SEARCH

In this issue of The Institutional Risk Analyst, we feature composer and media industry observer Michael Whalen on the prospects for the world of content given the aggressive spending by loss leader Netflix (NFLX). A veteran of three decades in the business of creating and distributing audio and video content, Michael has won two Emmy Awards is a composer of over 650 television and film scores. Question: Can you spend your way to success? Answer: Well, Netflix thinks so. The Economist projected this past June that Netflix will “probably” spend in excess of $12 billion on original programming this year. That’s far more than the $8 billion it was reported they would spend as of October 2017. It would also be way, way more than other studios are spending. HBO spent a reluctant $2.5 billion on content in 2017 (read: “Game of Thrones”), and CBS (the most insightful of the American television networks) will spend just under $4 billion. Upstart Apple (AAPL) will spend about $1 billion on its first few new original content shows. Apple plans to give these shows away for a time starting in 2019 as their platform takes shape and they rebrand iTunes and Apple Music. Apple is planning on spending more than $4 billion by 2022. But, as you will see, that’s barely a drop in the bucket. All those Netflix billions are attracting major talent: Ryan Murphy, Jerry Seinfeld, Barak & Michelle Obama, Chris Rock, Shonda Rhimes and David Letterman to name a very partial list. Netflix will also, according to The Economist , produce, purchase or license an incredible 82 feature films this year, compared to just 23 films for Warner Brothers and 10 for Disney. Goldman Sachs projects Netflix could be spending $22.5 billion on content per year by 2022. This would be more than all the other American television and movie studios combined. Netflix reports that in the second quarter of 2018, Netflix had over 130 million streaming subscribers worldwide. Of these subscribers, 56.71 million were in the United States of America paying $9/month or more on average. Even though the amounts are different, Netflix’ financial power play of 2018 has echoes of another era: The “Golden” Age of Hollywood of the 1930s. A century ago, America’s leading filmmakers settled in and around Hollywood. The many reasons for this westward exodus came down to one factor: location. The enclave of Los Angeles was as far away as possible from the New Jersey home of Thomas Edison. The distance made it impractical for the litigious inventor to sue filmmakers for patent infringements. Furthermore, the LA climate made filming year round possible. Skies were not only sunny but cloudless, providing the consistent light needed for continuity in film. Hollywood was even optimal within the Los Angeles basin; being 15 miles inland, it was little affected by marine fog. Hollywood’s nearby and eclectic terrains—ranches, mountains, forest, desert and seashore—could pass for most locales in the world, particularly in black and white. Into this world arrived the men who founded the Hollywood studio system—Adolph Zukor, Louis B. Mayer, and the brothers Jack, Harry and Sam Warner— all Jewish immigrants from Eastern Europe. With checkbooks out, they tried to out spend each other to get “top” talent under contract (for a certain number of years or films) and keep these actors and directors away from the other studios. Wind the clock forward to 2018. The studios now are trying to attract talent away from Netflix. For example, Peter Roth (head of Warner Bros. Entertainment) paid Greg Berlanti, who has 15 shows on the air, the most of any TV producer in history. These include several adaptations of DC Comics franchises such as Supergirl and Arrow that appeal to tweens and young women. He’s particularly valuable to Warner Bros., which owns DC as well as half of the CW Television Network, where many of its shows air. Of the 12 series that will run in prime time on the CW this fall, Berlanti is an executive producer of seven. So with two years before Berlanti’s contract was set to expire, Roth offered the 46-year-old a deal worth at least $400 million to stay at Warner Bros. through 2024. Berlanti and Roth both declined to comment on the deal. It is believed to be one of the most lucrative for a TV producer in the history of Hollywood, according to published interviews with more than a dozen executives, agents, and producers. It’s also a sign of how traditional studios, tired of losing their best people to Netflix, are fighting back. Warner Bros. bought out Berlanti’s rights to future profits on all his current shows, what’s known as the "back end," a structure that allowed it to offer him more money upfront than he would have otherwise received. Everything in the world of content is upside down… from the “old days”. The real question going forward is this: Are there enough dollars to support Netflix’ content spend or are the gigantic outlays just a extremely expensive game of “Chicken”? The image of Standard Oil and the "good soaking" of a century ago comes to mind, when the petroleum giant cut prices to eliminate competition. If you believe Netflix’ subscription numbers:, yes, there are plenty of dollars and plenty of ancillary dollars waiting in the wings to support Netflix’ expansion. But we haven’t yet talked about Amazon (where founder Jeff Bezos hates coming in second). Anyone who has looked for the “best” talent knows that it is a finite number of people who create, write, compose, direct, shoot and edit the best material. You can have an endless checkbook… but it doesn’t make the number in the talent pool bigger. They just get more expensive. The other studios will have to decide if feeding off the “bottom” or out at the edge of relevance when it comes to talent is enough for them. For the foreseeable future, Netflix is setting the pace when it comes to spending on new content. And we have not even talked about whether Netflix will ever make money as a business.

Washington | This week The Institutional Risk Analyst is attending the Mortgage Bankers Association annual conference in Washington, D.C., where we will be reporting on the presentations, meetings and other events. Last week we spoke to Michael Lau, CEO at Pingora Asset Management. Mike is one of the leaders of the mortgage finance industry, particularly when it comes to the world of mortgage servicing rights or MSRs. Pingora currently manages $1.5 billion in MSRs representing approximately $125 billion in unpaid principal balance (UPB) of residential mortgages on behalf of a variety of institutional clients. The IRA: SO Michael, you have been traveling the country, meeting with lenders and investors. What is your take on the US mortgage finance sector as 2018 heads to an end? Lau: I was just in Kalamazoo, Grand Rapids, and Scottsbluff. Yesterday I went into the old Lehman Aurora building in Scottsbluff. They only finished the building in 2007 and, it was Lehman, so it was state of the art. They had two million loans there, blah, blah. It is like walking back in time. Every cube is still there. Every office is still furnished. There are still signs that say Aurora Bank. It is bizarre. And of course, the building is two-thirds empty. Mike Lau and James Tunkey at Leen's Lodge, June 2018 The IRA: In the mid-2000s, Aurora was one of our favorite examples of an outlier among banks at Institutional Risk Analytics. The Lehman FSB was the best performing thrift in the US in 2006 because of the flow of mortgages that went through its conduit. They had 50% equity returns. And then one day it wasn’t there. But turning to MSRs, talk about how you view the steady increase in valuations for loans and servicing over the past year and even the past five years. How do you explain this market to clients and help manage their expectations? Lau: In terms of large, bulk acquisitions of MSRs, the pricing has been driven by a handful of firms that have a relatively insatiable appetite for assets along with very cheap leverage. We exercise pricing discipline in order to manage to the return expectations of our investors. When we re-engineer the pricing on some of these large bulk deals being won by other firms, the way we model and particularly this year, these deals are trading on an un-levered basis at a 5-6% IRR. There is risk on these assets regardless of where interest rates are and because of the credit quality of the book. There’s always risk in MSRs. There are a lot of entities in the market today that are incented to grow because of the way they are compensated. The IRA: We could mention some names, but we take the point. All of the mortgage loan production of the past five years was mispriced thanks to the Fed destroying the risk premium and also the term structure of interest rates. The 10-year Treasury, for example, should have a 4% handle had the FOMC not done QE 2-3 and Operation Twist. Adding leverage does not help. In working on the GNMA MSR Liquidity paper this year, we finally understood the risky tradeoff between retaining the MSR and selling participations in the servicing strip to those same hungry investors you describe. How do you parse that risk? When you have to describe MSR credit risk to investors, how do you talk about retaining enough cash flow from the servicing strip to carry you through periods of higher defaults? Lau: The risk we worry about is rising cost to service due to higher delinquencies in the book. At some point in the next few years we are going to have a mild recession. You are starting to see the real estate markets moderating in many of the hot markets like Dallas and Denver. I was in Dallas last week. The home market above $500,000 in Dallas, which is a nice house, has suddenly gone from multiple offers to none. The same thing is occurring in Denver. We are see indicators that we are approaching an equilibrium between buyers and sellers, and even tilting towards a buyers market. The IRA: You see the same in New York. Our friends at Weiss Research called the turn in some of these markets a year ago, but the broad media is only just catching on because the Case-Shiller average lags the market. How do you think about valuation of MSRs in a market where leveraged financial buyers will hit every target in sight? Lau: We put our best foot forward. Honestly, we tend to lose those bulk deals that are $3 billion or more in UPB, Fannie and Freddie collateral and a discount weight average coupon (WAC). We tend to lose those pools by 10-15bps. We find it hard to rationalize being more aggressive on these deals. The IRA: There seems to be a significant divide between how the sellers and newer buyers see pricing and how some of the more seasoned servicers view the longer-term cost of servicing, especially in the discount coupons. The recovery rates on the $2.5 trillion in bank owned 1-4 family collateral are so good that they mask the credit cost – at least for now (see chart below). Banks are still three quarters of the total servicing book, compared to the 50-50 split with non-banks in the lending sphere. But have we see the end of the large bulk sales of MSRs? Source: FDIC Lau: The larger holders of servicing that did not like the asset have parted ways with it. The banks and non-banks that have the larger portfolios today are the ones who want to keep it and like the asset. They are generally accumulating more through origination or outright purchase. I don’t expect to see a material number of large deals in the near term. When you look at the divide between the banks and the non-banks, there will continue to be non-bank portfolios that range from two or three hundred million in UPB to a couple of billion that will be coming to market. On the origination side, margins are continuing to be pressured and volumes are weak. The purchase money market is going to be down next year. Refis have moderated to what we know is closer to normal, roughly 15-20% instead of what we’ve seen due to the artificially low rates we’ve had for the past ten years. The IRA: You can thank the Fed for that. The Fed manipulated the yield curve and drove a lot of loan volume as asset values rose, but now rising rates are killing demand even as spreads tighten. We suspect that a lot of those low coupon FHA loans, which are assumable, will never prepay. But why are volumes falling with so much accumulated equity, especially for refinancing? Lau: A lot of consumers are loathe to tap the equity in their homes. It is hard to rationalize doing a 4 7/8 or 5% loan today. Pricing is not ideal from a consumer perspective. The low coupon FHA loans will be a great tool for owners when they are ready to sell their house. We really have not seen a lot of assumptions in the past ten years but I believe that we will see an increase. The IRA: What is behind the poor profitability in the mortgage market? Is it the tightness of credit spreads generally or the decline in lending volumes? Lau: I honestly believe that there are