eisenbeis raises a key question at the end of his commentary, namely whether the Federal Open Market Committee is going to run down the level of excess reserves back to pre-crisis levels. Should the FOMC refuse to allow the extraordinary levels of excess reserves to run off, then it implies the permanent nationalization of the short-term credit markets in the US by the Federal Reserve Board. In another week the FOMC will have its final meeting of 2018 and its last with the current mix of policy makers. Already, the discussion has turned to what the Committee will do at that and subsequent meetings: Will it proceed with further 25bp increases in the target range for the federal funds rate, or will it pause? Markets appear to have priced in another rate increase in December, at least as signaled by what has happened to the short end of the Treasury curve, shown in the chart below. Chairman Powell afforded this view credibility in a speech he gave on November 28 in New York. Although the purpose of the speech was to highlight the release of the Fed’s first-ever financial stability report, he did touch on monetary policy. After noting the delicate balance between moving policy rates too fast or too slow to achieve the Fed’s dual mandate and the need to consider information contained in incoming data, he stated that, as far as current policy is concerned, “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy….” What Powell is clearly saying is that he would be comfortable with at least one more rate increase, and this sets the stage for the FOMC’s next move in December. There are two important reasons why the FOMC will move at its next meeting. First, it has provided justification of where rates should be to be “neutral”- that is, neither too tight nor too loose with regards to slowing down or speeding up growth. Second, that justification blunts any perception that the FOMC may be bowing to political pressure from the White House when it comes to setting rates. By saying it is “almost there” and stating that further moves are data-dependent, the FOMC is setting the stage for a possible pause. And the rationale for such a pause will be contained in the Summary of Economic Projections, if the Committee does indeed decide that it has achieved a neutral policy stance. Clearly, world growth is slowing and should the slowing continue that may be sufficient to justify a pause by the Committee. The minutes of the November FOMC meeting, released November 29, reinforce the “almost there” view articulated by Chairman Powell in his speech. The minutes reveal some concern on the part of FOMC participants about the risks to inflation posed by uncertainty concerning the fiscal situation and trade policies. The Committee laid those concerns aside, however, in commenting on the path for policy, and there was agreement that “another increase in the target range for the federal funds rate was likely to be warranted fairly soon if incoming information on labor market and inflation was in line with or stronger than their current expectations.” However, some expressed uncertainty over the timing of further increases, while at least two participants expressed the view that the neutral policy stance had been achieved. The bottom line is that the minutes, combined with Chairman Powell’s “almost there” hint in his NY speech, perfectly position the FOMC for another rate increase at its December meeting, while preserving flexibility to pause at future meetings and putting some distance between the FOMC and the White House. The minutes are interesting for another reason as well, because they indicate the nature of the current state of the discussions about how future policy might be conducted once the Fed has normalized its balance sheet. That decision is shown to hinge critically on whether the FOMC decides to return to the pre-crisis regime of a balance sheet determined primarily by currency demand and a low level of excess reserves or favors instead a large balance sheet with a large volume of excess reserves. The former would imply policy exercised by small changes in the volume of excess reserves achieved through manipulation of the federal funds rate in the overnight market. The latter would imply continuing the reverse repo approach and dealing with a larger number of potential non-bank counterparties, such as money market mutual funds. It is clear from the discussion that no decision on these alternatives has been made, and the decision process is complicated by changes in how financial markets have functioned in the wake of the financial crisis. The clear message in the minutes is that this discussion is “to be continued.”

New York | Last week Federal Reserve Board Chairman Jay Powell blinked and thereby changed the monetary narrative. We suspect that this is just the start of a tactical retreat by the Fed in the face of mounting evidence of financial stress. Like the sailors who traveled to the New World with Columbus, Powell said something about nearing the “neutral rate” and promptly trimmed his sails for fear of encountering a reef. That reef, dear readers, is the sudden move in credit spreads. Equities rallied and, more important, corporate bond spreads narrowed a bit last week, slowing a worrisome trend towards the repricing of credit that almost certainly implies bad times ahead. The fact of a mountain of mis-priced corporate debt has become an almost commonplace topic in the financial media. We know that bond covenants have been weakened to an absurd degree, stripping investors of assets or any legal right to the supposed security. We also know that the Fed’s manipulation of interest rates and the term structure of same has likewise distorted the pricing of risk. Yet default rates remain extremely low, begging two questions: First, how much of the downward skew in current defaults is due to the Federal Open Market Committee? Second, how quickly will credit spreads reprice, especially with a market that is tightening by the day as the Fed’s bond purchases slowly run off. Even were Powell and his colleagues on the FOMC to do one more rate hike this year and then pause in 2019, the runoff from the FOMC System Portfolio would continue to shrink the US deposit base and thereby tighten liquidity. Thus the term “quantitative tightening.” Unknown to most Fed analysts, Chairman Powell actually has a great deal of leeway in terms of the Fed’s “data driven” policy. Even with no further rate hikes, the liquidity in the US markets will continue to tighten apace. Every dollar of Treasury debt that runs off from the Fed’s books means a dollar’s worth of bank deposits disappears (HT to Lee Alder at The Wall Street Examiner ). While many economists inside and outside of the central bank continue to waffle about the need to raise rates to enhance future “policy flexibility,” a truly bizarre construct, in fact the only decision that matters today is whether the FOMC is a net buyer of Treasury debt. Ponder that. Next week we’ll be releasing the Q4 edition of The IRA Bank Book , which will delve into this phenomenon of domestic bank deposit shrinkage more deeply. Suffice to say that the Fed and Treasury are alter egos, two faces of the same fiscal ledger, so that what one manifestation of America gives in terms of market liquidity the other takes away. Thus in our day job we see core bank deposits trading at a healthy mid-single digit premium again after years of no premium or even discounts. And yes, non-interest bearing bank balances at US banks fell again in Q3 2018. With non-interest bearing deposits falling, offset of note by growing foreign inflows into US banks, the bias for US deposits overall is flat to down, as shown in the chart below. Source: FDIC Ralph on the left coast notes that the fund community is already gearing up for the opportunity to purchase busted corporate bond deals, especially the collateralized loan obligations or “CLOs” that first became famous in the financial crisis. These deals typically have a weighted average rating factor or “WARF” in single digits for “B” rated debt, meaning that if too much of the collateral in the deal is downgraded below that rating, then the covenants kick in to protect the senior debt. Ralph sees several new funds with WARFs of 50% “CCC” being created to clean up the impending mess in corporate debt. “In nutshell, the new deals are designed to allow for up to 50% CCC with no WARF test, so they will be in perfect position to be buyers of the newly downgraded CCCs that will be puked up across the whole CLO surface,” opines Ralph. Yummy. It needs to be said that out of every market contagion, great fortunes are created. But the fact of these large opportunities to profit also attracts swarms of politicians, regulators and members of the trial bar. Just as there is a great concentration of public companies around the “BBB” investment grade band, there also is a large pile of “B” rated crap inside CLOs that is just perfectly situated to slide down into “CCC” nowhere land at the right moment. Again, ponder the velocity of the transition from apparent credit ratings visible today to where they ought to be in a world without the Fed. Sound like 2008? The value of QE and "Operation Twist" in terms of option adjusted duration is an important question in this regard. The gradual repricing of risk will not only bust more than a few CLOs, but may also provide some surprises in the world of investment grade credit. Consider a home owner in CT or CA or NY who has a FICO score north of 800, seven figure income and a home that in theory is worth $5 million. At the moment, however, there is no bid near that valuation. The home has a 50% mortgage on an appraised value of $4.5 million and is being rented for less than half of the monthly carrying costs. Q: How long will the affluent home owner fund the negative carry