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As Q1 2020 ends, the global banking industry faces a world that has been completely changed by the economic impact of the Wuhan virus, COVID19. Financing markets are greatly constrained and banks and government-supported debt markets remain the sole remaining islands of liquidity. Markets for corporate bonds and asset backed securities have taken a substantial hit and credit spreads have more than doubled in the past two weeks for many issuers. There are two worlds now: securities eligible for repo with the New York Fed and those that are not eligible for liquidity support. While public equity markets have rebounded after days of record selling, the markets for private equity and related debt remain disrupted and are likely to remain so for the foreseeable future. It is important for investors to understand that the Federal Reserve is going to provide liquidity to many different markets, but it cannot handle the process of restructuring credit defaults. This is one reason why the Fed has hired BlackRock (NYSE:BLK) to act as manager for its bond purchases a la 2008. The CARES Act provides liquidity for advances to cover arrears at mortgage servicers, for example, but no subsidies for actual credit defaults. In terms of Q1 2020 earnings, here’s what we expect from the banks: * The good news is that actual credit losses in general are likely to rise modestly in Q1, but the big change is going to be delayed until June 2020. We expect to see a modest increase in mortgage loan delinquency in March, for example, but the big numbers are probably not going to be seen until April 25th, when coupon payments are due on most MBS and advances increase proportionately. * The once benevolent balance between credit costs, income and cash dividends is about to be violated, but probably not in a big way until the June quarter end. This is a blessing and a curse, of sorts, since we have 90 days to ponder the substance as well as the presentation of the coming results, even as new information comes in regarding credit events. Most banks simply lack the data to make changes in credit risk allocations, but it goes without saying that a number of bank credits have slipped into “special mention” in the past two weeks. * Here’s our best guess of what bank provisions and net income look like over the next two quarters. We double provisions each quarter from the Q4 2019 baseline, hold income and expenses roughly stable in Q1, then start to push down net interest income and increase non-interest expense in Q2. Source: FDIC/WGA LLC * Q1 will be relatively quiet for financials compared to what lies ahead for the rest of 2020. As loan payment delinquency starts to accumulate in Q2, however, we expect that the larger banks and nonbanks are going to be forced to provide monthly guidance to investors on default rates and financing. * We expect, for example, that the increase in residential mortgage loan delinquency and the related advances to pay interest on agency and government MBS will be quite large for banks and nonbanks alike. Thus the Council of State Bank Supervisors wrote a letter requesting that the Federal Reserve Board invoke Section 13 (3) of the Act to directly support advances by nonbank mortgage servicers. * The financing issue is not merely a nonbank concern. Think about the cost of financing advances when we see significant delinquency on the $1.2 trillion servicing book of Wells Fargo & Co (NYSE:WFC) . More than just the credit costs of coming payment disruptions, the US banking and nonbank sector is about to undergo a vast expansion of operations around loan servicing and default mitigation. We are talking about increases in operating costs and decreases in short term fee revenue due to defaults of significant size and at least as large as 2008. * While the full weight of the credit costs COVID19 crisis will not be reflected in Q1 earnings, there are a lot of marks to bond positions and credit portfolios that will take down marks. Specifically, there are whole classes of corporate securities that have effectively been downgraded. Even things like the credit-risk transfer (CRT) bonds issued by the GSEs have fallen to distressed spreads over Treasuries. Just imagine what would have happened to large nonbank mortgage issuers like Fannie Mae and Freddie Mac last week were they already "privatized?" As we noted in ZeroHedge this week, the negative marks that must be taken to a variety of hedge and trading positions are going to be brutal in Q1 2020, effectively the precursor for more and continued bad news coming from the corporate and asset backed securities sectors over the balance of the year. Again, if the assets are not eligible for margin or repo, then they are likely to be illiquid. We continue to worry that some platforms in the REIT sector may be forced into a forced liquidation. The good news is that the market valuations of banks seem to have stabilized and credit spreads are starting to narrow on publicly traded financials. Citigroup (NYSE:C) is trading at half of book and +140bp over the curve in 5-year CDS, while Goldman Sachs (NYSE:GS) is loitering around 0.6x book and +140bp over the curve in CDS. More important, US banks have largely curtailed share repurchases, adding $30-40 billion per quarter to internal cash flow that is now available to absorb credit losses. Despite these grim figures, we'd strike a positive note. We've been accumulating bank preferreds this past week, in many cases below par. Recall that it was not capital that saw US banks through the 2008 financial crisis, but raw earnings power that was available to fund loan losses without touching capital. With the notable exception of the Citigroup rescue, the US banking industry cleaned up its own mess in 2008, with the active assistance of nonbank mortgage servicers we'd add. Remember that in Q4 2019, US banks had almost $150 billion in net income, dividends and cash used for share repurchases available to absorb losses . This substantial cash flow is now about to absorb the full weight of the COVID19 virus disruption. Yes, the numbers are large, but in our judgement, more than manageable by the US banking system. Source: Federal Reserve Form Y-9 We’ll be taking a look at the top-10 US banks and the outlook for financials in our next credit report which will be available in The IRA online store Monday.