two major themes on the loan origination side of the equation, whether we are talking about retail, wholesale or correspondent channels. Loan officer compensation is the elephant in the room that needs to be addressed and it is going to be a challenge. Dodd-Frank dictated how the Congress wants loan officer comp to be done to avoid steering, but it has created some unintended consequences as it relates to implementation. Production has always driven this industry. The better companies are around 100 to 110 bps in terms of loan comp, but the vast majority are around 125 to 150 bps. When you look at the loan officers being paid that much money and the companies that take all of the risk and have their equity at risk are working for a 5 bp margin pretax, that is not sustainable. The IRA: Well, as you just stated, the mortgage industry is essentially paying out equity to retain loan officers. What is the solution? Lau: We as an industry go through this periodically when we are on the downside of the lending cycle. We shoot ourselves in the foot because nobody has any pricing discipline and everyone is focused on maintaining market share. Lenders rationalize this by saying that they will be able to maintain fixed overhead. They hope that eventually, the marginal cost and marginal revenue lines will cross and they will make a lot of money. That is the beautiful thing about mortgage banking on the origination side because when you are in that position, you really make a lot of money. But few lenders are going to reach that point because they refuse to deal with the fixed part of the overhead relative to what realistic volumes are today. The IRA: As in the 2000s, the FOMC stimulated interest sensitive assets and a bubble resulted. You have just described the basic problem with neo-Keynesian economics. The Fed pulls lots of future sales into the present with low interest rates, but then volumes fall when the market demand is exhausted. Look at what is happening to auto sales. Everyone thought we would stabilize auto sales around 16-17 million units annually, but the auto market is shrinking after years of boom time sales growth driven by cheap credit. Lau: At the end of the day, 70% of the costs for most mortgage lenders is people. It is always challenging to cut people. You can look at the other 30% and tighten the belt, but if you are going to make significant cost reductions you have to lay off people. We have overcapacity. This industry is staffed to do $2 trillion in production annually, but we’ll do $1.6 trillion this year -- maybe. The IRA: Is the solution merely headcount reduction or do you have to come up with a new formula for compensating loan officers? Lau: In order to get the industry back to profitability, we must instill discipline around loan officer comp. The problem is that nobody wants to be the first one. If a lender reduces comp by 25 bp, then the better producers are going to go down the road to a competitor. That’s the fear that companies have with their better producers. Obviously lenders cannot collude on loan officer comp, but this is where we need leadership in the industry. You’ve got to have the bigger lenders take the step first. There has always been a differential between the big banks and the smaller non-bank lenders. And then you have Quicken which does not have loan officers and thus has a huge advantage in terms of their ability to price and be profitable. The IRA: Even with the huge television spend and marketing cost you think Quicken comes out ahead of the industry? That tells you that the industry needs to look at that model. What is the second issue affecting profitability after loan officer compensation? Lau: We are a dinosaur of an industry when it comes to IT. We have not effectively used technology. We still have paper files that are an inch thick. We are so slow to adopt any kind of cutting edge technology. You must have the best technology and work flow to be profitable. It is still a very clunky process to originate loans, which is part of the reason that I don’t work on the origination side. I manage a large servicing portfolio with 34 people, but only because we have sophisticated technology that we built to run our business efficiently. The IRA: Given what you are saying about operating costs and technology, is even being in the lending space a good idea? Should smaller players with access to capital be spending to build a loan business right now? Lau: This is the part of the cycle where the strong get stronger. This creates really good opportunities. The weaker are going to go away, either through acquisition or attrition. You will see much more consolidation next year than we saw this year. Production people are always optimistic. They always think that rates will fall and volumes will come back. But even after the rate hikes by the Fed, I still think that we are 50 to 100 bps away from what the natural market rate should be without the influence of the Fed. The IRA: Thanks Michael. Further Reading Zero Hedge: Donald Trump Is Right About The Fed Hedgeye: "Does Fed Tightening Trigger A Crisis?" #MichaelLau #MSR #MortgageFinance #Pingora #Lehman #AuroraBank #mortgagebankersassociation

New York | This week The Institutional Risk Analyst ponders Q3 ’18 earnings for financials and what other surprises lie ahead. The conventional wisdom on the Street is that higher interest rates are good for banks, but it is higher SPREADS that really matter. Today spreads are contracting as the Federal Open Market Committee forces short term interest rates higher. There is little demand in the market for higher short-term rates, but who needs demand when you have economists? Q: Will the FOMC’s relentless quest for “normal” as defined by the target for Fed Funds cause a liquidity squeeze among non-bank financial companies later this year or early in 2019? The entire Treasury yield curve moved about 25 bp higher in yield last week, a remarkably synchronized shift upward that caused many financial stocks to rise in reflexive response. Apart from an uptick in high yield spreads last week though, the corporate bond complex continues to see spreads grind lower on brisk investor demand (see chart below). And loan spreads, which compete with bond market execution and private equity, are not moving. Meanwhile in the world of non-bank finance, the prospect of rising rates is adding a significant burden on heavily leveraged lenders in the mortgage and consumer finance sectors. Wells Fargo (WFC), Chase and many others are shedding thousands of staff to right size shrinking residential lending businesses. There is already a steady outflow of firms and people as smaller issuers quietly shut their doors. We estimate that a significant portion of the issuers in the GNMA market could be out of business within the year. Last week in Washington we heard some of the biggest non-bank mortgage lenders in the US declare that while not yet concerned about credit quality today , they are very concerned about liquidity in the industry. In particular, the risk of over-leveraged developers of multi-family properties going bust is seen as a clear and present risk. By no coincidence, commercial banks are bidding aggressively for deposit business, well in excess of LIBOR plus 1%. Given that well more than half of the non-bank lenders in the residential mortgage finance space are probably in breech of loan covenants due to poor profitability, low capital or both, the question arises as to whether anyone at the FOMC is cognizant of this growing crisis. Non-banks are, after all, the customers of banks, typically the top 50 or so institutions. We wonder if Chairman Jay Powell and his colleagues on the FOMC will start to rethink the plan for boosting short-term rates further when a couple of large GNMA seller/servicers fail and file bankruptcy. “In years that end with eight -- like 2008, 1998 and 1988 -- we tend to see bad stuff happen,” notes one veteran mortgage banker. “When we’ve seen Treasury yield spreads invert, it is without exception a precursor to a liquidity issue. Today we have a non-bank mortgage finance industry levered a zillion to one with no credit risk, falling volumes and spreads, and no profits. We have to borrow money to make money, so higher interest rates are bad.” One of the things that economists and many investors fail to appreciate is that an increase in the absolute rate of interest in the market raises the overall cost of funds for banks as well as their customers. The rate charged for advances to fund new mortgage loans or to resolve delinquent loans is an important variable cost for a non-bank. Rising rates are a significant negative factor in terms of credit quality for these highly leveraged businesses. Also, the value of mortgage servicing assets can also be negatively impacted by rising funding costs. As readers of The IRA know very well, the costs of funds for US banks is increasing about 55% every 12 months, but interest earnings are rising by single digits. Thus our prediction in The IRA Bank Book that the growth rate of bank net interest income will flatten out and then go negative in 2019. This developing NIM squeeze is another example of the collateral damage caused by the “extraordinary” policy actions taken by the Fed during 2009-2015. What the Fed giveth in previous years, the Fed now taketh away by arbitrarily raising funding costs. We keep wondering why Chairman Powell and other members of the FOMC refer to the current state of US monetary policy as “accommodative” when assets prices in housing, commercial property and stocks are at record levels. And there is still a shortage of assets, real and financial, in technical terms a dearth of duration measured in the trillions of dollars. For this reason, we fully expect the 10-year Treasury bond to take a run at 3% yield between now and the end of the year as markets discount further rate Fed actions. Without an increase in spreads on bonds and loans of all types, it is difficult for banks to reprice their assets to adjust to rising funding costs. Take JPMorgan Chase (JPM) for example. At JPM, less than half of the total book is actually loans. The overall return on assets is dragged down by the relatively low returns on the bank’s bond portfolio. JPM earned 2.1% on its $2.5 trillion in assets after funding costs in the second quarter vs. 3% for the other 118 banks in the US about $10 billion in assets (aka “Peer Group 1” by the FFIEC). The bank earned a little over 5% gross spread before funding costs on its lending book, putting JPM better than three quarters of its peers on loan pricing, with an average almost a point higher than average. The cost of interest bearing balances at JPM was 1.45% at Q2’18, up 40bp since the start of the year. When you ponder the fact that this cost of funds figure could be 2% by year end, then you start to appreciate the enormity of the surprise in store for investors in bank stocks. As of Friday’s close, JPM was trading over 1.6x book value on a beta of 1.1. The Street has JPM delivering single digit revenue growth through 2022, but we suspect that those forward revenue estimates will be revised downward in good time. Of course, the earnings growth estimates are in the 20-30% range, suggesting continued cost cutting. Indeed, a number of Sell Side firms have recently boosted earnings estimates for JPM. The two key factors behind large bank earnings over the past decade are 1) cheap funding from the FOMC and 2) cost cutting. As funding costs for US banks “normalize” from $30 billion per quarter at Q2’18 to over $40 billion by year end, revisions to earnings estimates for JPM and other banks may start to turn downward. Given where interest rates are today, quarterly bank funding costs should continue to climb into the $60-70 billion range by next summer. The chart below shows funding costs and interest earnings for all US banks. When people stare at the numbers for the banking industry and try to guess what is going to happen next, they most often end up talking about the past. Understanding the oscillating cycles of credit, liquidity and market risk is perhaps more important. At present, high home prices and low loan to value (LTV) ratios provide a buffer for banks and investors against credit risk. We don’t expect to see significant credit losses on residential assets in the banking system for several more years. But there is considerable liquidity risk building in the financial markets as the FOMC continues its clumsy path toward normalization. Former Fed governor Kevin Warsh is right: the FOMC should have reduced the balance sheet before raising the Fed Funds rate. Past actions by the US central bank have distorted traditional indicators of credit demand, raising the possibility that market conditions actually are tighter than policy makers may suppose. Inverted yield curves may not predict recessions, but they do serve as a great indicator of liquidity risk events.