asset? A: We’ll find out. It's called "strategic default" by the way. Q: What is the true loan-to-value ratio of this mortgage? A: Higher than 50%. Just as there is an awful lot of toxic corporate exposures inside the world of CLOs, there is also a fair amount of apparently prime credit that are, in fact, susceptible to a forced reset due to the prospect of a buyers market in residential or commercial real estate. Indeed, the current vapor lock in high end residential property reminds us an awful lot of 2005, when the real estate market began the long slide that did not end until 2012. When the loan sales volumes at WaMu and Countrywide started to fall, you could tell that the party was over. And loan volumes have been falling for years. The toggle that starts the repricing process is not merely the absolute level of interest rates but rather spreads. We know that Chairman Powell and his colleagues watch many types of market indicators, but the most important and fast moving over the past month has been the rate of change in high-yield (HY) credit spreads. The folks at the Fed may want to increase interest rates to provide increased flexibility, but they are also trying to avoid a repeat of 2016, when worries about China drove high-yield spreads through the roof. Notice that even the modest uptick in spreads at the far right side of the chart was enough to almost destabilize the US equity markets. Owing to the China syndrome in the first part of 2016, when high yield spreads rose to more than 800 bp over Treasury yields, the bond and ABS markets were basically dead for six months. Nobody on the FOMC wants to repeat that experience. In plain English, when high-yield spreads jump 20 percent in a 30-day period, you can be pretty sure that the spaceship is approaching the neutral rate. Thankfully Chairman Jay Powell noticed. Yet even his soothing words last week are unlikely to slow the exodus of investors from CLOs and corporate debt more generally. Of note, the Fed is considering big change in how it sets US interest rates, possibly targeting the OBFR instead of the fed funds rate. But what is the OBFR? The Fed tells us that, "The overnight bank funding rate is calculated using federal funds transactions and certain Eurodollar transactions." All we can say is that Europe is short dollars and always has been. When the next idiosyncratic event strikes – Italy, Deutsche Bank, BREXIT, a New Hanseatic League – look for the dollar cost of credit in Europe to spike large. #WARF #Ralph #Powell #CLOs

New York | Reading the financial press over long holidays in essential. In the days immediately before or after a holiday, there are inevitably important news items that will be missed. Exhibit 1 is the festering situation in the world of non-bank mortgage finance, where a combination of excessive regulation and interest rate manipulation by the Federal Open Market Committee has set the industry on a collision course with reality in 2019. Eddie Small at The Real Deal in New York summarized the situation: “Lenders are trying to navigate the new landscape using tactics like selling their mortgage-servicing rights or lending to borrowers they would have previously overlooked. Dan Gilbert, chairman of the largest nonbank lender Quicken, told the Journal that purchase mortgages are becoming more central to the company’s business.” Let’s set the stage. Back in 2008, the FOMC opened the proverbial floodgates, pushing interest rates down to near zero and ushering in a bull market in both commercial and residential real estate starting in 2012. To give you a sense of just how far up the FOMC has manipulated home prices, the chart below shows loss given default (LGD) for the $2.5 trillion in bank-owned 1-4 family mortgages. Source: FDIC In Q3 ’18, the LGD for bank owned 1-4s was negative 15%, meaning that recoveries on foreclosed homes actually exceeded the gross amount of defaulted loans. The long-term average loss rate for bank-owned 1-4s is 65% going back to 1984. And the level of both recoveries and defaults for the portfolio is very low, below $1 billion. But both the negative level of credit loss and the low default rates are outliers that will be reversed. By engineering an artificial sellers market in real estate after 2012, the FOMC also created a huge opportunity for adept mortgage firms to make piles of money, both on mortgage refinance transactions and also by managing the vast flow of defaulted mortgages coming out of the crisis. At the start of 2012, by comparison, the LGD on bank owned 1-4 family mortgages was 94%, meaning that banks were loosing $0.94 per dollar of face amount of loan every time a mortgage defaulted. Today, with home prices now above 2008 levels, mortgage servicers are actually making $0.15 profit per dollar of the original loan amount in those rare cases where a mortgage actually goes through foreclosure. With interest rates rising and the accumulated backlog of defaulted mortgages largely (but not entirely) resolved, mortgage firms are now facing the worst of all possible worlds. On the one hand, mortgage servicing is no longer profitable for many non-banks because of the Dodd-Frank, the regulations imposed by the Bureau of Consumer Financial Protection and the 50 states. While mortgage firms are able to generate decent margins on mortgage refinancing, the cost of originating new purchase loans is over $8,000. Kroll Bond Ratings put the market into context in a recent report: “[N]on-bank lenders are experiencing [gain on sale] GoS margin compression and falling origination volumes as the industry transitions to a higher rate, purchase-focused market. For large banks, 3Q18 mortgage banking results largely mirrored industry trends with slightly better GoS margins and declining origination volumes. While linked quarter margins improved for some (JPM, WFC, HTH), margins compressed further for Flagstar (FBC), HomeStreet (HMST) and PennyMac (PFSI). More notably, GoS margins year-over-year (sometimes a better proxy given seasonality associated with the market) for all companies in KBRA’s FI Mortgage Panel were down an average of 33 bps (24%).” According to the Mortgage Bankers Association, the average pre-tax production profit for non-bank mortgage lenders was 21 basis points (bps) in the second quarter of 2018, up from an average net production loss of eight bps in the first quarter of 2018, but down 24 bps from the second quarter of 2017. Keep in mind that residential loan officers typically make 1% or more in commissions on new loans, thus the industry is still operating deep in the red on every loan originated. As lending volumes have slowed over the past several years and purchase mortgages have become the dominant loan type, the profitability of many non-bank lenders has disappeared. Unlike banks which are able to earn money from the custodial deposits related to mortgage payments, non-banks must survive on gain-on-sale of new loans and servicing fees. With the cost of servicing loans up 200-300% since 2008, however, many independent mortgage banks no longer can count on a profitable servicing book to see them through periods of a sellers market in housing, when new home purchase mortgage lending is typically unprofitable. The same market manipulation by the FOMC that has caused interest rates to fall and real estate prices to soar has also encouraged non-bank mortgage firms, which are already struggling with profitability, to sell a portion of future loan servicing fees at premium prices. New production mortgage servicing rights (MSRs) for conventional Fannie Mae and Freddie Mac loans are currently going at between 5.5 and 6x annual cash flow, record price multiples for MSRs that again illustrate the huge distortions introduced into the world of housing finance by the FOMC. Which brings us to that little pre-holiday data point. On November 15, 2018, the Government National Mortgage Association (aka “GNMA”) published a bulletin to issuers operating in that market that makes a number of changes to how MSRs are financed and sold. A few members of the industry press commented on the rule before T-Day, but by and large the mortgage bankers still don't get the joke. The memo from GNMA COO Michael Bright states: “Effective immediately, Ginnie Mae is implementing new notification requirements for Issuers engaged in certain subservicer advance or servicing income agreements, which do not require prior Ginnie Mae approval, but can impact an Issuer’s ongoing liquidity position and financial obligations. While Ginnie Mae currently permits subservicers to advance funds on behalf of an Issuer to pay security holders under the MBS Program, subservicers will now be required, upon request, to notify Ginnie Mae about such advances, including details about the frequency, amount, and purpose. Similarly, Issuers that enter into pledges of servicing income, or other transactions that encumber an Issuer’s Servicing Income, that are not subject to an Acknowledgment Agreement, must notify their Account Executive via email no later than 15 business days after the date that the transaction agreement is executed. Upon notification, Ginnie Mae may require the Issuer to provide the specific terms of the transaction, relevant documentation, or updated financial information.” The new GNMA regulations require all banks and non-banks operating in that market to disclose all past financings, sales and participations of MSRs. Why is this important? Because the ability of an issuer in the $2 trillion GNMA market to 1) pay bond holders and 2) purchase bad loans and conduct loss mitigation is crucially dependent upon the solvency of the issuer/servicer. When an independent mortgage bank “sells” part of their future servicing income to help offset current losses on lending, for example, we create a scenario where the mortgage bank is more likely to fail