New York | As the US financial markets get ready for another volatile week, leaders in the mortgage finance sector spent the weekend in meetings with regulators trying to fashion a way forward. In the $12 trillion marketplace for mortgage finance, liquidity is rapidly disappearing. Banks and even the GSEs are said to be backing away from the mortgage markets with potentially disastrous results. As one dealer noted on Friday: “The specified pool market is dead... there is no spec anymore, it is all TBA. The Fed action this morning did nothing. There are no buyers in the market. The refi rate is between 4.75-5.00%. There has been a massive widening of the Primary rate to swaps & Treasuries.” Another veteran mortgage manager tells The Institutional Risk Analyst : "You need to get them to buy $1 trillion of agency now.  They need to suspend the Volcker rule.  Banks are our only chance to not go into a depression.  They have to fix the system to let banks add liquidity. We also need a PPIP.  Get the mortgage market working.   ABS is totally shut down.  DoubleLines of the world are panicking.  This is worse than 2008 for the system.   If they don’t act soon we are in real trouble." Despite the efforts so far from the Federal Reserve, the mortgage finance markets are increasingly dysfunctional and the risk of a significant financial failure is growing. For example: * Liquidity is drying up in the short-term mortgage financing market for loans, mortgage backed securities (MBS) and servicing advances. There are no bids for specified pools in either the government or conventional markets. Primary dealers reportedly are forcing REITs and other levered investors to liquidate MBS positions, adding further pressure to the markets. Prior to the crisis, 20% of the government FHA/VA/USDA loan market was financed in specified pools. Also, the lack of a specified pool market in conventional and government loans hurts the low-income borrowers that pay the highest fees and need help the most. * The large banks and GSEs are stepping back from the MBS market and are withdrawing financing for warehouse and advance lines, putting further pressure on independent mortgage banks (IMBs). Fannie Mae and Freddie Mac reportedly are stepping away from bidding on specified pools in the conventional market, claiming that they have “balance sheet issues.” The Trump Administration is wasting what could be a valuable liquidity tool by not using the GSEs, including the FHLBs, to provide liquidity to the markets in tandem with the Federal Reserve . What must be done to avert a liquidity crisis in the housing market? * Liquidity : First, the Federal Reserve and other agencies must increase their support for the housing market. Specifically, the Fed needs to increase its purchases of MBS to alleviate strong selling pressure across the market. Add a zero to last week’s daily allocations by the New York Fed. The single biggest thing the Fed can do to help the market is to announce BIG MBS purchase numbers on Monday and keep buying until yields start to fall . The street is extremely fragile; with commercial banks and IMBs hoarding cash. The Fed in the government market and GSEs in conventional loan market should bid directly for specified pools, again until MBS yields start to fall and especially for discount coupons. The Fed’s explicit public policy goal should be to push consumer mortgage rates down to 3% or below . The Fed should use continuous MBS purchases to drive down yields on MBS until it is economic for the industry to originate government and conventional mortgages with 3% coupons. By putting a 103 bid for Ginnie Mae 2s in market and allowing issuers to deliver the pools directly to the FRBNY, the Fed could finance trillions in streamline mortgage refinance transactions and add balance sheet assets to the system open market account (SOMA). * Financing : Second, the Federal Reserve and other agencies, including Fannie Mae and Freddie Mac, should aggressively provide financing for loans, MBS and servicing advances on market terms. The Fed in particular should set up a standing repo facility (SRF) to provide financing directly to all market participants, including banks, nonbanks, dealers, REITs and the GSEs themselves, which will need financing support. As MBS spreads over government yields grow, so too do the funding costs to the GSEs increase. The government should give the GSEs balance sheet support, perhaps including exercise of the Treasury warrant to convert the government’s preferred equity position in the GSEs into common equity, and increase the GSE portfolio limits to allow them to create market liquidity in loans, MBs and servicing assets as well. * Third and also needing immediate attention, the Federal Reserve, Treasury/GSEs and other agencies must provide a liquidity backstop to help finance forbearance on mortgage payments for millions of consumers. Specifically, Congress needs to pass the “Section 13(3) Directive,” which is legislation prepared at the request of Chairman Mike Crapo (R-ID) to provide legal support for using the Federal Reserve’s 13(3) authority and Ginnie Mae’s Chapter 34 emergency authority to provide the needed liquidity to the housing sector. Importantly, this language would fix an impediment in the National Housing Act that effectively precludes financing servicer advances in the Ginnie Mae segment. Markets need this fixed to have collateral for any national liquidity program involving Ginnie Mae loans. Legislative action would greatly speed the administrative efforts on this long-debated topic. Bottom line is that the mortgage finance market, the second largest securities market in the world after the Treasury market, is dysfunctional and in need of government support. The Federal Reserve and the three GSEs, supported by the Treasury, need to provide strong support to the markets on Monday morning , including the provision of liquidity to prevent a disorderly liquidation in the MBS markets and potential contagion among banks, dealers, IMBs and REITs. Just as civil authorities are trying to get ahead of the threat from COVID19 , financial authorities in the US need to act decisively to protect the housing sector and then support the growth of refinance volumes to help drive economic recovery. By protecting the housing finance sector from liquidity-related disruptions, the Federal Reserve, GSEs and Treasury can ensure that this key part of the US economy is functional and able to support economic growth in the months and years ahead.

New York | Officials in Washington are looking for ways to quickly put money into the US economy to counteract the recession looming due to COVID19. One immediate way that the Federal Reserve can very directly add liquidity to the domestic scene is to initiate a massive program to purchase agency and government mortgage backed securities (MBS) directly from issuers, bypassing the too-be-announced (TBA) market and the large bank dealers, and focusing exclusively on refinance transactions at lower rates. Alan Boyce , retired mortgage banker and CA agribusiness executive, argues that the Federal Reserve should begin to immediately purchase pools of Fannie Mae , Freddie Mac and Ginnie Mae refinance mortgages directly from lenders. The former executive of Countrywide argues that given that the Fed’s existing $1.5 trillion portfolio in agency MBS is likely to prepay rapidly in the next few months, the Fed should be an aggressive buyer. He argues that the Federal Open Market Committee is actually adding duration pressure on dealers by allowing the SOMA portfolio to shrink. “Housing is the ultimate domestic market, argues Boyce in a conversation yesterday with The Institutional Risk Analyst . “Cutting the fed funds rate to zero and expanding QE4 is a very indirect and inefficient way to get liquidity into the US economy. With the 10-year Treasury yielding 75bp, it is outrageous to see Americans originating 3.5% mortgages. The Fed should