“Political economy is not a science, it’s a clinical art, like medicine.” Eliot Janeway (1913-1993) Washington | In this issue of The Institutional Risk Analyst we speak again to an old friend, William H. Janeway. Bill is a Managing Director and Senior Advisor of Warburg Pincus, and now a lecturer at Cambridge University, where he received his doctorate in economics as a Marshall Scholar. Our discussion with Bill back in 2009 (” New Hope for Financial Economics: Interview with Bill Janeway ”) was one of the most popular discussions ever published in The Institutional Risk Analyst. He just published a new edition of his important book “ Doing Capitalism in the Innovation Economy ” We spoke with Bill over lunch at The Lotos Club in New York. The IRA: Bill we loved your book when it came out half a decade ago, but the new edition is even better. Financial pros need to read the discussion of the remarkable series of deals and technologies you worked on over the years. With the benefit of time, talk about how you view the evolution of what you have called the “Three Player Game” between Markets, Speculators and the State? The role of the State seems to be diminished or, as you said, delegitimized as technology has created a new cadre of super corporations. Janeway: As you’ll gather from the new conclusion to the new edition, the “dark side” of the Three Player Game, the play on words between the Three Player Game and the three body problem in physics is not an accident. The point about the three body problem is that there is no stable equilibrium. There are an infinite number of configurations in the Three Player Game, as well, and, post 2008, we have definitely shifted into a different one. There are several elements, and you can trace causal relationships without being mechanistic about it. One is clearly - always in tension - the spillover from the marketplace into the distribution of political power. I talk about this more in the new edition because it is so evident. The IRA: Very clearly but nicely put. Janeway: I refer a lot to the work of Larry Bartels at Princeton who has written a great book called “Unequal Democracy.” For the past two hundred years, since President Andrew Jackson, we have had the coexistence of two sets of institutions, the marketplace and an open political process. Each has certain claims to legitimacy in terms of allocating resources and distributing the return on those resources. It does appear that over the past 30 years we’ve had a shift in the balance of power of the Three Player Game. with the marketplace having a greater weight than the political process than any time since the 1920s or even the pre-progressive era, the 1890s. There is some great work being done in this area. I always like to provide reading lists. The IRA: Would that there was more time to go through all of the wonderful footnotes in your book. You are very generous with your praise of good work. For example, in your book you have a wonderful quotation from Fernand Braudel: “Capitalism does not invent the market or production or consumption, it merely uses it.” Janeway: The noted historians Naomi Lamoreaux and William Novak co-edited a great set of essays in a volume published by Harvard entitled “ Corporations and American Democracy. ” The book contains a deep history of the evolution of the 14th Amendment and goes through generations of Supreme Court opinions. The second focus of the new edition is the unanticipated consequences of the digital revolution that I talk about at length, for example, namely the rise of the giant, “superstar” digital firms. Here the reference is to the work led by David Autor at MIT , showing that across all of the four digit SIC codes across industries there has been a material increase in market concentration. The top four firms account for a larger share of the market, and this is accompanied by an increase in profit margins. Despite important questions about how we measure profits, the apparent markup enjoyed by these firms suggest that they are able to capture rents. The IRA: Of course. We don’t enforce antitrust laws in the US, as evidenced by the banking sector. The largest banks grew after 2008, depositors and creditors saw their share of the interest earnings of banks cut by 90 percent thanks to the FOMC, and thereby fueled public anger and resentment against Wall Street that you describe in the book. Janeway: David Autor’s biggest contribution may be showing a visible decline in labor’s share of revenues across SIC codes. And then you have to go back through the Game to look at the enormous impact over a long generation through the 1970s of the triumph of the Mont Pelerin Society as translated into economic theory and political prescriptions mostly at the University of Chicago. In the broad political domain, Milton Friedman's book and TV series “Free to Choose” translated into Ronald Reagan saying in 1981 that “government is not the solution…,government is the problem." These ideas were deeply reinforced and rendered not just intellectually legitimate but politically powerful. Like the rise of the efficient market hypothesis and the rational expectations hypothesis, which pervaded the economics profession, we accepted that markets would deliver a solution that is both efficient and fair, and also stable. So the message was that the only economic role for government is to screw up markets that would otherwise be fair and efficient and stable. The IRA: Well 2008 seems to have refuted that idea pretty conclusively. Janeway: From the perspective of the economics of innovation, the field I am most concerned with, the idea of a marginal role for the state is a recipe for at best stagnation and at worst a freeze-frame. Without an entrepreneurial role for a mission-driven government legitimized, to make investments, innovation suffers and so does economic growth. The IRA: Just as banks do not fund risk investments, but instead this is the role for private equity, some investments like space exploration are too large for private capital, at least initially. Janeway: The third related factor in the dark side of the Three Player Game is the institutionalization of the market. With the dominant portion of investment cash being managed by people on behalf of other people, who must hit at least the same performance as the broad indices, there is an endogenous tendency toward short-term herding behavior. Connected with that was the idea that we could address the “agency problem” between management and owners by turning managers into owners by giving them lottery tickets in the form of stock options. Back in the 1970s, we called it “Silicon Valley socialism." If you wanted to induce a senior executive or engineer or anyone else to leave the safe harbor of Hewlett-Packard, you had to give them tickets to the lottery. Most tickets to the lottery and most stock options are never exercised because they expire worthless. A startup is one thing, but giving stock options to the managers of stable public companies with secure market positions is, I believe, a crime against society. I have sat on enough public company compensation committees to know that the directors all look at one another and say “we have a great management team.” It is the Lake Wobegon phenomenon where everyone is above average. The IRA: Get no argument from us. The agency problem is pervasive throughout American society. And the public shareholders or corporations have no effective way to limit executive compensation. But even large unicorns cannot escape from the law of cash flow. As your friend Fred Adler said: “Corporate happiness is positive cash flow.” But how are these changes affecting investment and thus innovation? Janeway: We’ve currently got an Administration in Washington that has decided that science and the use of science to generate evidence is in no way concerned with public policy. Cutbacks in the flow of information and dollars to support scientific research will have a significant impact on future innovation. The other piece of this, which at team at Duke led by Wes Cohen and Ashish Arora have researched extensively is the shortening of research time horizons for American corporations. They track how company-employed researchers have shifted away from publishing in science journals to putting their work in trade publications as a proxy for development funding. The IRA: So coming back to The Three Player Game, do you see any promising developments in the world of “artificial intelligence?” We have largely written off crypto currencies and blockchains as a dead end . We put quantitative models used in economics in the same bucket, but are fascinated by the particular. In your book, you alluded to using computers to do what computers do well, namely count, as opposed to trying to model human financial behavior or speech or whatever. Where is AI now vs when you began your work four decades ago? Janeway: I have been a student of AI since the 1970s when I got involved with Xerox PARC. Since 2008, we have seen speculative capital focused on extending the digital domain, the digitization of all things, and machine learning techniques applied to what is genuinely unique, which are these very large data sets. This is really the third wave of computer techniques being hyped as artificial intelligence. First was the 1960s when DARPA funded some of the earliest AI research in an example of effective state support. Then came expert systems in the 1970s and 80s. Now we have Machine Learning based on “deep networks”. Clearly there are applications where it can be very powerful, but based on my research and discussions with many people in the field, AI systems seem to be very brittle. They are subject to the implicit and explicit bias of the people who set up the training set. The IRA: That has always been the Achilles heel of search engines. Is it fuzzy and forgiving? Or does the search engine require a precise match? Obviously a huge area for military and intelligence research. What is AI good for commercially? This is not “simulated cognition” quite yet, is it? Janeway: AI systems seem to be good at pattern recognition when they have been properly trained as to the pattern in question. They are good at playing games where the rules of the game are given exogenously such as in chess or go. They are good at that. But the games that really matter, like the Three Player Game, are those where we must co-invent the rules as we go along. For example, in any conversation, even with people you know well, you are constantly trying to understand the context of the words used by the other speaker and vice versa. The IRA: Speaking of changing the rules as we go, how do you feel about the various unicorns in the market today that are violating Fred Adler’s rule about positive cash flow and happiness? Janeway: While the unicorn bubble along with crypto-mania has absorbed animal spirits and speculative fever and more money than will of course be realized in due course by the investors, what is missing is the dynamics in this country of applying what we learned in the 1950s and 1960s about creating a new, low-carbon economy in response to climate change. When Richard Nixon declared “war on cancer”, he mobilized the same dynamic as in any war, the suspension of prospective cost-benefit analysis at National Institutes of Health. What matters is being effective, not efficient. The NIH grew by a factor of ten and the new industry flourished. The entire genetics, genomics and biotechnology revolution came out of President Nixon declaring war on cancer. There is a nation state with a legitimate government that has taken climate change as the next category for massive state investment, and of course that is China. The big question facing the US is whether another nation will take the mantle of innovation leader in the 21st Century, much as the US took the lead from Europe in the early part of the last century. The IRA: Thanks Bill #WilliamJaneway #NaomiLamoreaux #WilliamNovak #TheMontPelerinSociety #WarburgPincus #FredAdler