when 1) interest rates rise and/or 2) default rates increase. The Economics of Servicing Let’s quickly dive into the economics of loan servicing in the Ginnie Mae market, which we addressed in depth last summer in a working paper entitled “ Increasing Capital & Liquidity for GNMA Mortgage Servicing Rights ” last summer. Let’s assume that we have a hypothetical mortgage with an unpaid principal balance of $300,000 and a loan coupon of 5%. The typical GNMA issuer gets a net servicing fee of 32bp annually. Take 32 bps on $300k and you get $960 per year in gross servicing. Most servicers can administer a performing mortgage for $7 per month, so again 12 x $7 or $84 per year. This means that, in theory, the non-bank could “sell” the other $880 or so of the servicing income or "strip" to a financial investor like Black Rock or Apollo. But this works only if there are no problems with the loan, no need to speak to the obligor, call them or send them mail, etc. Sending out a piece of first class mail costs at least $1, for example, vs an electronic mortgage statement. The moment a GNMA loan goes delinquent, the cost of servicing skyrockets, 10x the normal cost or more, as do the fees the servicer eventually receives for fixing the loan. But all of the excess fees for servicing a distressed loan are on the back end and must be financed by the non-bank, along with advances of interest, principal, taxes and insurance required to protect the value of the home. The only cash the GNMA issuer/servicer receives each month is the 32 bps servicing fee. Thus the reason why GNMA wants to know how much of a non-bank’s 32 bps of servicing has been sold away. Remember that the full 32 bp strip is capital meant to finance operations during periods of peak defaults. Under the current practice in the mortgage industry, many non-banks have sold away more than half of their gross spread from their MSR. We hear in the channel that GNMA is considering in the near future imposing a 25bp minimum for retention of income from the MSR. Note that the annual float on the mortgage example above is in excess of $30,000 per year in a high tax state. This float can generate twice the fees that a servicer receives for actually administering the loan, but only a bank can fully capture this benefit. Note too that larger loans generate bigger servicing fees, one reason that big banks like Wells Fargo and Bank American will pay up for jumbo loans, which they often hold in portfolio. The trouble for investors in MSRs arises from the optionality regarding termination of servicing rights by GNMA, an issue that is fundamentally connected to the solvency of the issuer/servicer. Thus the new GNMA regulations provide a stark warning and also a roadmap to future contagion in the non-bank sector. Keep in mind well more than half of the non-banks in the US residential space have probably blown through their bank credit covenants due to impaired capital, poor profitability or both. The other issue for investors in non-bank mortgage firms and MSRs is participations. When a non-bank sells or finances part of their 32 bp GNMA servicing strip to a financial investor, this is most often done via a participation agreement. There is no “sale” and the mortgage bank remains the owner of record of the MSR. In the event of default, a bankruptcy trustee for a non-bank or the FDIC acting as receiver for a failed bank will likely try to reject the participation agreements that have not been fully isolated. As we noted in American Banker , some lawyers like to pretend that the current practice on Wall Street regarding loan participations is safe and sound, but in fact unless the asset is legally isolated from the failed bank or non-bank, the purchaser of participations in loans or MSRs stand at risk of total loss. It happened before in a little mess called Penn Square Bank. The FDIC repudiated all of the dead bank’s loan participations, gutting five large banks in the process and causing four (Chase Manhattan, Continental Illinois, Seafirst and Michigan National) to subsequently fail and be sold. Of the five banks most impacted, today only Northern Trust Co (NTRS) survives that default event as an independent bank. The Road to Contagion The first step toward contagion in the world of non-bank finance, as we’ve noted before, will be a liquidity squeeze that is ongoing and forcing many smaller non-bank firms out of business. Even were the FOMC to do just one more rate hike in 2018 and then wait awhile for the System Portfolio to unwind, it is unlikely that loan spreads in residential loans or other asset classes are likely to recover in the near term. In fact, so great is the concern about profitability that GNMA is meeting with the largest issuers, industry maven Rob Chrisman wrote just before the holiday: “Ginnie Mae sent a "liquidity letter" to its 14 largest issuer/servicers in late October, telling them to come up with contingency plans as the profitability picture worsens. The management teams of these 14 shops will be sitting down with Ginnie officials in early January to discuss the matter further. Ginnie also issued an all-participants memo, dictating new standards for firms seeking to become issuers, including the stipulation that applicants submit to a corporate credit evaluation similar to what the rating agencies put them through.” The industry currently has capacity to do at least $2 trillion in new mortgages annually, but volumes in 2018 will be closer to $1.4 trillion and declining – and with little profitability. We easily could see a 10% reduction in the number of non-bank mortgage firms this year and a larger downward headcount adjustment in 2019, a grim figure that suggests thousands of job losses in the world of residential mortgage finance. Step two in the Merry-go-Round of non-bank risk will be credit. The real fun is some two to three years out. This is when years of low-interest rate lending starts to mature and throw off supra-normal loss rates. We suspect that some of the REITs and Buy Side shops that have been hungrily acquiring MSRs at single digit returns may become sellers when the true cost of credit is revealed. As Mike Lau told us a few weeks back in The Institutional Risk Analyst (" The Interview: Michael Lau on the State of Mortgage Finance " ) , MSRs are a mid-single digit internal rate of return asset (IRR) through the credit cycle and w/o leverage. Just as credit spreads have galloped 20% in the past 30 days, we suspect that indicators such as LGDs and loan default rates for bank owned loans will also start to move pretty quickly as and when movement occurs. Whether or not home prices start to soften as quickly as credit turns across the US is really the big question. If we see loss rates for residential and commercial assets start to rise in a sustained way, then we’ll know that overheated home prices are headed for a correction. Watch those LGDs over the next year. We’ll be addressing this point in the next edition of The IRA Bank Book . Further Reading Goldman Chairman Met Privately With Fugitive Accused in Malaysian Fraud The New York Times By Emily Flitter, Matthew Goldstein and Kate Kelly A Cautionary Tale from the '80s for Today's Loan Participations American Banker By R.C. Whalen #GNMA #MSR #MichaelBright #loanparticipation

New York | Last week in The Institutional Risk Analyst we mentioned the transition from that carefully managed reality, that “new abnormal” of the past decade, to something very unfamiliar to most investors. Over the past two months, wildfires have swept over numerous industry sectors, leaving a lot of previously expected investment returns in ashes. The real human tragedy in CA will certainly hurt economic growth, but the carnage on Wall Street also is immense and growing. Financials have taken a hit over the past 12 months, even as the benchmark S&P 500 has managed to stay positive single digits. Exemplars among financials like US Bancorp (USB) have actually stayed even with the S&P at plus single digits, but the KBW Bank ETF is basically flat for the year. In the latest edition of The IRA Top Ten Banks , we talk about why USB is the best performing money center bank in the US. And we also tell you who we believe is the weakest CEO among the top ten US depository institutions. Most of the market’s attention currently is focused on two related risk hot spots: Asia and Technology. In the case of the former the great deflation in China is gathering speed thanks to Beijing's spending and President Donald Trump’s asymmetrical trade war. As illustrated by the massive liquidation of HNA , the implosion of Uncle Xi’s paper tiger continues apace. When we say “paper” of course we are not only referring to mystical papier-mâché creatures that can be used in parades, but rather our suspicion that China’s mountain of bad debt may be imploding under its own weight. When global investor Kyle Bass says China needs a reset, he knows not how right he is this time around. Savings obsessed Japan is very different from crazy rich China under the early years of Xi Jinping. The use of leverage in China over the past decade dwarfs even American levels of fiscal profligacy. China’s banking system, for example, is twice the size of the US if you believe the statistics. “It’s insane how levered this market has become,” Bass told Reuters . “You’re starting to see bankruptcies across the board in China that are hard to hide, if you look at the corporate default rate, the bankruptcy rate, M1 and M2 (money supply), the slowest money growth in over four decades.” When you combine decades of economic mismanagement with the natural tendency of members of the Chinese Communist Party (CCP) to steal everything in sight, the obvious conclusion in that there is no equity underlying China’s economy or financial markets. Add the random factor of President Trump and