create a market for agency MBS with 2% coupons at a premium in order to guarantee mortgage bankers a profit if they refinance homeowners into 3% mortgages or lower.” Boyce continues: “The Fed should be buying GNMA and UBMS 2 percent coupon (2s) MBS……lots of them and directly from mortgage bankers. Issue an open order to buy $5 trillion of UMBS 2s and GNMA 2s at a price of 103! Let mortgage bankers focus on the paperwork instead of the market volatility. The refi wave is already burning though a huge part of the Fed’s existing MBS portfolio. The runoff of MBS from the Fed’s system open market account (SOMA) is like the Fed selling bonds into the market. Instead, the Fed should start buying back the duration/balance sheet exposure and selling the gamma/vega back to the bond market ASAP. Specifically, Powell should not wait for the actual prepays to hit the SOMA in two months. Buy TBAs now! Drive the prepays and help out homeowners by going directly to the mortgage bankers.” “Below is an example of loan pricing below with better Fannie Mae 2 coupon pricing via the Fed. This approach gets the borrower into a 3% 30yr fixed rate mortgage. We need to direct the GSEs to buy the excess interest only strip at a reasonable price from the lender. More, we can reduce borrower rates by another 29bps with the elimination of the appraisal and loan level pricing adjustments (LLPAs) required from the GSEs. This gets the borrower into a 2.75% mortgage and allows the lender a profit. The FHFA Board of Directors is made up of bank regulators and Fed. They can push Mark Calabria and FHFA to tell GSEs to waive appraisal and LLPAs to make for a more streamlined refinancing process. Remember we were pushing this for HARP 2 back in 2011?” Boyce argues that the lenders can simply create conventional agency and government insured pools comprised entirely of mortgage refinance loans to drive the process and could add several hundred billion in liquidity to US households in the next year. And his larger point about the impact of the runoff of the Fed’s MBS portfolio is crucial and alone makes the argument for direct Fed purchases of securities with refinance loans. Finally, Boyce notes that most of the Street is short duration thanks to the sudden rally in bonds, thus having the Fed act directly may be the only way to get mortgage rates to actually fall without bankrupting a lot of lenders. Boyce argues that mortgage bankers will let their current pipeline of mortgage loans float down to the Fed bid of 103, especially if it comes with no appraisal, no LLPAS and a lower guarantee fee. The resultant MSR will be worth a 5x multiple, that adds to the mortgage banker profits. “All of the mortgage banker pipelines are short duration due to the rally in Treasuries,” Boyce notes. “If the Fed comes in and simply pumps up the price of GNMA 2's to 103, it will put the vast majority of independent mortgaage lenders out of business due to margin calls they cannot meet, not to mention massive pipeline fallout. This is a systemic risk that needs to be addressed. If instead the Fed bids directly for $5 trillion of refis and guarantees a risk free takeout of 103, then the mortgage bankers can originate loans without worrying about market volatility. Mortgage bankers will have a chance to help the economy and make money at the same time. Win-win.”

“It is not learning, grace nor gear Nor easy meat nor drink But bitter pinch of pain and fear That makes creation think” They Told Barron: The Notes of Clarence W. Barron (1930) New York | Just how low is the lower bound in US mortgage rates? We may have found out over the past few months. The benchmark 10-year Treasury bond fell to almost zero this past couple weeks, but the companion 30-year mortgage has actually gone up in yield. Now with the Fed dropping the target for fed funds to zero and restarting quantitative easing, will mortgage rates comply with the Fed's guidance? Our bet is maybe. But why are mortgage rates not falling? One word: convexity . When a mortgage bond goes down in price when everything else is rising, that is called convexity. To quote “ Fabozzi Bond Markets and Strategies Sixth Edition, ” “The key point is that measures (such as yield, duration, or convexity) reveal little about performance over some investment horizon because performance depends on the magnitude of the change in yields and how the yield curve shifts. Therefore, when a manager wants to position a portfolio based on expectations as to how the yield curve is expected to shift, it is essential to perform total return analysis.” We are seeing one of those rare events, like a lunar eclipse, where unseen market forces actually thwart the intentions of central bankers and the hopes of a lot of mortgage lenders. We hear many complaints from the secondary mortgage channel about rising primary rates. Now the Federal Open Market Committee has overtly resumed quantitative easing and again includes mortgage backed securities on the shopping list. But will mortgage rates fall below 3%? The Chart of the Week from March 6th posted by the Mortgage Bankers Association tells the convexity story with the rising spread between the 10-year Treasury note and the 30-year mortgage. Today the federal funds rate is a government managed number. Are mortgage bonds next in terms of explicit government manipulation? Probably too big a lift, even for the Fed. What does this say about the efficacy of monetary policy and, in particular, the choice by the FOMC several decades ago to target the overnight rate for federal funds as its monetary tool of choice? Prior to WWI, the benchmarks for the fixed income were high grade corporate bonds and even the bonds issued by Great Britain and other European nations. Government finance was barely considered. Indeed, prior to the creation of the Fed in 1913, where the Treasury deposited its cash balances was the big question on the minds of financiers. But in the 1980s, the FOMC began using the rate for overnight lending between banks as its benchmark for policy. For decades, the FOMC could drop the target for fed funds and the housing market would respond. But now that relationship is in doubt. The private markets for debt and equity in the US remain quite large and provide an effective check on Fed efforts at outright manipulation of markets. Witness the housing market. The nearly $12 trillion in outstanding mortgage debt in the US is the result of originating a couple trillion annually in new mortgages. The average 30-year mortgage actually prepays within 8-10 years, at least in theory. These loans are originated by brokers, financed by large finance companies, banks and REITs, and ultimately sold to investors in the global bond markets. About half the market is conventional mortgages guaranteed by Fannie Mae and Freddie Mac, a bit more than 20% resides in government insured loans that are financed via Ginnie Mae securities, and the rest is held directly in portfolio by commercial banks. The second largest market in the world is the forward or “TBA” market in mortgage securities. Because of the assumed 8 to 10-year average life of a residential mortgage, the markets tend to price these assets against the 10-year Treasury. But in fact, thanks to the extreme volatility of interest rates, the agency and government RMBS markets have seen prepayments accelerate, thereby making the effective life of these securities more like 4-5 years. Markets try to value agency RMBS against the 10-year Treasury, but in fact the 5-year Treasury note is probably a better bet. Yet in either event, the spread between government bond yields has widened in recent months, directly challenging the Fed’s continued use of federal funds as the benchmark for policy. The chart below shows the 10-year Treasury bond and the 30-year fixed mortgage average from Freddie Mac. Much like the Vatican in Rome, the Federal Reserve Board is reluctant to make changes to canon law. First among these rules