New York | Last week we almost welcomed the news that the Securities and Exchange Commission had accused Tesla Motors (TSLA) founder Elon Musk of securities fraud. This is not because we hold any ill will towards Mr. Musk, but rather because news of the SEC action provided some relief from the political spectacle that dominated the past week. Speaking of real news, we were on CNBC Monday to talk financials with Brian Sullivan (below). Fortunately Mr. Musk was smart enough to cut a deal to settle the SEC charges on the following day, but that changes little for the hapless shareholders of TSLA. After years of false promises and worse, TSLA seems headed for a reckoning as a dearth of liquidity forces more difficult decisions. Access to liquidity provides time and protects control. As we said on Twitter over the weekend, the bond holders of Tesla own the company -- regardless of whether Musk is an officer of the company or not. But moving on to more promising considerations, we return to the question of the evolution of Goldman Sachs (GS) from securities dealer to commercial bank as the firm prepares to go through a leadership change. The leadership transition process at Goldman is not unlike a reptile shedding its skin. The century old firm gains a glossy veneer, a new outer shell, but inside the operational machinery of financial chicanery remains unchanged. Does it matter whether Lloyd Blankfein or David Solomon sit at the top of the house built by Marcus Goldman or Samuel Sachs? Not really. After all, the culture of Goldman Sachs is bigger than any single person. Goldman has always been a firm that seeks unique opportunities at the edge of propriety and often at the expense of clients and counterparties. Between July 2004 and May 2007, according to the Financial Crisis Inquiry Commission , GS packaged and sold $73 billion in synthetic collateralized debt obligations (CDOs) that referenced subprime mortgages. When the subprime loan market and related derivatives began to collapse, Goldman deliberately sought to shift its exposure to its clients. “Despite the first of Goldman’s business principles—that ‘our clients’ interests always come first’—documents indicate that the firm targeted less-sophisticated customers in its efforts to reduce subprime exposure,” the FCIC concluded with considerable understatement. In the Abacus 2004-1 CDO, the FCIC reported, GS earned nearly $1 billion while “long investors lost just about all of their investments.” As we’ve noted previously in The Institutional Risk Analyst (“ Is Goldman Sachs Really a Bank? Really? ”), GS is not so much a commercial bank as much as a large broker dealer with a small depository attached. In the decade since GS involuntarily converted its Utah non-bank industrial loan company into a commercial bank, and thereby came under the supervision of the Federal Reserve Board, the firm has become less innovative, if that is the right word. But the core competency of the firm remains informational arbitrage combined with all of the magic of derivatives and structured finance. For example, GS makes half the interest income of other large banks on its almost $1 trillion in total assets, just shy of 2% vs over 4% for the 119 members of Peer Group 1. GS is in the 90th percentile in terms of interest expense vs earning assets, a reflection of the bank’s tiny deposit base and dependence upon costly market funding. Of note, GS saw its cost of funds rise 68% year over year as of June 30, 2018, according to the latest FFIEC performance report, following the disturbing trend in the US banking industry of rising funding costs that we have highlighted previously. Indeed, when pondering the future under incoming CEO Solomon, ask yourself how much is Goldman Sachs willing or able to change its culture. To us, the first question facing Solomon and his colleagues on the board of GS is whether the company ought to reverse the 2008 decision to become a bank holding company and return to being a broker dealer that owns an industrial bank domiciled in Utah. If Goldman is to remain a trading firm, rather than a full service depository, then this would be the logical course of action. Support our Team in the Fight Against MS! For many years, there has been a lot of talk at GS about growing the existing bank’s business, but this has not materialized in assets, revenue and earnings. Just as Elon Musk has promised electric cars for his clients, GS has promised banking revenue for its shareholders. The bank was even given a name – Marcus – after firm co-founder, Marcus Goldman. GS has always been better at formulating investment schemes to deprive the less astute of their hard earned savings than lending them money for some productive purpose. Consider the Shenandoah and Blue Ridge investment trusts of 1928, a precursor of the derivatives mess at American International Group (AIG) in 2008. John Kenneth Galbraith in his essential book “The Great Crash 1929” wrote that Goldman’s nearly simultaneous promotion of Shenandoah and Blue Ridge in 1928 “was to stand as the pinnacle of new era finance. It is difficult not to marvel at the imagination implicit in this gargantuan insanity.” Galbraith immortalized the subsequent 1932 exchange between Senator James Couzens of Michigan and Samuel Goldman, the co-founder of the firm, during hearings on the market crash: Senator Couzens: Did Goldman Sachs organize the Goldman Sachs Trading Corporation? Mr. Sachs: Yes, sir. Senator Couzens: And it sold stock to the public? Mr. Sachs: A portion of it. The firms invested originally in ten percent of the entire issue for the sum of $10,000,000. Senator Couzens: And the remaining 90 percent was sold to the public? Mr. Sachs: Yes, sir. Senator Couzens: And at what price? Mr. Sachs: At $104. That is the old stock… the stock was spit two for one. Senator Couzens: And what is the price of the stock now? Mr. Sachs: Approximately $1¾. The fraud perpetrated by GS with respect to Shenandoah and Blue Ridge was monumental, but none of the firm’s principals did any jail time. Yet it took the great Goldman Sachs managing partner Sidney Weinberg decades of labor in corporate boardrooms and the salons of Washington to redeem the sins Goldman Sachs committed in the 1920s. By the time that Lloyd Blankfein took over as CEO in 2006, Goldman was as respectable as any investment bank – admittedly not much of a statement. But then as now, the business today is about arbitrage and sales, not the lending and credit management of commercial banking. If GS really has no intention of growing a commercial banking business, then why not save millions of dollars a year and simplify the firm’s regulatory structure by de-banking? The same comment goes for Morgan Stanley (MS), of note. If GS is really not serious about building a large depository business to go alongside the investment bank, then there is no point in dealing with the Fed and several other federal regulators. If, on the other hand, GS does truly want to become a full service bank, then Solomon and company need to consider a combination with an established regional depository, a bank that has core deposits and also has a commercial lending business. A wealth management business would be desirable as well. There are a number of possibilities including: Keycorp: With $138 billion in consolidated assets, Keycorp (KEY) is a solid regional bank headquartered in Cleveland, OH. The stock trades at 1.5x book on a beta of 0.9, so below market volatility for a stable business. But more than just a retail business and a $100 billion core deposit base, KEY is a significant national lender and has a strong position in financing and servicing commercial real estate – a sector that GS knows well. First Republic Bank: At $88 billion in total assets, this San Francisco based state-chartered unitary bank has carved out a profitable niche in wealth management and prime mortgage originations. First Republic Bank (FRC) has $66 billion in core deposits, $5 billion in fiduciary assets and another $12 billion in custody and safekeeping assets, and $21 billion in off balance sheet securitizations. And FRC competes head-to-head with Wells Fargo (WFC), JPMorgan (JPM) and Bank of America (BAC) in the prime jumbo channel, another asset class that Goldman knows and loves. At over 2x book value, FRC is not cheap – but then again, neither is GS at 1.1x book. Now of course the big question is whether the Fed and other regulators actually would allow the folks at GS to acquire a real bank with retail deposits. Some would argue that a decade after the financial crisis, GS has already lost much of the recklessness and “innovative” vision that characterized the firm’s market actions prior to 2008. Acquiring a large depository might help Goldman finally leave behind the bad old days and complete the transition to true mediocrity under the vigilant gaze of federal bank regulators. But somehow we think that GS under its new leadership will continue to focus on trading and investments, not commercial banking. Banking is about patience, prudence and care. Leaving aside the fact that GS resides at the bottom decile of Peer Group 1 when it comes to Tier One Capital, the idea of the masters of the universe making loans to consumers and managing credit seems too far fetched. Just as the Guardians of the Galaxy would never forsake their heritage as ravagers, the traders and bankers at Goldman are all about being smarter than everyone else. Better for Goldman to stay true to the proud legacy of Blue Ridge and Shenandoah, Penn Central and AIG Financial Products, ABACUS and Timber Wolf. In those glorious transactions, where the firm put its own interests ahead of those of its customers and counterparties, it proved that they will never really be bankers. Further Reading “YOU CAN’T OUT-LLOYD LLOYD”: AT GOLDMAN SACHS, THE DAVID SOLOMON ERA BEGINS WITH SUBTLE BUT SIGNIFICANT CHANGES William Cohan | Vanity Fair