the CCP is left in disarray. The “Belt and Road” initiative is alienating many important overseas relationships for China and leaves behind a huge cost in terms of bad debt, but economics is not the point. As one close observer of China joked during dinner in New York: “Think of Chinese infrastructure spending as a giant pension plan. It is literally a way to occupy people and get them out of the cities or even out of the country entirely. Profit is secondary.” Goldman Sachs: Chasing Growth Much of the risk coming out of Asia has to do not just with economic slowdown but also plain vanilla fraud. Consider the 1 Malaysia Development Berhad (1MDB) scandal involving Goldman Sachs (GS), which has seen its common shares drop double digits for the year and now trades comfortably below book value. Vampyroteuthis infernalis The 1MDB scandal features Malaysia's former Prime Minister Najib Razak and "financier” Jho Low and is Exhibit A for the Age of Credulity scrapbook. As with highly leveraged conglomerate HNA, nobody had any idea as to the origins of Low or where the money came from or was going. Somehow GS raised another $6 billion from investors to support this apparent act of fraud against the Malaysian state. We can’t help but wonder if GS, the organization famously dubbed the “vampire squid” by Rolling Stone’s Matt Taibbi, knew about the assistance one of its partners gave to Mr. Low, contrary to what former Goldman Sachs CEO Lloyd Blankfein suggests. Or maybe they did not want to know. And here's our question: Did Blankfein step down as Goldman CEO in anticipation of the 1MDB blow-back? Like Citigroup (C), which suffers periodic breakdowns in its internal controls related to the offshore venues where it does business, Goldman is also known for regular operational risk events. And chasing growth in Asia, to paraphrase Blankfein, is an ideal way to get into big trouble. That noise factor, the near certainty that both Citi and Goldman will trip up when it comes to operational risk events such as fraud and money laundering, seems to keep these names trading at a discount to less exciting peers like USB. We could tell you a story about John Reed, Citibank Private Banking and Raul Salinas de Gortari in Mexico, but we digress. Ben Walsh at Barron’s writes: “[T]he bank has warned that the investigation could result “in the imposition of significant fines, penalties, and other sanctions. Whether or not Goldman is penalized, the 1MDB scandal is a huge setback to its campaign to repair its public image after the financial crisis.” Agreed. But we wonder, regarding Q4 earnings, whether GS will be forced to take a reserve for the cost of cleaning up this mess, including the return of $600 million in ill-gotten investment banking fees? To us the bigger question is whether the new CEO David Solomon, who headed the GS investment bank, will survive the 1MDB scandal. No matter how you cut it, the answer to the key question to Goldman Sachs of why didn’t you know about the relationship between Goldman Asia banking head Tim Leissner and Jho Low is unsatisfactory. Whether the answer is (1) a breakdown in systems and controls or (2) a failure to supervise, Solomon must ultimately shoulder the blame for failure to supervise one of his key managers and direct reports. Goldman Chairman Blankfein says that Goldman investment bankers “evaded our safeguards, and lied—stuff like that’s going to happen.” Really? Bank holding companies and broker dealers subject to Fed and FINRA supervision, respectively, are supposed to have systems and controls in place that prevent employees from evading safeguards. Blankfein telling us “that’s going to happen” is an absurd response. The risk facing Goldman is very similar to the situation at Wells Fargo & Co (WFC), where the board of directors failed to take action for more than a year in the face of clear acts of fraud. Given that Solomon was the manager of Tim Leissner, it seems difficult to envision a pathway for the GS board that does not involve Solomon stepping down. At the very least, the SEC, Fed and other regulators will need to extract a pound of flesh from Goldman Sachs a la Wells Fargo to atone for what seems like a truly ugly example of management failure. Spreads Widen, Deals Slow Meanwhile in the world of emerging technology and high yield debt, the great deflation being led by the Federal Open Market Committee is starting to show a modest upward impact on credit spreads. Some names are doing better than others. Deal flow is starting to suffer as a result. Members of the financial punditry will fashion endlessly ingenious explanations for why tech stocks are cheap – and getting cheaper -- yet the simple fact is that rising rates will sink many speculative stories in the debt and equity markets. For example, even with all the "good" news of the past several weeks, Tesla Motors (TSLA) 5.3s of 2025 trade + 475 bp to the 10-year Treasury bond. This puts TSLA on the wrong side of “B” in terms of ratings breakpoints even after a remarkable rebound for the stock since October 8th when it was down 20% for the year. Of note, the FOMC seems perfectly content to crater the market for leveraged loans and collateralized loan obligations or “CLOs,” an acronym you unfortunately want to remember. A key indicator of rising investor caution, namely credit spreads, are starting to widen, as shown in the chart from FRED below. From a low of 316 bp back in early October, the ICE BAML high yield index has widened more than 20% to 400 bp over the Treasury yield curve. That is a very rapid change. As and when this indicator gets to 450 bp or higher, that is a danger signal for both market contagion and economic recession. Deal flow stops when spreads widen too much too fast. When high yield debt spreads get near 500 bp over the Treasury curve, financing activity for speculative firms essentially stops and related bank lending will follow that example. Of all of the time series and indicators that the FOMC can watch, high yield and corporate credit spreads are the most relevant. Rising high yield spreads will accelerate the reckoning in leveraged loans and CLOs. The temporary redemption of Elon Musk’s little science project at TSLA, however, cannot reverse the overall market gloom due to the fall of Facebook (FB) one of the big tech beneficiaries of the irrational easing of the FOMC. Going back to 2012, FB is still up more that 330% vs last week’s close – this at a time when the economy was barely growing. But over the past quarter, the stock has moved sharply lower, from up 20% in the first week in July to down a like amount last week. Idiosyncratic Risks The negative factor weighing down GS, FB and TSLA, however, is idiosyncratic risk coming from the CSUITE. In the case of FB and TSLA, these two publicly owned organizations have founder risk. Both have reached the point in their development where a transition to a more stable and competent management team could benefit shareholders. But an exit by either Musk or Zuckerberg could crater each stock. Goldman Sachs, on the other hand, may be in serious jeopardy because of its big dependence upon risky investment banking revenue. GS is a compliance violation disguised as a going concern. Bankers always evade. Or as Richie Metrick, COO of the investment bank at Bear, Stearns & Co was famously known to say about bankers: “If their lips are moving, they’re lying.” JP Morgan & Co (JPM) was known a century ago as “The Octopus.” Goldman Sachs is merely a squid. That is, fish bait. JPM has trillions of dollars in core deposits, while Goldman has yet to bank the first $100 billion in stable cash funding. GS is too small to be credible as a commercial bank and ranks just behind the largest universal bank, JPM, in the overall global league tables for deals. In the world of deals, GS is pursued by Barclays, Merrill Lynch, Morgan Stanley (MS) and Credit Suisse (CS), among others. But in the next few weeks and months, Goldman’s fate may rest on how it extricates itself from the 1MDB mess, a when not if proposition that we think could be visible in Q4 earning for GS. The eventual cost of salvation may include disgorgement of the $600 million in fees, appropriate fines and penalties, and perhaps the departure of both Blankfein and Solomon. But atonement in the world of investment banking is, as the Economist wrote in 2002 about the WorldCom scandal, “a worrying process whose end still seems a long way off.” #GoldmanSachs #VampireSquid