is the idea that the Fed can effectively execute monetary policy through the few large banks – aka “primary dealers” – that directly face the Fed as counterparties. Second, the Fed’s changes in policy, once transmitted via the primary dealers, will influence the US economy and particularly housing finance and related sectors such as home building. The dealer-centric world of the FOMC not only creates liquidity problems for markets but now seems less and less effective in terms of influencing housing. Since housing broadly defined is one of the biggest parts of the US economy, whether the FOMC can use interest rate targets to influence credit availability in housing is kind of a big deal. But we also need to raise another issue in this regard and that is the growing inventories of unsold Treasury debt on the books of large, primary dealer banks. With a nod to our friend Marshall Auerbach at Levy Economics Institute , we hereby rehabilitate the long discredited economic notion of “crowding out.” The combination of liquidity and capital rules for big banks, crazy levels of volatility, and massive Treasury issuance of new securities has sapped the Street’s ability to efficiently finance debt – all debt. Add to this the natural reluctance of investment managers to lose money and we have today’s situation: massive liquidity coming to the dealers from the FOMC, but ebbing liquidity in the rest of the global money markets. While the yield on the US Treasury 10-year bond came close to the zero bound last week, the forward market for mortgages rates actually backed up in yield, further widening the secondary market spread. Investors suspect that prepayments will accelerate, thus they discount the premium coupons still left in the market and yields rise. New production GNMA 3s are being priced around 3.5X cash flow multiple, according to SitusAMC. We have it on good authority from several large mortgage issuers in New Jersey that a GNMA 2% coupon was briefly quoted offscreen in the TBA market last week, but by the close on Friday, GNMA 2.5s were the lowest coupon offered in TBA. With the Fed's rate action and QE resumed, will the housing market’s response to the latest Fed action remain muted? Look for GNMA 2s to reappear on dealer TBA screens next week, but will they actually trade in significant volumes? Only if mortgage rates fall. The Fed has the ability to influence markets, but the private debt and equity markets in the US are still too large for the FOMC to overtly manipulate. Should the FOMC decide, in its arrogance, to buy existing 3.5% and 4% coupons in RMBS in an effort to force mortgage interest rates down, the Committee should not be surprised that they will take significant losses due to prepayments. The FOMC also may find itself the among a dwindling number of buyers of agency and government RMBS if 30-year mortgage rates actually go below 3% annual rates and RMBS coupons fall accordingly. For now, at least, there remains a limit on the ability of the central bank to intimidate private investors into taking losses on mortgage securities. The way out of this monetary cul-de-sac is for the FOMC to gradually shift away from explicit targeting of the federal funds rate and towards a regime focused on the legal mandates of employment and prices, two relevant yet fuzzy concepts that provide better political cover for the Fed. The downside risk of sticking with the current regime is considerable. With the disappearance of LIBOR, for one thing, federal funds and the TBA market becomes the de facto benchmark for private finance in the US. Does the FOMC propose to manage the federal funds and TBA markets after LIBOR actually disappears? Imagine how different market conditions might be if the FOMC ceased providing guidance on federal funds entirely and simply provided the volume of liquidity necessary to clear the markets? To us, continuing to beat the proverbial dead horse by targeting federal funds seems only to be creating excess volatility in the markets and little else in terms of public policy. For one thing, without the Fed’s clumsy effort to manage fed funds higher in 2018, the level of prepayments in the world of residential mortgages would be a good bit lower. We suspect also that the level of volatility in the global equity markets would be less as well. And Chairman Jay Powell and other FOMC members could take themselves out of the media crosshairs. Ending the FOMC’s targeting of fed funds might be a big win for all concerned. See below our comments to Barron’s last week as carried by Fox Business .

New York | The great sucking sound heard last week was the release of accumulated froth in the global equity markets. The FOMC’s decision to act with a 50bp cut in the target for Fed funds had little effect on real markets for real counterparties. Meanwhile, the panic in the media is having outsized effects on people, companies and society. Below we ponder the effects and consequences. The unfolding impact of COVID19 changed the effective ratings for dozens of corporate issuers, resulting in an increase in the effective cost of equity finance for everyone from American Airlines (NYSE:AAL) to Amazon (NASDAQ:AMZN) . And the fact that the Fed dropped the target for federal funds is nice, but does nothing really to help these and other companies. Assets move for ratings, a fact we learned long ago from Bob Salvaggio at AMBAC in the world of RMBS. John Dizard writes in the Financial Times on the topic of Fed interest rate announcements: “The actual rates at which even most institutions can borrow against Treasuries or government backed securities have not been cut by any 50bp. On Tuesday, the widely used DTCC GCF Repo index quickly rose from 1.6 per cent at the open to 1.85 per cent, and only came briefly down to 1.5 per cent before creeping up again. The index settled at a 1.72 percent average for the day. By that evening, “ease” or no ease, the Fed was turning down some of the record $111bn of bids for repo from within its own select circle of counterparties.” Because so much of the world of monetary policy is predicated upon maintaining consumer confidence, and since the availability of credit impacts same very directly, times of market stress are costly to the economy. The Fed now faces a sudden, twin crisis of both liquidity constraint and sharply discounted credit profiles for some major corporate and public sector names. The Fed’s 50bp was thought to be a way to reinforce confidence, but instead it signaled that the worst is yet to come. Treasury Secretary Hank Paulson’s suggestion that the government had to buy bad assets from Citigroup (NYSE:C) over a decade ago had a similar effect. Robert Eisenbeis at Cumberland Advisors asks whether the Fed wasted 50bps last week. Our thought is probably yes. Nobody in the mortgage industry is going to agree with you on that count, however, with secondary market spreads north of two and one half points and widening. He writes: “The Fed’s move was clearly intended as insurance designed to convince participants that the Fed will do what it takes to support the economy in the face of the coronavirus threat. As the day proceeded, however, the realization set in that rate cuts aren’t medicine when it comes to the threat of a pandemic. It can’t get consumers out of their homes to spend and it can’t fix supply chain bottlenecks.” The first question, of course, is whether the virus panic now being fanned in the global media and also in the political sphere is going to cause a global credit crisis and recession. Specifically, and to the questions about the efficacy of last week’s Fed rate cut, is merely adjusting the target for Fed funds sufficient to meet the growing demand for the volume of credit? Specifically, will the hit to the supply chain also cause crippled corporate credits to lean hard on bank lines and other sources of liquidity. “Just cutting funds and IOER without backstopping liquidity is going to make USD