New York | Q: How do you say “black swan” in Norwegian? A: sort svane . But hold that thought for a moment. Last week readers of The Institutional Risk Analyst probably did not notice the failure of a small NASDAQ clearing member in Scandinavia. The dollar amount of the default event was relatively small, but the details are disturbing in terms of the use of hidden leverage in the trade and the potential risk to central counterparties (CCPs) such as exchanges. The NASDAQ made the following statement: “On Monday September 10, 2018, the markets in Nordic and German power experienced an extreme movement in the spread. One of Nasdaq Clearing´s members had a portfolio containing a large spread position between Nordic and German Power that was negatively impacted by the fluctuations.” Negative indeed. We hear in the credit channel that the “private trader” leveraged his spread position multiple times, then doubled down again before the trade went sideways. The “relevant clearing member” was unable to meet a margin call, says NASDAQ, so the exchange saw the position closed out and liquidated at a loss. The exchange replenished the default fund via a $107 million euro assessment of the other clearing members. NASDAQ also stated: “When analyzing the data of the event, we concluded that the market movement leading to the extraordinary fluctuations in the defaulted portfolio´s spread was 17 times larger than the normal observed daily spread changes. This has also been confirmed by two external parties, and has been characterized as a true ‘Black Swan’ event.” Somebody call Nassim Taleb. Meanwhile, the aftermath of the NASDAQ default event played out in a lot of overtime for credit managers at a number of major US banks. The speed and suddenness of the event of default, which was apparently caused by excessive leverage in the trader's position, suggested that existing risk tolerances were at fault. But was there any way to even anticipate this market contortion? Did the NASDAQ surveillance function notice the over-leveraged position? Support Our Team for BikeMSNYC! You can of course say that the NASDAQ did their job, closed out the position in good order and passed the hat to the surviving clearing members to replenish the default fund. But the reality of the situation is far more complicated. When NASDAQ liquidated the positions, for example, the exchange had to use its own capital to close the positions. Had multiple clearing members failed at the same time, the thinly capitalized NASDAQ would have been under water. Not long ago the Research Department of the FRBNY posted a comment in the Liberty Street blog praising the manifold blessings of centralized clearing: “First, central clearing allows trades to be netted across all CCP members, lowering net settlement exposures and thereby reducing counterparty credit risks. Second, CCPs employ loss-sharing mechanisms that spread the cost of a member default across all members, thereby lowering the burden of default on any one participant. Third, the clearing process at a CCP is transparent and uniform for all CCP members, which reduces the uncertainty over potential losses owing to counterparty default.” Our colleague Nom de Plumber , a veteran of the world of credit and counterparty risk who appreciates a good bottle, begs to differ. He notes that the socialization of clearing-member counterparty losses “invites both adverse-selection and moral-hazard risks.” He continues: “Low regulatory credit-risk capital requirements (2% to 4%, per US Basel Rule Section 35) for counterparty exposures to CCPs seem hardly to suffice for or even acknowledge such risks, which gap market movements can materially exacerbate.” We agree with a number of our colleagues in the world of credit that while the Scandinavian default event last week was relatively small in terms of dollars, the large magnitude move in the position of a single trader forced the NASDAQ to use its own capital to fill the gap until the clearing members kicked in their share the following day. The loss sharing among clearing members is not instantaneous or equitable, thus the exchange must have capital of its own when a clearing member fails, otherwise the supposed benefits of CCP are an empty promise. One credit manager at a large bank told The Institutional Risk Analyst that the default process “did not work as entirely hoped.” He notes that the NASDAQ is getting a lot of questions from clearing members about the margin process and the auction of the position. One trader says that the NASDAQ did not notify some clearing members of the default for several days. “The lessons learned from securitizations and CDOs in terms of first loss waterfalls and the sequential failure of obligors do not seem to have translated into the world of centralized clearing," notes the veteran credit portfolio manager. "Are all clearing members equal? Are JPMorgan and the smallest clearing member that trades one product equal in terms of first loss? In this case, first loss was not properly assessed." Nom de Plumber agrees and notes that the one-size-fits-all process of CCP margin calls may also be a weakness, especially if non-member counterparties inject idiosyncratic counterparty risks---which can then be socialized to member counterparties, perhaps spawning systemic risk. He observes that the recent NASDAQ counterparty default loss may be an example. The FRBNY says that “CCPs employ loss-sharing mechanisms that spread the cost of a member default across all members, thereby lowering the burden of default on any one participant.” Perhaps. What the default of the NASDAQ member last week seems to illustrate is that a significant market move can take down a clearing member in an afternoon. Had the position been larger, a 10x standard deviation market move could have impaired the capital of other clearing members as well. Regulators take great comfort in the idea of centralized clearing, but a thinly capitalized exchange and clearing members may not provide much surety against contagion regardless of how the mutual clearing regime is labeled. The bottom line is that there is not much different between how centralized clearing exists today and the mutual exchanges that existed prior to the creation of the Federal Reserve System in 1913. As former Fed Chairman Ben Bernanke has noted in his research, sometimes exchanges die (see below). Further Reading Asset-Price "Bubbles" and Monetary Policy #NASDAQ #BlackSwan #Taleb #AmericanBalletTheater #GillianMurphy #sortsvane

New York | The term financial technology or “fintech” was reportedly coined back in the 1980s by Peter Knight in The Sunday Times , but from the start the buzzword carried political connotations. Banks are among the most protected industries, thus seeking to displace banks is by definition treasonable. Some media and investment circles joyfully described fintech as an alternative to big banks, especially following the 2008 financial debacle and bailout. Big banks are bad, so the post crisis consensus goes, thus smaller, new fintech firms perhaps are a good solution. With the innovation of technology, however, come all the perennial problems of modern finance. Bitcoin, blockchain and fintech all were dipped in the magical waters of salvation via technology, yet much of the time these “emerging” technologies and companies are just plain vanilla. Along with alternative money a la bitcoin, fintech has flourished into a new investment sector, at least in a virtual sense. When you actually peruse the growing list of firms that claim to be part of the fintech vanguard, very few of them actually bring new technology or even new business models to the table. Mostly fintech firms add efficiency and value on top of the old world of banks, which is naturally protected by regulation. The existing bank monopoly on credit and payments, as when a bank clears the payment you make on Amazon (AMZN), is a powerful barrier to entry for fintech firms. For the past several years, New York and other states have been battling with the Office of the Comptroller of the Currency (OCC) over that agency’s plan to offer “fintech” charters to online lenders and payment companies. The states lost the first round of litigation with the OCC, but now New York has just filed a new complaint, again arguing that the OCC’s fintech charters are unconstitutional and an affront to consumers. This fight between the OCC and the states is all ultimately about consumer politics and money. New York’s latest lawsuit reads more like a political manifesto than a serious legal argument as to the OCC’s long ago settled powers under the National Bank Act of 1865. The 2010 Dodd-Frank law gave back to the states significant powers in terms of federal preemption and the ability to bring enforcement actions under state law against national banks. But naturally the states and their political officials, who like the idea of levying big fines on financials firms, want more power. Maria Vullo, superintendent of New York’s Department of Financial Services, called the July 2018 decision by the OCC to let fintech firms obtain charters “lawless, ill-conceived, and destabilizing of financial markets,” reports Reuters . Spokesman Bryan Hubbard said OCC would vigorously defend its authority to grant national charters to qualified companies “engaged in the business of banking.” The OCC plans to allow “fintech” companies to operate under a national charter, thereby potentially replacing 50 state regulators and 50 state attorney’s general with a single federal watchdog in terms of activities. Also, fintech banks would still be regulated by the Bureau of Consumer Financial Protection. Significantly, these limited purpose OCC chartered fintech banks would not be depositories and would not offer deposits or have FDIC insurance. The OCC’s fintech charter offers a non-bank lender or mortgage company a way to avoid state law regulation entirely, but not be a full bank in terms of taking deposits or access to the payments system. Of interest, the OCC just announced preliminary approval for Varo Bank, a full service depository focused on consumer lending. It is notable that Varo Bank is sponsored by private equity firm Warburg Pincus, which has had a string of successful bank investments over the past decade. The firm’s counsel, Sullivan & Cromwell, notes that Varo Bank did not seek a fintech charter but instead sought full bank powers. “Rather, this approval relates to a full-service national bank charter with a nationwide ‘footprint.’ However, this approval, we believe, will be indicative of the OCC’s approach to applications by fintech businesses for special purpose charters.” Varo Bank was chartered by the OCC and approved by the FDIC in terms of federal deposit insurance, but no approval from the Fed was required or sought. Because Varo Bank is a national association chartered by the OCC and since there is no bank holding company, the Fed does not have any direct regulatory authority. Avoiding regulation by the Fed greatly reduces operating and compliance costs for “unitary” banks such as Bank of the Ozarks (OZK) and Signature Bank (SBNY). The developments with Varo Bank and Square, among others, are indications of evolving regulatory arbitrage between state and federal regulation more than the wonders of new technology. The harsh, often arbitrary actions of state regulators have greatly increased operating costs in all consumer facing credit lines and especially in the mortgage sector. Regulatory expenses can sometime exceed loan servicing fees in smaller states, for example, making mortgage lending is those jurisdictions problematic over the longer term. Fintech Bank vs ILC? One of our favorite LT equity holdings is Square ( SQ ), a payments processor that has created a very profitable niche by disrupting the bad old world of bank vendor accounts for small businesses. With considerable effort, Square pushed its way into the big bank world of payments, even without owning its own set of “rails,” but is Square a “tech” firm? Not so much. Square does not create new technology, but they make use of existing technologies in ways that never occurred to big dumb banks. In the context of the fintech wars between state and federal authorities, Square is significant because they have expressed interest in obtaining a bank charter. Specifically, the non-bank payments processor is reportedly preparing to apply for federal deposit insurance for a Utah industrial loan company (ILC), according to American Banker . FDIC Chairman Jelena McWilliams is said to be prepared to consider new applications for industrial banks aka "ILCs." FDIC officials have reportedly encouraged applicants to file “robust” applications that fully address safety and soundness concerns. While several states offer ILC charters, new entrants would likely select Utah chartered ILCs with FDIC insurance that can both take deposits and make loans. As readers of The Institutional Risk Analyst may recall, SoFi started down road to get an ILC charter but had to withdraw its application due to management turmoil . In the range of potential options for non-banks seeking to become a depository, an ILC seems superior to both a national bank and a thrift because they do not come under regulation by the Fed or OCC. Fewer regulators equals lower cost. A mortgage lender like Quicken or Caliber, for