Washington | Last week in response to popular demand we published our first Top Ten List for the largest US lenders . We noted that credit performance for the top institutions is pristine, but we also noted that spreads on loans and securities remain extremely tight, discouraging lenders in high-cost markets in such sectors as residential mortgages and even multifamily lending. This seems to be the paradox of the post 2008 markets: credit underwriting standards are better, but the profitability of originating assets is minimal and cash flow coverage is stretched, suggesting serious problems ahead that will cause loan and bond default rates to rise. The present situation in the financial markets reminds us of our favorite quotation from “A Tale of Two Cities": This week we got to hear FDIC Chairman Jelena McWilliams talk about current market conditions at a bank conference sponsored by Kroll Bond Rating Agency. Taking a page from “A Tale of Two Cities,” McWilliams said it is “the best of times” but noted that regulators need to work with banks to make the cost of compliance balance with the size and resources of the bank. Chairman McWilliams then made a comment on credit conditions that could easily be applied to the equity markets as well: “There has not yet been a single bank failure this year but as you all know that is not normal. We are in abnormally good times. Usually we have three or four bank failures per year. That happens and it is a normal part of the business cycle. We have been in what I like to call the best of times this year. This is the new abnormal. At some point we will get back to normal.” What is most striking about Chairman McWilliam’s comments is that they could apply to many sectors of the debt and also equity markets. The premium pricing seen for many assets and, as one reader put it so well, the “velocity of collateral” moving through the financial system, makes us wonder if the target for the next crisis has moved from asset quality to the operating and market stress caused by excessive competition on price. The impact of an abnormal market on many normal businesses is profoundly negative. We note from the banking channel that while there may not have been any bank failures this year, there are certainly a lot of smaller banks for sale at the present time because these businesses simply do not make money. The rising cost of regulation and compliance has likewise raised the bar in terms of the minimum size of a bank that can be economically viable. To give you some idea of the scale of cost increases for the industry, the direct cost of servicing a performing mortgage loan in the US is about 15 basis points (bp), according to The Mortgage Bankers Association, or half of the income from the gross servicing strip. A decade ago the cost to service a performing residential mortgage was closer to 5 bp. With rising operating costs and horrible execution on the loan origination and secondary market sale, many banks have decided to flee residential lending. Meanwhile in the market for multifamily and commercial construction and finance, there are growing signs of stress due to years of abnormal markets c/o the Federal Open Market Committee (“FOMC”). We heard Eric Thompson, Senior Managing Director of the Real Estate group at KBRA, remark at the same conference that “interest only” mortgages are now all the rage in the market for commercial mortgage backed securities or CMBS. In the brave new world of Dodd-Frank, lower loan to value (“LTV”) ratios are supposed to protect lenders and investors from shoddy underwriting, right? But nature finds a way. A case in point regarding the new abnormal is New York City multifamily. Andrew Dansker, a first vice president of finance at Marcus & Millichap, writes in The Commercial Observer about the combination of historically low capitalization or “cap” rates and low interest rates: “Because of these underwriting constraints, and the low loan-to-value ratios that they imply for low capitalization rate deals, almost every acquisition made in New York City in the past five to 10 years has a loan which was underwritten to a maximum size based on the ratio of available cash flow to the cost of the debt. The low leverage points make these deals appear to be conservative, but they are actually very aggressive on current cash-flow underwriting standards.” The moral of the story is that asset prices are high, abnormally so, but so is the cost of acquisition and construction. As interest rates rise, deals that seemed “normal” three or four years ago based upon cash flow coverage of debt may no longer work at higher interest rates. And the same logic that suggests that there is trouble brewing in the commercial real estate sector also applies to leveraged loans and collateralized loan obligations or “CLOs.” One of the most interesting and frightening aspects of the great normalization is the way in which the earlier machinations of the FOMC, which were supposed to help the economy, have now become a gale force headwind in terms of both liquidity and credit. Rising interest rates, for example, are pushing many obligors over their debt covenants with lenders. Meanwhile, regulators are downgrading these cash flow stressed exposures, making lenders far less inclined to roll the credit. And tenants are pushing back on sky high rents, further hurting the cash flow and ultimate viability of new projects. The collective effect is a reduction in liquidity that will result in higher defaults in commercial real estate. As the market for luxury multifamily properties in New York and other major metros around the US rolls over, look for sponsors to seek renegotiated terms on loans, a dangerous strategy that can get the credit flagged by auditors and regulators. But a more likely outcome is that lenders will refuse to renew these credits, notes Dansker, “forcing the issue into the arms of borrowers.” He concludes: “Whatever course of action is chosen, it seems we are poised to see a rise in transaction volume in the coming year. Investors should be ready to transact either with banks or with owners opting to sell instead of recapitalizing their holdings.” #FDIC #KBRA #JelenaMcWilliams #CMBS

New York | The Institutional Risk Analyst is pleased to announce the publication of The IRA Top Ten US Banks, a quarterly look at the ten largest commercial banks in the U.S. Copies of the The IRA Top Ten US Banks report are available for sale via our online store. In this inaugural issue of The IRA Top Ten US Banks, we profile the financial performance of the ten largest depositories in the U.S., all part of the 119 banks above $10 billion in total assets that are included in Peer Group 1 defined by the Federal Financial Institutions Examination Council (FFIEC). Below are the banks that are included in the report: Source: Board of Governors/FFIEC You will notice that we have excluded Bank of NY Mellon (BK) and State Street Corp (STT) from the list. This is because these institutions are more in the business of custody and data processing than credit. You also do not see Goldman Sachs (GS) or Morgan Stanley among the top ten, this even though the consolidated assets of the parent companies put them into the top of Peer Group 1. The total bank assets of GS and MS are still less than 20% of the total assets of the parent holding company, a reflection of business models that are still predominantly focused on securities dealing (and related bad acts) rather than banking. Below are some basic metrics that illustrate the different business models of the top ten banks. Notice that the largest banks have far less than half of their total assets in loans, again reflecting the diversity of business models that includes securities dealing and wealth management. Source: Board of Governors/FFIEC The first thing to notice about this list is the ways in which the largest US banks diverge in terms of business models. The highest return on assets (ROA) among the group is Capital One Financial (COF), a below prime credit card issuer and consumer lender. Next in terms of ROA is U.S. Bancorp (USB), our long-term favorite among the top five money centers because of the strong earnings, solid funding and business stability. Notice in particular that the USB’s cost of funds at just 0.32% is one third of the peer group average of 1.42%. This is a reflection of the large escrow and other non-interest bearing balances that are the core of USB’s consistent profitability. Another important observation is that JPMorgan (JPM) and Citigroup (C) have less than 40% of total assets in loans, again a reflection of how the universal bank business model differs from more traditional domestic commercial banks. Even Wells Fargo (WFC) and Bank of America (BAC), which are largely domestic, have barely half of total parent company assets deployed in loans. But as we proceed down the list, from USB on in terms of total assets, the proportion of loans to total bank assets is well more than half. Among the top banks, the highest net default rate comes from COF due to the credit card and consumer loan books, followed by Citi, JPM and USB. Notice that USB has more than 80bp better return on its loan book than JPM. And none of these loan spreads are particularly impressive when you remember that the machinations of the Federal Open Market Committee have resulted in the systemic underpricing of risk over the past decade. Just as we think that the twin idiocies of QE2-3 and Operation Twist have understated the 10-Year Treasury by a point in yield, we suspect that commercial and consumer loan yields are off by a like spread vs the Treasury benchmarks. Another observation that needs to be made is the enormous difference in the number of physical branches among the top four banks. Notice that Citi had just 704 domestic branches, but almost 175 offshore. More than two thirds of Citi’s total deposits are offshore and uninsured. While Citi has the second lowest cost of funds among the top ten banks after USB, it is for very different reasons. Citi has a huge float from its global payments business and also manages its institutional funding base astutely, but the results in terms of ROA are still disappointing. Even with a gross yield on its loan book almost 200bp above its peers, Citi’s overall results measured by asset and equity returns are still mediocre. Finally, by subtracting net loan losses and funding costs from gross loan spreads, we generate a nominal return for the lending book for the top ten banks. While these metrics differ from the official stats published (or not) from these respective issuers, they do allow for a comparison of the cash returns on credit extensions from the different banks. Suffice to say that while COF and C may top the list in terms of nominal returns, were we to risk-adjust these figures both of these banks would quickly fall to the bottom of the list. And more importantly, in terms of growth, the biggest share of value creation is toward the bottom of the list among the smaller institutions. Indeed, since 2015 the number of banks above $10 billion in total assets has grown from 93 to 119 today. Copies of the The IRA Top Ten US Banks report are available for sale via our online store.