funding offshore a nightmare in coming days as the global supply chain (which is a payments chain in reverse, thanks Zoltan) clogs and backs up like bad plumbing,” says Ralph Delguidice of Pavilion Global Markets . “Companies not shipping high value-added goods (chips, etc) will draw down USDs to make payments to fill the gap (resulting in a temporary surfeit of liquidity). This will become a global scramble for dollars among those banks seeing deposits flee and credit lines drawn the longer the chain stays disrupted.” Source: FDIC/Whalen Global Advisors LLC As the chart above suggests, the FOMC has managed to throttle bank deposit growth since December 2018. Strangely, this is when the central bank stopped raising rates and started to become aware of ST liquidity risk. With the shock to the global supply chain will also come a shock to commercial banks, first in terms of increased volatility in once stable corporate deposits from longtime customers. Later these same customers may come under financial stress or even be forced into default and restructuring due to the disruption of COVID19. Liquidity, like confidence, is something that economists discuss endlessly but cannot define or measure. We constrain bank liquidity with rules and regulations, but then lament when funding is insufficient to meet market demand. And cash liquidity available to the broad market, not the target rate for Fed funds, is what gets stuff to happen in the economy such as loan growth. In fact, the volume of liquidity flowing through GCF repo for Treasury collateral has been falling for the past year even as interest rates have fallen – or rather have been pushed down by the Fed. GCF RMBS repo volumes have been strong, of note, even as new loan origination volumes climbed 20% year-over-year. As with this past September and December 2018, when we took large cap stocks off by a third in value, the forward concern seems to be liquidity risk resulting from numerous examples of falling corporate cash balances and deteriorating credit conditions. We cannot see whole industries such as airlines, lodging and hospitality grappling with sharp cuts in revenue and not expect a substantial reaction in terms of reducing costs and raising liquidity in those sectors. Another worry when it comes to liquidity is the new issue market, which was going great guns in January but may have slowed significantly in February with the notable exception of mortgage securities. At $158 billion in January, RMBS volumes were up 25% YOY according to SIFMA. But more worrisome is the fact that corporate and ABS bond issuance has fallen dramatically since September of 2019. This may have been the early sell signal from the world of credit in this cycle. We’re struck by the fact that corporate debt issuance started to dive five months ago, but the equity markets did not respond until the arrival of COVID19. In fact, after a small pop in high yield (HY) spreads in the September 2019 time frame, HY credit spreads actually rallied 50bp in yield down to the mid-300s over the curve by early 2020. With the arrival of COVID19, however, HY spreads have widened to plus 500bp over, dangerous territory that can be a predictor of an impending credit risk reset event. Fred Feldkamp’s First Rule states simply that when HY spreads go much about 400bp over the swaps curve, financing activity on the fringes of the consumer economy slows as counterparties start to demand wider spreads on risk transactions. Get to plus 500bp as we are today and the economy is in danger of an outright stall. An economy is an airplane that never actually takes off but must always be at least at sufficient autorotation speed necessary for flight. Falling volumes in the GCF repo market, stagnant bank deposit growth and a sharp drop in corporate bond and ABS issuance don’t sound like a particularly positive combination to us. Add a likely spike in cash demands by a range of public and private obligors whose effective credit ratings changed over the past week and we see a variety of immediate and long-term problems facing the Fed and the Trump Administration. For starts, we think the Fed should worry less about targeting interest rate price and more about understanding, intimately, what is happening in terms of apparent and real liquidity in the credit markets. Like we said, assets move for ratings. There is a huge, sudden and somewhat hysterical asset allocation shift underway out of equities and into safe assets due to uncertainty arising from COVID19. At some point, however, the lack of yield in bonds will drive investors back into equities.

New York | Is the Federal Reserve Board killing America’s banks, pension funds and anybody else that saves with low interest rates? The answer we provide in the latest issue of The IRA Bank Book Q1 2020 is a resounding yes! Points: * Bank interest expenses fell in Q4 as lower market interest rates and ample liquidity provided by the Fed ended the steady increase in bank funding costs since 2016. The drop in yields, however, hurt asset returns as well. Earnings are down several quarters in a row. As bank earnings fell in Q4, revenue decreased faster than funding costs. * Despite increasing credit provisions at most banks, overall credit continues to be a distant worry. Banks are preparing for another very strong year in residential mortgage lending, a notable bright spot in terms of volume growth. * In particular, Q4 2019 actually saw sales of mortgage notes into RMBS with servicing retained rise for the first time in almost a decade, again signaling a renewed interest in correspondent lending on the part of several large mortgage banks including JPMorganChase (NYSEJPM) , Quicken Loans, Freedom Mortgage, Amerihome, a unit of Athene (NYSE:ATH) and Mr. Cooper (NYSE:COOP) . Copies of The IRA Bank Book Q1 2020 may be purchased at The IRA online store. To say thank you to readers of The Institutional Risk Analyst , copies of The IRA Bank Book Q1 2020 are on sale, 50% off through COB Friday, March 6, 2020 . Just how is the @federalreserve killing America's banks? Read and learn about the true cost of Financial Repression. Source: FDIC/Whalen Global Advisors LLC

New York | Last week, financial markets wiped out about a quarter of the market value of large US banks and nonbank companies. One of our core holdings, U.S. Bancorp (NYSE:USB) , closed Friday just shy of 1.6x book vs over 2x only a couple of weeks back. When USB goes below 1.5x book, we’ll be nibbling again. In a funny way, as we said on Twitter last week , the coronavirus or COVID19, took some excess air out of the obvious bubble in US equities. This market wanted to go down, but did not know how. Thanks to Uncle Xi Jinping and COVID19, Federal Reserve Board Chairman Jay Powell’s problem is fixed for now. Yet the low level of interest rates remain both an immediate opportunity and also the most important long-term problem facing the US banks and the broader financial sector. First the good news. Last year, thanks to lower interest rates, was the best year in mortgage lending and secondary market sales in half a decade with over $2 trillion in production. Refinance volumes actually exceeded purchase loans in Q4 2019. And 2020 is looking to be another record year in terms of both volumes and profitability, this even as loan loss rates continue to be muted due to low interest rates. JPMorganChase (NYSE:JPM) , for example, reported strong results in mortgage banking for the past several quarters. But with the rising volumes comes risk in terms of home price appreciation. The chart below shows loss given default (LGD) skewing sharply negative for bank owned multifamily loans, a pattern that is shared with LGDs for residential loans, construction and development loans, and home equity loans (HELOCS). These outlier indications of negative credit costs harken back to 2005. Then as now, negative LGDs for residential real estate suggest that monetary policy is too accommodative