example, would not be considered bank holding companies by owning an ILC. Late vintage banks such as Goldman Sachs (GS), American Express (AX) and Morgan Stanley (MS) used to own ILCs before converting them to full bank charters during the 2008 financial crisis. An ILC would give non-banks access to both state law preemption for lending and servicing, and the ability to take deposits. Why is this important? Two reasons: First, the value of the float generated from the deposits created through lending and servicing consumer loans is growing every day. Second, a war is raging over the efforts by federal regulators to give non-bank financial firms a way to escape the noose of state law regulation. So why wouldn’t a mortgage servicer or auto loan issuer want a fintech bank charter? They might. But the more interesting and relevant pathway for many fintech and consumer finance companies to become banks is the ILC. By creating an industrial bank, consumer finance firms can enhance profitability and reduce operating costs while greatly simplifying regulatory and compliance tasks. An ILC typically is a state-chartered banking institution that functions in almost every way like a commercial bank. ILCs may make all types of loans and, most important, have access to the national payments system. If an ILC has more than $100 million in assets, it may not accept demand deposit accounts (DDAs). Larger ILCs may, however, offer NOW accounts, MMDAs, fiduciary and time deposits (CDs). Today industrial loan companies and industrial banks are FDIC-supervised, state-chartered financial institutions that are owned by commercial firms but not subject to supervision by the Federal Reserve Board and the non-bank activities limitations under the Bank Holding Company Act. The FDIC implemented a moratorium on granting new ILC charters in 2006 after the Federal Reserve Board and, later, the FDIC expressed policy concerns with the control of insured banks by large commercial firms, specifically WalMart ( WMT ). Section 603 of Dodd-Frank reflected the same policy concerns by Congress and put in place a statutory moratorium, but that freeze expired in 2013. The underlying provisions of law permitting control of ILCs by commercial and financial firms remain in effect. After a decade long hiatus, new players are seeking to own ILCs. If FDIC is indeed ready to process new ILC applications from financial firms, as opposed to commercial companies, then every well-managed and capitalized consumer lender and mortgage servicer in the country should be preparing an application. Is it time to consider turning your mortgage company or consumer lender into some sort of bank? Yes. But the ILC route rather than the OCC chartered fintech bank may be the optimal path. Contact us if you wish to discuss. Further Reading New York sues federal government over fintech bank charter plan Housing Wire #ILC #Fintech #OCC #NewYork #SoFi #LendingClub

In this issue of The Institutional Risk Analyst, we feature composer and media industry observer Michael Whalen on the prospects for CBS in the wake of the departure of CEO Les Moonves. A veteran of three decades in the business of creating and distributing audio and video content, Michael has won two Emmy Awards is a composer of over 650 television and film scores. Brooklyn | Even before Pulitzer-winning journalist Ronan Farrow identified Leslie Moonves as an alleged serial sexual abuser, a final straw which led to his resignation, you could have been misled into thinking that the merger of CBS (CBS) and Viacom (VIA) was "inevitable." After all, industry insiders and an army of consultants and investment bankers have waited more than two years for this anticipated marriage to consummate. But was the reunion of CBS and VIA really inevitable? The “Big 4” television networks (ABC, CBS, NBC, FOX) have been largely put back on their heels as the number of “cord cutters” (people who are disconnecting from their cable television service while keeping the Internet portion) will hit 33 million households in 2018. To give you some perspective, there are about 110 million single family homes in the US. From any point of view, how Americans are using the giant screens in their homes (don’t call them “televisions” anymore) has radically changed in the last 5 years. After 20 years of pressing and pushing, Netflix (NFLX) rules the content streaming universe -- for now. How does NFLX achieve this? By outspending its peers for content creation and licenses, and being very aggressive about pushing out their competition (both present and future). Television executives are at a loss at how to attract viewers, retain advertising revenue and keep the boat afloat for another season. The conventional wisdom says that having great content is a big part of how they will survive. But with AT&T (T) unit HBO slipping in overall popularity, this even while having hugely popular series like “Game of Thrones", “Westworld", “Ballers” and others, the answer to the question of how keep viewers is far more complicated. Into this maelstrom now comes former CBS CEO Leslie Moonves, arguably one of the few senior executives in the industry to respond to the challenge of cord cutting. Mr. Moonves had a successful television career before coming to CBS in 1995. In his many positions at VIA and then CBS, he pushed to break the walls down between the content that CBS was producing and the audience. What was in the way of change? Affiliates and cable companies. The old local affiliate networks of all the major television networks have been the pipelines for how programming was aggregated from the 1940s to now. Moonves towed the line with affiliates when needed, but in recent years he saw them as an irrelevant albatross. Criticized early on for being reactive without a cogent long-term strategy for CBS, Moonves pushed hard to have CBS be THE first of the traditional television networks to offer their content on an app (read: without a cable company [and their ancient carriage agreements] or a local television affiliate to stand in the way.) Today “CBS All-access” appears on every Apple (AAPL) TV device and all other iOS platforms with all of the prime time shows plus EVERY EPISODE OF EVERY SHOW EVER PRODUCED, plus one new series created just for streaming. The industry was shocked and viewers are thrilled. Quickly following suit were NBC (powered largely by their multi-channel + internet broadcast of the 2018 Winter Olympics in Pyeongchang), ABC and coming-in way behind has been FOX. CBS arguably has a five year lead on the other networks when it comes to the channel agnostic distribution of content. From the sidelines, Shari Redstone, the embattled daughter of Sumner Redstone (former CBS & Viacom Chairman) has watched as her own drama played out. At 62, she has been waiting for decades for her opportunity to be THE head of CBS/Viacom. Passed over by the CBS board in 2016, her not-too-secret plans for consolidating CBS/Viacom and replacing the board has been her greatest wish. Not surprisingly, Redstone does not care for the obsequious Mr. Moonves, this despite his clear success at CBS. Les was named Chairman of CBS in 2016 after her father’s resignation (she is vice chair). In the wake of the resignation, she released this statement: "my father's Trust states his intention that I succeed him as (non-executive) Chair at CBS and Viacom, and also names me as a Trustee after his death." Redstone stated that she wanted the chairs of each company to be "not a Trustee of my father's trust or otherwise intertwined in Redstone family matters." She only grudgingly nominated Les Moonves as the CBS chair. Philippe Dauman was named Chairman in 2016 (to replace Sumner Redstone), reportedly against Shari’s bitter boardroom protests. For many observers, Dauman’s elevation reportedly was the declaration of war that provided a pretext for now pushing massive changes at CBS. The multiple allegations of sexual misconduct, harassment and more against Moonves surprised no one who has known him or spent any serious time with him. A charming man, Les liked to flirt with the many actresses that graced his offices for decades (first at Warner Brothers and then at CBS). A longtime joke circulated in the hallways of CBS both in New York and LA was that: “Les needs an HR department all to himself.” Given the high-pressure politics of a television network, Les’ Achilles' heel with the ladies was known to the entire board of CBS. For years, the company had these complaints and incidents locked-down in the form of payments and settlements to at least three women. More like an episode of “Mad Men” and less like a publicly owned entertainment company, CBS accepted that part of the price of Moonves’ success was in managing this situation with discretion and an open checkbook. So, was it Ronan Farrow’s #MeToo revelation that ultimately threw out the man that built CBS into the only relevant and profitable television network in the United States? No, it was Shari Redstone. This was her coup d'état. She told the board that CBS would “no longer protect a serial abuser who’s actions could harm the company.” This pitch-perfect political response was anticipated but it was really only to remove a serious barrier to Shari taking control of the entire company. By having Moonves removed and putting the company into chaos, Redstone has the opportunity to reshape the CBS board and the future of CBS to her vision – finally. Is this risky? Yes, very risky. CBS shareholders LOVED Moonves and his ability to explain the strategy and rally the troops – especially in the tough times. Redstone has no television experience but is said to like the traditional TV affiliates because she understands how that part of the business works. Obviously, CBS’ ability to stay on top of the charts in the world of content is threatened without a clear vision and strong leadership to continue the evolution that Moonves started. Will CBS cut its own throat to satisfy the ambition of the founder’s daughter? That is a question that Shari Redstone and the boards of both companies must answer to their shareholders. In the meantime, the key question that should warrant the full attention of investors and the media is where next will Les Moonves land? Where will this proven operator take those decades of experience and contacts? By ejecting Moonves, Redstone is perhaps helping one of her competitors to make up for lost ground. #LeslieMonvees #CBS #Viacom #Redstone #MeToo