New York | When we first heard news reports about a new investor in Deutsche Bank (DB), we of course assumed that this meant the purchase of new shares and thus an increase in capital. But no, it was merely an “activist investor” taking a stake in existing shares. Is this really news or merely a sign of a top in large bank stocks? The DB common is trading a hair over $10 or just 0.3x book value and has a beta of 1.5. Douglas Braunstein, founder and managing partner of Hudson Executive Capital and J.P. Morgan's (JPM) former CFO, said in an interview with CNBC that the firm has taken on the stake over the last few months after studying the stock for a year. We’ve been following DB for a lot longer than that and have great difficulty constructing a bull case for the name. But let’s take a look anyway. First on the list of concerns is profitability. DB has been struggling for years to find a business strategy to deliver consistent profitability, the key measure of stability for any bank. Through the first nine months of the year, DB delivered net income of less than a €1 billion compared with €1.6 billion a year ago. For the full year 2017 the bank lost €750 million. As yet, no one on the management team – if we may so dignify DB’s executives – have been able to articulate a coherent plan to move forward. Second is capital. DB has just €61 billion or 4% capital to total assets of €1.5 trillion, one of the lowest simple leverage ratios of any major bank worldwide. The bank tries to hide this capital deficiency behind calculations that exclusively use “risk weighted “assets” of just €354 billion. In the bank’s non-GAPP disclosure, there is just €54 billion in tangible capital disclosed for a leverage ratio closer to 3%. In the Q3 ’18 earnings call, when CEO Christian Sewing said that “we committed to conservative balance sheet management and maintaining a CET1 ratio above 13%,” he was referring to risk weighted assets, not total assets. If one assumes that the entire Basel III/IV framework is a confused mess when it comes to describing risk, then the leverage ratio is what matters. Risk weighted assets is a way to pretend that the rest of the banks in Europe and Asia are solvent. To be fair to DB, most European banks play the game of only referring to “risk weighted assets” in their financial disclosure to investors. The EU bank regulators are entirely complicit in this charade. Indeed, since the end of 2017 DB’s total capital has actually fallen 4%. The last major infusion of capital for DB came from the generous folks at HNA, who are in the process of liquidating their debt financed empire at the behest of Uncle Xi. Regulators in the EU and US never asked about the source of the funds provided by HNA nor the beneficial ownership of the Chinese firm. Since the initial investment was raised to almost a 10% stake in 2017, HNA has been a distressed seller, partly because so much of the investment seems to have been funded with debt. The third key concern among a far longer list of questions is the franchise. The DB supervisory board has shown no vision when it comes to focusing the bank’s business on more profitable areas. DB is more a securities firm than a bank. It does not have a strong banking franchise in Europe and has a mediocre investment banking and capital markets business in London and New York. Ranking eighth in the league tables after Barclays (BCS) and above Wells Fargo & Co. (WFC) in total deals YTD, there is no sector where DB has a commanding presence in either capital markets or investment banking. Like JPMorgan (JPM) and Citigroup (C), less than a third of DB’s book is allocated to loans, reflecting the bank’s focus on trading and derivatives. The bank does have a strong position in commercial real estate in the US, but the greatly stretched valuations in that sector do not inspire confidence about future loan and securitization volumes. Notice, for example, that the bid for agency RMBS had largely disappeared in the US. Spreads are set to widen as the year-end approaches. Sewing says that “Our principal near-term target is to reach a return on tangible equity of more than 4% next year.” Such a goal is relatively bold given the parlous state of the banking industry in Europe, but DB’s US peers have equity returns well in excess of twice this level. Perhaps more frightening is Sewing’s intention to “deploy part of our capital into our business,“ something that DB has never done well. The ill-fated investment in the Postbank, for example, is currently being restructured at a cost of tens of millions of euros as the bank seeks savings by merging the two entities. So will DB have a negative surprise for investors in Q4’18? As Sewing said during the conference call: “I'm well aware of Deutsche Bank's history of negative surprises in the fourth quarter, and we are absolutely determined to not repeat this.” But even without any drama, the fact remains that cost cutting of various types is the predominant activity at DB this year and in 2019. Investors can expect another couple hundred million in restructuring charges in the fourth quarter, although DB management is telling investors that overall charges could be well below original estimates for 2018. But the big challenge will be increasing revenue through the enterprise, for example by moving several hundred billion euros earning negative 40bp at the Bundesbank into other, more remunerative activities. DB executives point to such accomplishments as taking share in the market for leveraged loans, a sector we can be pretty sure will figure prominently in the next downturn in the credit cycle. Despite the happy talk coming from senior management about deploying capital prudently, the fact is that DB does not have a lot of options when it comes to new business outside of a low-quality capital markets business. Putting scarce capital into growing market share in leveraged loans and collateralized loan obligations (CLOs), for example, strikes us a distinctly unattractive right now. But the fact is that for the past decade or more, DB has made a living of sorts by structuring crappy assets that other banks will not touch. The legal and reputational risk from these activities have been enormous. As CEO Sewing told investors: “[w]e are seen as one of the better banks in this business and, therefore, we see increasing volume.” Wunderbar! Later this week and by popular demand, we will be launching our second publication, The IRA Top Ten Banks, which will focus on the ten largest US commercial lenders. Stay tuned for updates! #DeutscheBank #DouglasBraunstein #JPM #DB #BCS #WFC

New York | In his new book, “ Keeping At It: The Quest for Sound Money and Good Government ,” by Paul Volcker (1979-1987) with Christine Harper, the former Fed Chairman delivers a sound rebuke to Chairmen Ben Bernanke (2006-2014) and Janet Yellen (2014-2018), and other Fed governors and economists, for fretting overmuch about deflation. He argues that the true danger is that loose monetary policy leads to inflation and market contagion caused by the manipulation of risk preferences. Volcker specifically chides Bernanke and Yellen for their fixation on a two percent inflation target, one of the main ornaments on the data dependent Fed Christmas Tree. “How did central bankers fall into the trap of assigning such weight to tiny changes in a single statistic, with all of its inherent weakness?” he asks. Good question. Volcker writes in Bloomberg : “Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk. The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the ‘easy money,’ striving for a ‘little inflation’ as a means of forestalling deflation, could, in the end, be what brings it about. That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of those requirements inexorably lead to the responsibilities of a central bank.” Of course, Volcker is cut from different cloth than his successors. Janet Yellen was only chairman of the Federal Reserve Board for four years and with good reason. She was arguably the most dovish Fed Chairmen in the history of the central bank, with a strong tendency to do too much rather than too little. Yellen confessed to the Financial Times last week that “I really thought we needed to pull every rabbit out of the hat.” And she did. An adherent of the state-intervention school championed by her Yale mentor James Tobin, Yellen has always followed the tendency of the left to support