and that home price inflation is actually quite high. Source: FDIC/Whalen Global Advisors LLC “JPMorgan Chase & Co. is shifting workers to handle an expected surge in demand for home loans as the American housing market looks forward to its strongest spring in at least a decade and the coronavirus sends mortgage rates lower,” reports National Mortgage News . Indeed, the entire industry is gearing up for a big year in terms of both purchase and refinance transactions, with a bumper crop of new mortgage servicing assets awaiting financial investors. Indeed, as we reported earlier in The Institutional Risk Analyst , both JPM and Citigroup (NYSE:C) are said to be keen on re-entering the correspondent channel in a serious way, part of a larger trend that is seeing commercial banks regaining market share in residential mortgage aggregation and servicing. As we prepare The IRA Bank Book Q1 2020 for publication later this week, there are a couple of key takeaways regarding the mortgage sector from the Q4 2019 data from the FDIC. In particular, Q4 2019 actually saw bank sales of mortgage notes with servicing retained rise above $6 trillion for the first time in almost a decade, again signaling a renewed interest in correspondent lending and servicing on the part of several large banks including JPM, C and others . Of note, the unlevered yield on the $38 billion in bank owned mortgage servicing assets in Q4 2019 was over 9%, as shown in the chart below. Source: FDIC/Whalen Global Advisors LLC Another positive data point for bank mortgage banking: The nonbank share in mortgage servicing actually grew modestly as well in Q4 2019, this as bank sales of residential mortgage backed securities (RMBS) surged. In particular, Q4 2019 actually saw sales of mortgage notes with servicing retained rise $20 billion, the first time in almost a decade bank RMBS securitization volumes have risen . Source: FDIC While the banks are re-entering the market as aggregators and sellers of correspondent loans into the agency and government RMBS market, the nonbanks remain the predominant originators of loans. And with the surge in lending volume driven by falling interest rates will also come a surge in loan prepayments on existing mortgage securities. Last month, our friends at SitusAMC had capitalization rates for new production conventional 3.5% coupons indicated at 5x annual cash flow, a valuation that now is rendered stale by February’s frantic equity selloff and interest rate rally. Maybe 3-4x? As with the MBA production volume estimates for 2020 and beyond, we expect to see significant revisions to prepayment rates for premium coupons in coming days. Now the bad news, of sorts. Even as volumes for residential mortgage loans surge in 2020 and beyond, the rest of the bank loan book is being squeezed. Yes, the wild rise in bank interest expense has stopped and reversed down below $40 billion per quarter. The trouble is, interest earnings are falling faster, and thus net income for US banks fell again in Q4 2019. Returns on earning assets, one of the most basic measures of aggregate bank profitability, are again falling under the dead weight of quantitative easing (QE) and panic buying of risk-free assets. We’ll discuss this troubling trend in detail in the new edition of The IRA Bank Book . The forward scenario for residential mortgage risk kinda looks like this. Falling rates cause a surge in residential mortgage production in 2020, but the disruption due to COVID19 is so pronounced that the US economy slips into recession. The FOMC responds with even lower interest rates, causing yet another manic surge in mortgage refinance and purchase loan production in 2021-22. RMBS coupons will fall into the low 2s, but then comes the punch line after 2022: a larger than expected upsurge in credit costs. After almost a decade of FOMC-suppressed credit default activity, the LGDs in the $11 trillion portfolio of residential mortgages will skew in the other direction. We suspect the rate of change in visible default rates will be considerably faster than in past cycles. Defaults will occur at both ends of the mortgage credit stack, including the high-end, prime jumbo production that is now trading well through the TBA curve. And with the industry and many large institutional investors in the residential asset class leveraged to the rafters, the cost of distressed servicing will come as a very unpleasant surprise to some investors. Large Buy Side players who think that they own cash flows attributable to specific mortgage servicing assets via participations may also be surprised, in the event of servicer default or forced sales. Read the fine print. And the mortgage industry will see another wrenching process of distressed loan resolution and also consolidation among nonbank mortgage companies and REITs. The nonbank servicers will clean up the mess as the commercial banks happily provide the financing. And life will go on. But the next couple of years in residential mortgage lending and servicing could be a very profitable and also quite volatile ride indeed.

New York | The rally in risk-free bonds is quickly rendering irrelevant the policy direction of the Federal Open Market Committee . We’ve talked in past comments in The Institutional Risk Analyst about the structural shortage of risk-free collateral, even with bond yields down 50% from the November 2018 peak. As fear of the economic effects of the COVID-19 virus grow, investors are seeking liquidity and high-grade credit. Many of the financial and risk decisions that were made even six months ago now look questionable in view of the unfolding flu epidemic from China. But as we noted earlier, the risk to the US markets was always meant to come from offshore. At present the forward risk is that the combination of QE by central banks and fear driven purchases of US Treasury paper may drive US interest rates to zero, further inflating the US bubbles in housing and financial assets. The chart below shows the now negative cost of default for 1-4 family loans held by US banks, another way of saying home prices have risen strongly. Source: FDIC Some analysts continue to point to a future increase in unemployment or an economic slowdown as the likely pretext for lower interest rates. But the market already has discounted a slowdown. And lower market rates provide the impetus for another spasmodic surge in valuations for stocks, bonds and real estate – and all at the same time. Traditional correlations are dead and gone, thus the question is only the timing of the next upward surge in dollar asset prices. A sustained drop in interest rates may actually forestall an economic slowdown, again dashing the hope and expectations of many forecasting economists. Even as the fear trade drives dollar interest rates down, estimates for forward loan origination volumes are rising. Indications of growing froth in the housing markets such as the LGD chart above go largely unheeded by investors, but regulators are concerned. Such is the level of consternation among regulators over the visible level of inflation in housing assets that lenders are being told to step back from certain housing markets, particularly in overheated coastal cities. Worries that a sharp decline in home prices will occur as and when the next recession begins are driving the increasingly frantic directives coming from the Federal Housing Administration and the Federal Housing Finance Agency regarding capital levels in a stressed economic scenario. Across the mall in Washington, however, no less a luminary than Fed Governor Lael Brainard is pushing for an even higher inflation target. Why? The Fed Board does not really say. Perhaps to goose asset prices ever higher? Referring to the policy as “flexible inflation averaging,” Governor Brainard believes that the US central bank needs to set temporary inflation targets above its current goal of 2 per cent, to make up for periods when inflation runs below “target.” But what exactly is the target? The fact that the Fed’s governing statute refers to “price stability” as the Fed’s policy target does not seem to bother Governor Brainard. Neither the former MD bank regulator nor the rest of the FOMC seem to have noticed that asset inflation in housing, stocks and bonds and other asset classes are presently running at low- to mid-double-digit rates of increase. Another surge in the value of housing assets impends. Were US home prices rising at say 25 or even 50 percent annually, do you think Governor Brainard and other FOMC members would take notice? Would such a circumstance constitute inflation or at least a rise in consumer living expenses that warranted recognition? That depends. The Debt Avalanche The fixation of the FOMC and other world central banks with statistical “inflation” stems less from a concern about weak employment, consumer price inflation and economic activity than from the growing pile of debt held by public sector obligors. Unless global central banks lean against the potential debt deflation by monetizing a certain amount of public obligations each year via QE, the situation will very soon become problematic. The new update of the IMF’s Global Debt Database shows that total global debt (public plus private) reached US$188 trillion at the end of 2018, up by US$3 trillion when compared to 2017. Ponder how these figures will look at the end of 2020 after a year of dealing with the coronavirus. “The global average debt-to-GDP ratio (weighted by each country’s GDP) edged up to 226 percent in 2018, 1½ percentage points above the previous year,” the IMF notes. “Although this was the smallest annual increase in the global debt ratio since 2004, a closer look at the country-by-country data reveals rising vulnerabilities, suggesting that many countries may be ill-prepared for the next downturn.” China, of note, has seen the fastest growth in its debt load, this as the Chinese Communist Party has turned to ever larger and more ridiculous types of public spending to keep the nation’s 1.4 billion citizens cowed and under control. We are now into year five of the great debt deflation in China, which was signaled by the collapse of HNA Group and Anbang Insurance and the growing red ink in China’s overall payment flows. Again, ponder China's debt numbers in 2020. Source: IMF We wrote in The American Conservative last week that much of China’s pile of debt is really just deficit spending in disguise: “The collapse of heavily indebted Chinese companies such as HNA and Anbang Insurance Group several years ago illustrated the growing pressure on the Chinese economy caused by hundreds of billions of dollars in subsidies to state companies and local governments that are treated as ‘debt.’” Yet even with the consternation over China, any correction in equity markets as a result of reduced expectations for growth due to COVID-19 will be quickly overwhelmed by the rising demand for dollar assets. The world already had a propensity to hold dollar assets before the start of the year, but as 2020 progresses, the downward pressure on US interest rates will become intense. Should the US central bank, as well as the European Central Bank and Bank of Japan , be buying dollar assets via QE when the rest of the world is piling into risk free securities as well? You can be sure that Governor Lael Brainard and the rest of the FOMC will never ask that question – at least not in public. That would involve an open admission of policy error, something that Federal Reserve is unable to accept. But to be fair, the concept of delegated infallibility is well established in Washington agencies, most notably Defense, Treasury and particularly FiNCEN. We have long maintained that the decision first by the BOJ, then the Fed and ECB, to force interest rates negative via public asset purchases was inevitably deflationary. The diversion of interest payments from private investors to governments, and the reduction in carry on assets generally, reduces private leverage on capital and also current income. We suspect that the deflationary effects of QE cause consumers and investors alike to become ever more cautious. The good news, of sorts, is that inhabitants of the dollar zone will continue to benefit from the spreading deflation in China and the rest of the world as the dollar soars. So long as the dollar remains the global means of exchange, the US under Donald Trump can seemingly issue infinite amounts of debt in competition with profligate communist China, which of course will hyperinflate endlessly to forestall political unrest. The bad news, again in relative terms, is that real inflation on a personal level in the US will remain brisk, with prices for housing and financial assets continuing to rise and with it the true cost of living in dollars. Even in the event of a global debt crisis and restructuring, perhaps by Italy and/or China in several years’ time, we suspect that the demand for fiat dollars will only grow. Global central banks are deliberately engineering a shrinkage of the stock of risk-free assets via asset purchases or QE. This continued manipulation of credit spreads is perhaps the single biggest risk to the market in 2020. We wonder when the FOMC will realize that it is easier to be a price setter rather than trying to physically manipulate the short-term money markets.

New York | This week in The Institutional Risk Analyst , we review the new book by David Enrich , “ Dark Towers: Deutsche Bank, Donald Trump, and an Epic Trail of Destruction. ” Enrich is currently financial editor at The New York Times and was previously an editor at The Wall Street Journal covering financial institutions. This important book puts in perspective the history of Deutsche Bank AG (NYSE:DB) , one of the most mismanaged and politically tainted global banks in modern history. “Dark Towers” also tells the story of how Deutsche Bank provided $2 billion in financing to President Donald Trump , cash that enabled the former real estate developer to continue in business despite his many poor business decisions and credit defaults. As the book makes clear, the only reason that Donald Trump was able to win the American presidency was due to the financial support of Deutsche Bank over more than two decades. Reading “Dark Towers,” one is left with the impression that Deutsche Bank is less a financial institution and more an ongoing criminal enterprise. We published a negative credit profile of DB earlier this year , but frankly our assessment was far too generous. Deutsche Bank cut a swath of destruction “and is about the consequences—dead people, doomed companies, broken economies,” Enrich writes, “and the 45th president of the United States—that Deutsche Bank wrought on the world.” From the founding of Deutsche Bank in the 1870s, to the bank’s near failure financing an American railroad baron, to its active support for the Nazis under Adolf Hitler , to its involvement in money laundering, risky derivatives and the subprime mortgage crisis in the early 2000s, the history of the “German Bank” is a tale of malfeasance and mismanagement that has few equals. As we said to a senior Fed official last week: Everyone in the Federal Reserve System needs to read this book and ask a basic question: why was this bank not shut down? The simple answer is politics. The Fed and other agencies would not or could not do their jobs as required by US law for fear of the political ramifications in Germany. “Dark Towers” follows the transformation of Deutsche Bank from a small, relatively low risk institution that existed after WWII to a malignant cancer on the body of global political economy. The bank’s focus on derivatives and investment banking, albeit as a second-rate player in the global capital markets, is presented in simple terms that leaves a sense of astonishment, even for veteran risk professionals. The poorly considered strategies, acquisitions, and geopolitical