New York | People keep asking what we think of the 10-year anniversary of the collapse of Lehman Brothers. Our answer is that not much has changed. Lehman once had the best performing bank in the US and then it was gone. Why? Fraud on loans and securities. Fraud in different forms still prevails in the world of investing, but has migrated from banks to non-banks like funds and BDCs, and of course structured securities. Derivatives are the enablers of fraud. That is the core lesson of the 2008 financial crisis, but a truth that is rarely discussed. Instead we talk endlessly about "capital" as though it matters. Saying banal, irrelevant things about the anniversary of the Lehman failure certainly helps to fill an otherwise empty media void. But we never, ever talk about the true cause of the crisis, namely securities fraud by some of the biggest firms on Wall Street. These bankers and firms were not punished, thus we remain at risk. Not only has nothing changed since 2008, but as in 2006, we have convinced ourselves that everything is just fine. Residential and commercial real estate valuations have gone crazy since 2010, but everything is fine. Just remember that the financial crisis of 2008 really began in 2005 when Countrywide and Washington Mutual began their slow motion collapse, like a small rock slide at the top of a mountain. By 2006 the mortgage market was slowing -- as it is today -- and smaller non-bank firms were collapsing under the double whammy of falling volumes and rising costs. When New Century Financial and Long Beach collapsed in 2007, regulators were approached about the coming contagion, but nobody at the Fed or other agencies believed it. By 2008 came the avalanche. We identified the cause of the subprime crisis a decade ago in a paper published by Indiana State University entitled: "The Subprime Crisis: Cause, Effect and Consequences." We argued that three basic issues were at the root of the problem -- issues that remain unresolved today. First was an odious public policy partnership, spawned in Washington and comprising hundreds of companies, associations and government agencies, to enhance the availability of affordable housing via the use of creative financing techniques. Second, federal regulators have actively encouraged the rapid growth of over-the-counter (OTC) derivatives and securities by all types of financial institutions. And third, also bearing blame for the subprime crisis is the related embrace by the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board of fair value accounting. Again, nothing has changed in a decade. Most of the "sales" of securities done on Wall Street are not true sales at all. For example, how does a lender transfer the ability-to-repay (ATR) risk in a prime, non-QM mortgage to an end investor? Ben Bernanke, Hank Paulson and Tim Geithner are heroes and the regulators will save us next time. Click here to read the paper on SSRN. Further Reading Why Rising Interest Rates Are Not Always Good For Banks https://www.zerohedge.com/news/2018-09-07/why-rising-interest-rates-are-not-always-good-banks #LehmanBrothers #FederalReserveBoard #NewCenturyFinancial

New York | In this issue of The Institutional Risk Analyst , we take a look at an important player in the world of mortgage finance, Texas Capital Bancshares (TCBI), a $27 billion asset institution that punches well above its weight in regional and national markets. If you want to know how we view the entire US banking industry, including our projections for bank funding costs, the latest Q3'18 edition of The IRA Bank Book is now available in our online store. The first thing to notice about TCBI is that the stock price is up 20% over the past year, outperforming the S&P 500. It currently trades around 2x book value, putting it into the select category of smaller members of Peer Group 1. The equity of the Dallas-based institution has a beta of almost 2, making it twice as volatile as the broad market and a comp for high beta stocks such as Citigroup (C). Bank of the Ozarks (OZRK) has a beta of 1.4, by comparison. Half of the bank’s $22 billion loan book is allocated to commercial and industrial loans, with about a quarter of total loans held in mortgage finance loans. But that statistic is misleading. Over the past six months, the bank originated and sold short-term mortgage finance loans totaling $45.6 billion or twice the bank’s balance sheet. The C&I loan portfolio includes business finance and energy sector loans. A lot of the bank’s exposure is tied to the Texas economy and, directly and indirectly, to residential and commercial real estate, but TCBI has a national footprint. “More than 50% of our loan exposure is outside of Texas and more than 50% of our deposits are sourced outside of Texas,” TCBI notes in its most recent 10-Q. “However, as of June 30, 2018, a majority of our loans held for investment, excluding our mortgage finance loans and other national lines of business, were to businesses with headquarters and operations in Texas. This geographic concentration subjects the loan portfolio to the general economic conditions within this area. We also make loans to these customers that are secured by assets located outside of Texas.” TCBI is a significant lender to mortgage finance companies, an important but increasingly risky business given the parlous state of the residential lending business. One national warehouse lender told The Institutional Risk Analyst last month that most non-bank mortgage lenders are in violation of their loan covenants due to the poor profitability of the industry. The good news is that most of TCBI’s lending is secured, but once the non-bank mortgage company disappears, the customer is gone and so is the revenue. The watchword in the world of mortgage finance today is “forbearance.” TCBI is a very strong financial performer, consistently reporting above peer profits and below peer loan loss rates. The bank is very focused on lending as opposed to non-interest income, with almost 88% of total assets in loans and leases vs the mid-60s for its peers. Interest income from earning assets is near the top of the peer group, but loan commitments as a percentage of total loans – what we call “exposure at default” in the lingo of Basel I -- is actually lower than its larger peers. Significantly, 85% of the bank’s deposits are sourced from “core customers,” the life’s blood of any lender. But with that said, the rate of growth in non-core funding is far higher than its peers, reflecting the above peer rate of asset growth for the bank. This includes $4 billion in advances from the Federal Home Loan Banks or some 15% of total assets. Overall, the funding costs for TCBI have doubled over the past 12 months as with many other banks in the US There are two big potential threats on the horizon for small, growth oriented lenders such as TCBI. First, the real estate market will eventually cool, making the easy money seen in recent years just a distant memory. That process is already underway in many markets served by this institution. When residential and commercial real estate prices start to weaken in markets such as Texas, that's when you learn that all loans have real estate exposure behind them. Second, the phenomenal economic growth experienced in Texas over the past decade may also start to falter. “At a time where rest of the country is challenged by aging populations, slowing workforce growth and a loss of working age population, with this population growth, Texas is bucking a lot of those trends,” says Robert Kaplan, President of the Federal Reserve Bank of Dallas. “Texas is extremely well positioned.” Trees never grow to the sky, even South of the Pecos. But in Texas sometimes the trees can get so tall that you don’t see the clouds forming on the horizon. Remember the oil bust of the 1970s and pass the hot sauce please.

Grand Lake Stream | The discussions this weekend at Leen’s Lodge in Maine were wide ranging and, as always, of great interest. Will Argentina’s economy implode? (A: Sadly yes). Argentina is trading at a discount to Uruguay. Will the commercial real estate market in the UK likewise collapse as the train wreck called Brexit unfolds? (A: In progress). When will the yield curve invert? (A: Soon). Indian Township, Maine One of the most interesting points of debate was the impact of the 2001 decision by the US Treasury to focus debt issuance on the front of the yield curve in order to minimize the debt service cost to the United States. Along the way, the question arose: Is the United States really a “AAA” credit? Readers of The Institutional Risk Analyst know that we have recently been focused on how Fed policy has manipulated the pricing of the yield curve as well as private credit spreads . But so too has the Treasury’s decision almost two decades ago to limit issuance of 30-year debt affected the cost of credit and, at the present time, is exacerbating the flattening of the yield curve. On October 31, 2001, following the 9/11 attacks, Treasury Undersecretary for Domestic Finance Peter Fisher famously made the following statement: “We do not need the 30-year bond to meet the government's current financing needs, nor those that we expect to face in coming years. Looking beyond the next few years, as I already observed, we believe that the likely outcome is that the federal government's fiscal position will improve after the temporary setback that we are now experiencing.” But of course the Treasury’s fiscal situation did not improve. Since 9/11, continued profligacy in Washington has caused the federal debt to explode. As the surge of tax receipts generated by the aging of the baby boom have ebbed, the indebtedness of the United States has soared and with it the portion of US debt that is issued in short-term maturities. The 2017 tax legislation has only accelerated an already negative fiscal trend. The General Accountability Office notes in its most recent audit that since fiscal year 1997 total federal debt has increased by 275 percent. Also during this period, the statutory debt limit has been raised 17 times. The GAO notes in its most recent audit report: “Debt held by the public as a share of gross domestic product (GDP) was roughly 76 percent at the end of fiscal year 2017, down slightly from roughly 77 percent at the end of fiscal year 2016. Over the longer term, debt held by the public as a share of GDP is expected to grow as a result of the structural imbalance between revenue and spending. Federal spending on health care programs—driven by an aging population—and interest on the debt held by the public are the key drivers of growing spending in the long term… While today’s relatively lower interest rates have kept interest costs down, interest rates are expected to rise in the long term, resulting in increasing interest costs on the debt. The key drivers of spending will continue to put upward pressure on the budget. Absent action to address the growing imbalance between spending and revenue, the federal government faces an unsustainable growth in debt.” On August 5, 2011, Standard & Poor's (S&P) reduced the US sovereign rating from AAA (outstanding) to AA+ (excellent), causing more than a little commotion among the economists and investment professionals attending Camp Kotok at the time. Panicked members of the financial media were seen desperately trying to acquire a cell phone connection in order to opine on the S&P action. Of note, at the time of the rating action, S&P left the transfer and convertibility (T&C) assessment of the US at “AAA” in a reflection of the strong global acceptance of the dollar as a means of exchange. The fact of the dollar’s role as the reserve currency, as a means of exchange and also as a store of value for the citizens of smaller nations enables the US to largely escape the consequences of the libertine behavior of Congress. Nations such as Argentina, Greece, Venezuela and Turkey feel the consequence of fiscal deficits in terms of T&C. Just as investors like to trade the equity of zombie banks like Citigroup (C) and Deutsche Bank (DB) because of liquidity, the world uses dollars because of universal acceptance and size. No other currency is big enough to support international trade flows for things like energy and capital goods, and also be the reserve currency for global finance. This is the key factor that enables the US to avoid the impact of increasingly absurd fiscal decisions in Washington. As noted in the 2010 book “ Inflated: How Money and Debt Built the American Dream, ” Americans like to think themselves prudent in financial matters, but also have a libertine streak a mile wide. The purposeful citizens who a century ago survived depressions and wars have been succeeded by grandchildren who neither know nor understand practical limits to their wants and desires. Whether or not governments in China or Russia buy Treasury debt or not does not matter, for now at least, because the vast world of dollar finance will easily absorb the assets. The slowly deteriorating credit standing of the US seems to prove the old