greater ease and tolerate higher levels of inflation. During her tenure as a Fed governor and then chairman, the Fed engaged in the purchase of trillions of dollars in government debt and mortgage securities through “quantitative easing” – a free loan to the Treasury that was couched as “stimulus.” The Federal Open Market Committee (FOMC) under Bernanke and Yellen also engaged in a deliberate manipulation of the term structure of interest rates via “Operation Twist,” a terrible mistake that has yet to be reversed. Operation twist caused untold damage to the financial markets and the US economy – damage that is still in process. In that interview with the FT , Yellen worries that the rhetorical attacks on the central bank by President Donald Trump is “whittling away the legitimacy and stature of institutions the public has traditionally had some confidence in. I feel it ultimately undermines social and economic stability.” She then goes on to say that “Trump has the potential to undermine confidence in the Fed.” Former Chairman Alan Greenspan, the most politically astute Fed chief in half a century, puts such worries in perspective: "I don't know a single President, and I worked for a lot of them, who don't want lower interest rates. Now, obviously that's not possible. You keep lowering them down to zero, where do you go from there?" Like Yellen, many observers worry that criticism of the Fed will make it difficult for the central bank to act when necessary. The dual, conflicted political mandate of full employment and price stability created by the Humphrey Hawkins law is not possible to achieve in practice, thus the FOMC lurches from one extreme to the other, causing enormous collateral damage. Consider the effects of QE and Operation Twist on housing. Think about the thousands of people in the mortgage industry, for example, that have lost their livelihoods because the boom and bust policies followed by the Fed since 2008 and even before. Think about the millions of American families today that cannot afford to buy a home because asset prices have skyrocketed over the past five years. By pulling tomorrow’s home sales and other economic activity forward via various policy manipulations, tomorrow is now light in terms of growth. Tomorrow also carries hidden market and credit risks caused by the Fed’s past actions. As we watch mortgage lending and home building volumes fall next year and thereafter thanks to the property price inflation created by the FOMC under Bernanke and Yellen, remember that Fed policy was explicitly meant to “help” the housing sector. When people talk about “Fed independence,” our response is independence from what? Presidents going back to FDR have tried, unsuccessfully, to bend the central bank to the political circumstances of the day. In the book Inflated: How Money and Debt Built the American Dream , we wrote about how Chairman Thomas McCabe (1948-1951) and his colleagues on the FOMC starred down President Harry Truman on the eve of the Korean War. He won back the Fed’s independence from the Treasury. But the Fed and Treasury, like all federal agencies, are notional institutions, merely alter egos for the United States. The greatest threat to the central bank’s existence is the tendency of Fed governors and economists to pursue abstract economic theories that make no sense in real world terms and often do more harm than good. We have written at length about how the radical policies followed by the FOMC, first under Bernanke and then Yellen, have distorted asset allocations, and the term structure of interest rates and credit spreads. For example, our best guess is that the 10-year Treasury bond, in the absence of QE2-3 and Operation Twist, should be yielding well-over 4 percent today. Instead this important benchmark of risk is barely over three percent. Indeed, the entire Treasury yield curve still shows a strong tendency to fall thanks to debt purchases by the Fed and other central banks. And corporate credit spreads remain compressed, with high-yield spreads up 25bps in the past month but really unchanged from a year ago, as shown in the chart below. Traditionally, Fed chairmen have disappeared into the world of academia, speaking or consulting after leaving office. Bernanke has followed this rule, but Yellen seems unconstrained by such conventions. During her discussion with the FT , Yellen worries about lending to heavily indebted, less creditworthy corporate borrowers, which she sees as a source of potential “systemic risk.” She also talks about the need for more regulation, to counter the potential for systemic risk caused by this accumulation of risk. Is it really possible that Chair Yellen fails to understand that the Fed’s deliberate manipulation of the credit markets since 2008 made this worrisome accumulation of corporate junk debt possible? Does she understand why most corporate debt issuers are clustered around the “lower bound” of investment grade ("BBB")? As we noted this past week, liquidity in the credit sector is the next risk on the merry-go-round of financial markets, a cycle of asset and market risk that the Fed largely controls. Today the FOMC under Chairman Jay Powell is working to “normalize” policy, but without unwinding QE2-3 and Operation twist. Last week, at a talk at the Peterson Institute for International Economics, newly confirmed Fed Vice Chairman Richard Clarida discussed monetary policy normalization, but significantly made no mention of ending other legacies of "unconventional" policy such as QE 2-3 and Operation Twist, or paying above-market interest rates on excess bank reserves. In the language of the FOMC, QE and Operation Twist were a form of stimulus. In the language of the financial markets, they represented a back door loan to the Treasury and the manipulation of credit markets. Even in the supposedly conventional world of Fed monetary policy, the concepts and indicators used to formulate public policy are often vague – a point that has already drawn the critical notice of Chairman Powell. Chairman Volcker is not the first member of the Federal Reserve System to criticize the dangerous policy drift inside the US central bank, but his comments are entirely on point. By substituting nonsensical concepts like “neutral” interest rates for hard data, and by manipulating the financial markets so that they are no longer reliable measures of risk or inflation, the FOMC under Bernanke and Yellen has been deliberately flying blind. Former Cleveland Fed President Lee Hoskins and his former colleague Walker Todd note in a important research paper, “ Twenty Years after the Fall of the Berlin Wall: Rethinking the Role of Money and Markets in the Global Economy ,” that the Fed is now a source of systemic risk. They write: “Today we bear the fruits of state-managed intervention and seat-of-the-pants monetary policy. Many of the interventions from the 1930s are still with us—the Federal Housing Administration, Fannie Mae, and Freddie Mac, to name just a few—and they all played a major role in the housing bubble and its collapse in 2008… Meanwhile, government guarantees and insurance programs for financial assets, along with bank bailouts, have produced, arguably, the largest increase in moral hazard in the history of financial markets. The Fed’s zero interest rate policy lasted so long (2008–15) that it encouraged excessive risk-taking, certainly riding the yield curve for banks (funding short and lending long). Unless reversed, these policies will plant the seeds for the next bubble.” So far, Chairman Powell and his colleagues on the FOMC have refused to speak publicly about unwinding QE 2-3 and Operation Twist. Meanwhile, former Fed Chairs Bernanke and Yellen travel the globe, congratulating themselves for saving the world from the threat of deflation even while encouraging the accumulation of the biggest pile of debt in modern history. But the full aftermath of the 2008 crisis is still incomplete. As and when the wheels come off the proverbial cart in the credit markets around 12-18 months out, it will not be due to a lack of regulation but rather because of reckless polices of the FOMC under the past two Fed chairmen. As Jim Grant noted recently, Chairman Powell truly is a prisoner of history. Click here to listen to the interview with Jim Grant of Grant's Interest Rate Observer . #Volcker #Bernanke #Yellen #PaulVolcker #InflatedHowMoneyandDebtBuilttheAmericanDr #Greenspan