judgment that Americans will always do the right thing after exhausting all of the other possibilities. For now the fact of dollar hegemony saves us from our collective idiocy – as when the Congress confiscates the assets of the Federal Reserve System to paper over what thin budgetary restraints remain. The Fed is the alter ego of the Treasury in financial and economic terms, a nuance that is happily ignored in Washington. In 21st century America, members of Congress pretend that debt forgiveness by the central bank – aka “quantitative easing” -- is revenue. Members of the FOMC are notably silent on the question. When Americans reach the point of seeing debt-to-GDP for publicly held debt over 100%, then both S&P and the other rating agencies will be forced to start weighing quantitative fiscal factors more heavily. In terms of total debt, we're already there. The special role of the dollar as a global exchange medium will come under greater pressure as the public debt grows. When and if the markets ever start to cool on dollars, the management of the Treasury’s debt issuance strategy may also come under scrutiny. Back in 2001, Peter Fisher outlined two possible but “less likely outcomes” for the US following the 9/11 attacks: “First, it is possible that the federal government will return to significant and sustained budget surpluses even more quickly than we now expect. In this event, maintaining current issuance levels of 30-year bonds would be unnecessary and expensive to taxpayers.” “Second, we face the possibility that sustained surpluses do not materialize as promptly as we now expect. If later in this decade it turns out that 30-year borrowing is necessary to meet the government's financing needs, it is still likely that our decision to suspend 30-year borrowing at this time will have saved the taxpayers money. In addition, the reintroduction of the 30-year bond, at some point in the future, if necessary, would likely be costless to the Treasury.” In 2009 during the depths of the financial crisis, the Treasury temporarily reversed the Fisher decision and began to issue longer-dated securities. From an average maturity of just 45 months in 2009 the Treasury issued longer dated debt until the end of 2017, when the average maturity reached almost 72 months, Bloomberg reports. At one point Treasury Secretary Steven Mnuchin actually talked about issuing an ultra-long bond with a maturity of more than 30 years, but such ruminations have stopped with the end of QE. Almost two decades since 9/11, the fiscal situation of the US has reached crisis proportions, but so far Washington is saved by the fact that the dollar is still the biggest game in town. The Fed’s experiment with purchases of trillions in Treasury debt, the kind of behavior seen from developing nations like Mexico and Argentina during the 1980s debt crisis, has also provided a huge subsidy to the Treasury. Congress may one day mandate such an expedient on a permanent basis. In the event, the pretense of Fed independence will be discarded with finality and America’s credit rating is likely to fall further. The decision by Treasury in 2001 and more recently in 2017 to limit the duration of the Treasury’s debt, may have less efficacy in a world where central banks are manipulating interest rates and credit spreads. Or more to the point, if the Treasury today can borrow at 30 or 50 or even a hundred years at low single digit rates, why doesn’t Secretary Mnuchin do that trade? Additional issuance of longer dated Treasury debt might counteract a flattening curve and restore spreads and profitability to many parts of the financial economy such as banking and housing finance. As we'll be discussing in future issues of The Institutional Risk Analyst , US banks are not profitable because they are making great spreads on loans or securities, but because of cheap funding -- an advantage that is rapidly disappearing. Nations like Argentina and Turkey show the dangers of funding in dollars when you have a weak, small currency. Size matters. That is one big reason why the EU, China and Brazil have not been able to create an effective competitor to the dollar. Those remaining “AAA” sovereigns like Canada, Australia and Belgium have limited capital markets access. But if Americans manage to convince the rest of the world that we are indeed libertines and appropriate subjects for ridicule, then size may become a considerable disadvantage. As Mark Twain observed: “Suppose you were an idiot, and suppose you were a member of Congress; but I repeat myself.” View from landing at Leen's Lodge on West Grand Lake #CampKotok #PeterFisher #Treasury #Mnuchin

New York | Last week Federal Reserve Board Chairman Jerome Powell confirmed that the Federal Open Market Committee intends to keep raising short-term interest rates based upon the strength of the US economy. Powell gave no indication that he is concerned about the rapidly approaching inversion of the Treasury yield curve or what this portends for banks and leveraged investors of all stripes, including the housing finance sector. Also last week, the Federal Deposit Insurance Corporation released the Q2 ’18 data for the US banking industry, allowing us to update readers of The Institutional Risk Analyst on the increasingly dire situation in the credit markets. Spreads are as tight as they’ve been in decades and behavior by issuers grows more absurd by the day. Bank interest income rose 15.7% year-over-year but interest costs rose 61% between Q2’17 and Q2’18. We’ll be updating our projections for the impending peak and decline in bank net interest margins after Labor Day in The IRA Bank Book. Even though the costs of funds for US banks is rising four times faster than bank interest earnings, the degree of financial subsidy -- aka "financial repression" -- to the US banking system c/o the FOMC remains massive. As the chart below illustrates, 83% of bank net interest earnings is still going to bank equity investors vs just 17% to depositors and bond holders. Or to quote Barry Ritholtz over the weekend: “I always translate the phrase ‘financial repression’ as ‘God damn, I just missed a hell of an equities rally.’” Banks have benefited enormously from “quantitative easing” (QE). “Net interest income totaled $134.1 billion, an increase of $10.7 billion (8.7 percent) from 12 months earlier and the largest annual dollar increase ever reported by the industry,” notes the FDIC. But strangely our favorite prudential regulator fails to note that bank funding costs rose $5 billion in Q2’18 and, by year end, interest expenses will be rising as much or even faster than are bank asset returns. The same curve flattening dynamic that is threatening bank profitability will also severely impact REITs and other leveraged investors, which may be forced to liquidate leveraged positions. Unless and until the Fed liquidates its own portfolio down to pre-crisis levels (~ $3.2 trillion), the return on bank assets is unlikely to rise very quickly. Under the baseline scenario released by the Federal Reserve Bank of New York in April 2017, the FOMC would push excess reserves down from $2 trillion today to ~ $500 billion in 2021 in a "normalized" Fed balance sheet. Of note, there is currently a debate inside the Fed as to whether the FOMC should slow its portfolio reduction plans in order to maintain a higher level of excess reserves. In an excellent August 14 research report entitled "The Fed's USD1.0tr question," Kevin Logan of HSBC writes: “[R]ecent money market developments suggest that the demand for bank reserves in a normalized Fed balance sheet could be USD1trn or more, at least twice as large as the USD500bn in the New York Fed’s baseline scenario. New bank regulations imposed after the 2008/2009 financial crisis have increased the amount of high quality liquid assets (HQLA) that banks are now required to hold. Reserves held at the Fed are the ultimate in HQLA for banks. They are completely liquid and, from a credit risk standpoint, are of the highest quality.” Logan argues that the FOMC may end its portfolio reduction program sooner than expected, perhaps by the end of 2019 because regulatory changes have made a larger excess reserve position necessary. But he also notes that: “[S]everal academics and former Fed officials have argued that the Fed should return to a small balance sheet, one in which reserves are scarce. They argue that a large balance sheet distorts capital markets by putting unnecessary downward pressure on longer-term interest rates. A large balance sheet could also impede market functioning and the price signals coming from an active federal funds market that reflects the credit worthiness of banks involved in the market.” Put us on the side of the academics and former Fed officials who understand that the FOMC’s expansion of excess reserves to fund its purchases of trillions of dollars in securities for QE did enormous damage to the US money markets – damage yet to be undone. Instead of encouraging banks to again buy US Treasury debt to fund liquidity requirements, the FOMC apparently prefers to further subsidize the banking industry by indefinitely providing a ready supply of risk-free assets in the form of excess reserves. But doing so also suggests that bank interest income will not rise along with the FOMC’s increase in short-term interest rates, as shown in the chart below. We all need to remember that QE was not a form of economic "stimulus," but rather a backdoor subsidy for the US Treasury. The bonds owned by the FOMC that created the excess reserves ought to be in private hands. The Fed (and other central banks) are suppressing long-term interest rates by holding $10 trillion worth of securities, positions that are entirely passive, not financed in the private markets and also unhedged. These large portfolios of securities held by central banks are not only keeping long-term rates down, but are also responsible for tight credit spreads and low levels of secondary market activity. The only beneficiaries of QE are the growing number of governments among the G-10 nations that are headed for debt problems. Some economists worry that providing banks with risk free reserves discourages lending, but we think the damage to the money markets is a far more grave concern. QE and “Operation Twist” have forcibly crushed credit spreads and loan profitability. Large US banks, for example, lost almost 1% net on residential production in Q2’18, according to the Mortgage Bankers Association. As in 2006, banks in the residential mortgage sector are fighting over conforming loans to put into private label securitization deals, this as lending volumes fall. Only by gradually forcing banks to shed excess reserves and replace these risk free assets with Treasury and agency securities will the money markets again begin to operate. Of course, as excess reserves run off, the real debt load on the Treasury will grow. Do Jay Powell and the other FOMC members have the political courage to end the subsidies for the US Treasury and banks, and thereby end financial repression? If the FOMC sticks to its guns and pushes excess reserves down to $500 billion as now planned, long term rates will rise, the functioning of private money markets will return and savers will see an increased share of the interest rate pie. Banks will trade and hedge and finance larger Treasury positions, and this private market activity will put upward pressure on long-term Treasury yields. Dealers will earn additional income from an increase in trading and hedging activity. Lenders may even start to see expansion of spreads for credit products. Then and only then, when the functioning of private markets have been restored, can the FOMC truly declare victory. #financialrepression #REIT #HSBC