New York | This past week, readers of The Institutional Risk Analyst awoke to see that banking exemplar Bank of the Ozarks (OZK) had taken a loss on two legacy loans on regional mall properties in the Carolinas. First and foremost, this event shows that commercial real estate many parts of the US have still not recovered from the 2008 bust. Bank OZK, as it is now known since shedding its bank holding company, had previously reserved for the write-down. Our friends at Kroll Bond Ratings , who rate Bank OZK “A-“, summarized the situation nicely: “While reiterating that we consider these two credit issues to be largely idiosyncratic, KBRA notes that OZK’s core business strategy, which is centered on underwriting large commercial real estate loans, certainly offers the potential for some asset quality volatility even in generally favorable economic environments. Notwithstanding these unexpected charge-offs, Bank OZK’s ratings continue to be supported by its long and consistent record of solid risk-adjusted returns, which, in no small part, stem from disciplined underwriting and an effective risk management framework.” So, no, we do not see the earnings miss at Bank OZK as a sign that a wider apocalypse is impending in the world of commercial real estate -- at least not yet. Yes, multifamily and CRE properties are overbuilt and there is a rising glut of luxury properties in many urban areas. But the credit consequences of this latest round of irrational exuberance are probably a couple of years away in terms of bank earnings results. Indeed, we see the near term risks to financials coming from ebbing liquidity rather than festering credit. Writing in The Wall Street Journal , Rachel Louise Ensign reports that the levels of non-interest bearing deposits at US banks are falling. We discussed same in The Institutional Risk Analyst several months ago (see chart below) and in the most recent edition of The IRA Bank Book . Source: FDIC While Ensign correctly notes that rising interest rates are driving the secular decline in non-interest bearing deposits, that is certainly not the only reason. Among the largest components of bank transaction deposits is escrow balances for residential and commercial mortgages. Figure about $1 trillion annually in non-interest bearing float for the $11 trillion or so in outstanding single family mortgages. As large banks such as JPMorganChase (JPM) and Wells Fargo (WFC) have sold distressed servicing and withdrawn from low-FICO lending, the related deposits naturally decline as well. Indeed, we hear that WFC is preparing to follow the example of JPM and withdraw entirely from the Federal Housing Administration market. A sale of all of WFC's GNMA servicing portfolio is also said to be in process. The key insight in the WSJ report is that funding costs are rising – and quickly. How long will it take the financial media and investors to figure out what this means for bank earnings? As we told Grants Interest Rate Observer (October 19): “The average cost of funds for the whole industry right now is a little over 1%. The average earnings on total earning assets is barely 3%. You’ve got about 2 points of spread. If funding costs keep rising faster than earnings, then you will see net interest margin start to contract by Q1. How do you think the Street will react to that?” We have opined previously that the Federal Open Market Committee is not only going to squeeze bank earnings by raising short-term interest rates, but the Fed may very well cause a liquidity crisis in the world of non-bank finance. A year or two hence, we fully expect to see over-leveraged developers of luxury multifamily properties hanging from lampposts – figuratively speaking, that is. A key bellwether to watch is the net loss rate on CRE and multifamily exposures, which at present is deeply negative. That means that when a rare default event actually occurs in the multifamily sector, the bank gets its money back and then some, as shown in the chart below. When you see loss given default back into positive territory, that will be a signal that the period of artificially boosted asset prices is at an end. Source: FDIC Meanwhile, our friend Ralph Delguidice has been sending a steady flow of commentary about the hottest spot in the world of credit risk, namely the increasingly rancid world of collateralized loan obligations or “CLOs”. Remember this acronym. Tomorrow’s headlines about credit risk exploding in the face of investors will originate from this little-known corner of the financial markets. How? As credit spreads eventually start to widen with rising interest rates, the flaws in this deeply overbought institutional market for CLOs will become apparent. But for now the overall tightness in the credit markets is actually causing spreads in CLOs to tighten. Think of this as the melodic prelude to the final, disastrous finale of credit misallocation. The astute folks at TCW wrote: “CLO triple A liabilities are still widening while we see loan collateral prices tighten. The arbitrage is already stressed and every time we see rates go higher, the asset class seems to get incremental inflows from retail funds and SMAs, which only further pressures the arbitrage. Something will have to give. We will either see triple A CLO liabilities begin to tighten again or we will need to see enough outflows in loans that it restores the supply/demand relationship necessary to print new CLOs. However, when CLOs have represented roughly 60% of the loan demand, it is hard to craft a scenario where SMAs and retail funds can replace that demand for a prolonged period of time.” Many late vintage CLOs are indeed headed for credit problems, but the first act in that tragedy will be a massive and relatively sudden reset in credit spreads. The tightness in asset prices due to the FOMC’s twin idiocies of “quantitative easing” and “Operation Twist” will transform overnight into a buyers market. The low-quality leverage buyout and acquisition loans that make up more than half of CLO issuance and have been sold at high-investment grade spreads will suddenly be no bid. A number of observers have noted that the quantity and quality of debt issuance in the US over the past five years suggests troubling similarities to the 2008 credit bust. As was the case a decade ago, mis-pricing of risk thanks to the market manipulation of the FOMC is at the root of the mounting problem in CLOs. Delguidice offers some insights: “The torrential demand for leveraged loans — institutional and now increasingly retail—comes down to two things: 1). The loans float. This gives way to the proposition/myth that they offer protection against an increasingly aggressive Fed. 2) The EBITDA interest coverage is currently solid given the (12%) revenue growth in 2018 YTD. That said, the base line effects of 2015/16 will fade into next year even as the FOMC goes five more times and the fiscal impulse fades. This will (would) require 50%+ of the leveraged loan universe to post the same (12%) EBITDA growth in ALL the coming quarters just to keep coverage ratios from slipping. The red-hot demand for CLOs has also eroded covenants on the deals. This is impossible to quantify but critical to credit recovery and thus cycle dynamics of the structure) to the point where every new deal pushes the limits. Some 75% of the credit stack in leveraged loans is now 'covenant lite.'” Slipping coverage ratios? Mis-pricing of risk? Does that sound familiar? The good news is that the credit quality of US bank portfolios is very strong. The bad news is that many bank customers are leveraged up to their ears and more. When EBITDA coverage ratios start to slip as the FOMC withdraws liquidity from the system, these mis-priced risk exposures in the leveraged loan market will cause a terrible slaughter among fixed income investors who have blindly purchased these toxic exposures. The contagion of credit losses that starts in the market for leveraged loans and CLOs will slowly but surely impact the banking system as well. Early stage companies and leveraged buyouts will fail, causing a cascade of credit losses throughout the economy. Credit rating agencies will scramble to downgrade heretofore investment grade CLOs. And once again, the FOMC will be called upon to solve the problem of collapsing assets prices, a problem that its previous policies have caused. #KrollBondRatings #OZK #deposits #NIM #JPM #WFC #RalpDeguidice #Grants