machinations of Deutsche Bank are skillfully described in a concise yet detailed fashion, reflecting hundreds of interviews and thousands of documents obtained during the research for the book. Enrich follows the tragic careers of Edson Mitchell and his sidekick and best friend, Bill Broeksmit , who took his own life in 2014 when the businesses accumulated within Deutsche Bank starting in the 1980s finally exploded two decades later. Neither the Federal Reserve System, EU regulators, Deutsche Bank’s management nor the German government are spared from the harsh light of scrutiny that this book brings into sharp focus. The fact that Deutsche Bank laundered billions in dirty money for the likes of Russian dictator Vladimir Putin and others via Deutsche Bank Trust Company in New York raises basic question about the efficacy of the bank supervision functions of the Federal Reserve, the State of New York and other agencies around the globe. The fact that Deutsche Bank's US subsidiary was home to both the Trump loans and the money-laundering Russian mirror trades makes the culpability of American regulators even more alarming. While the Fed emerges badly tainted from the narrative so skillfully presented in “Dark Towers,” the incompetence and indifference of European regulators and political leaders also is laid bare. The role played by former Deutsche Bank CEO Josef Ackerman , in particular, is painted by Enrich as being extremely damaging to the bank and the global financial system. Starting from the acquisition of Morgan Grenfell in 1990 and then Bankers Trust a decade later, Deutsche Bank officials oversaw a sharp increase in the bank’s risk-taking activities that was neither prudent nor well-supervised. By the time Ackerman left Deutsche Bank in 2012, the bank was the largest in the word but was also in serious trouble, difficulties that would bring it to the brink of financial failure. In particular, Ackerman’s obsession with an absurd 25% target for equity returns and his focus on Russia seemed to doom the bank to take ever increasing risks and violate laws in the search for profits. Enrich writes of Ackerman’s doomed strategy to expand in Russia in the early 2000s: “Doubling down on Russia with the United Financial acquisition only added to the risks the bank was taking. But this was what it took to achieve Ackermann’s return-on-equity target—especially since Ackermann himself was an unabashed cheerleader of the bank’s expansion into Russia. Just as Georg von Siemens’s entrancement with the United States had led Deutsche into the Henry Villard swamp a century earlier, now Ackermann’s fixation with Russia would spur Deutsche into a similar quagmire. Like Siemens in America, Ackermann was blinded by his fascination with Russian culture and had developed tastes for its theater, opera, and food (blini with caviar was among his favorite dishes). He visited the country as much as once a month, striking up what he described as friendships with some of the bankers in Vladimir Putin’s inner circle.” At times the story told in “Dark Towers” is extremely sad, particularly following the trail of dead bodies that seemed to follow this very large global banking institution. At other times, the narrative will almost seem absurd to financial professionals as the accumulation of poor management decisions and outright criminality created an impossible situation. Enrich writes: “Inside Deutsche, some senior executives, including Anshu Jain , warned Mitchell that Bankers Trust was a third-rate institution with a lot of third-rate employees and a deep well of managerial, financial, and accounting problems. Jain expressed his preference to acquire a more conservative and well-respected firm like Lehman Brothers .” The deliberate indifference to risk and the overt willingness of Deutsche Bank officials to engage in money laundering, fraud and other wanton acts of criminality raises basic questions about the ability of governments in the EU to regulate financial institutions. Officials up to the board level of Deutsche Bank, for example, apparently were aware of illegal activities such as providing billions in cash to the Revolutionary Guards in Iran, yet did nothing to stop the activity. Enrich reports that “By 2006, Deutsche had zapped nearly $11 billion into Iran, Burma, Syria, Libya, and Sudan, providing desperately needed hard currency to the world’s outlaw regimes and singlehandedly eroding the effectiveness of peaceful efforts to defuse international crises.” The book seemingly confirms a 2018 lawsuit which alleges that Deutsche played an “integral role in helping Iran finance, orchestrate, and support terrorist attacks on U.S. peacekeeping forces in Iraq from 2004 to 2011.” The book also documents the role of Deutsche Bank in financing the real estate activities of President Donald Trump, presenting a textbook case of failure to manage credit and reputational risk. The comical situation where one arm of Deutsche Bank refused to lend to Trump while another aggressively pursued his business provides a classic example of “unsafe and unsound” banking practices in the United States. But, again, the Federal Reserve Board and other US regulators repeatedly refused to shut down this renegade institution. Enrich describes how “for nearly two decades, Deutsche had been the only mainstream bank consistently willing to do business with [Trump]. It had bankrolled his development of luxury high rises, golf courses, and hotels. Over the past eighteen years, the bank had doled out well over $2 billion in loans to Trump and his companies…” “Dark Towers” is an important and very timely book. It reveals the seamy underside of the world of illicit banking and money laundering but also documents the incompetence of regulators in the US and Europe. This book makes a mockery of American banking and anti-money laundering laws, and raises basic questions about the state of prudential regulation on both sides of the Atlantic. The role of Deutsche Bank in these activities was a deliberate choice by management that is impossible to explain away as the result of innocent errors and omissions. Here was a bank that decided that it needed to be large and hyper-profitable, and was willing to do literally anything to achieve these goals. As readers of The Institutional Risk Analyst know well, when a bank pretends to deliver supra-normal equity returns without excessive risk, you can be sure that there is something wrong with the institution. After reading “Dark Towers,” most reasonable observers will ask one basic question: Why is this bank still open for business at all but specifically in the United States? Sadly, neither officials of the Federal Reserve Board, the US Treasury nor the other agencies responsible for oversight and surveillance of financial institutions and markets have ever been called to account for their failure to supervise Deutsche Bank. " China’s Iron Fist Is Turning The Coronavirus Into An Economic Disaster " The American Conservative

New York | Last week, Goldman Sachs Group (NYSE:GS) held its long awaited investor day event. As GS says on its web site: “Our senior leadership team delivered presentations on the firm’s strategic priorities and how we are focused on driving shareholder value.” The message was tight, the presentation polished as usual – but not entirely well-executed. GS made its treasured investors wait through hours of banal presentations before allowing any questions. The PPT runs to 263 glorious pages of investment bankster BS . There was even the required panel on “sustainability.” The conversation between GS and investors could have taken 90 minutes and ten slides, but GS instead took a whole day from investors and still did not answer the question. What are you going to do with the business? Images were conjured, horizons were illuminated. China, post corona virus of course, was dangled before investors as a possible revenue driver. GS talked about few tangibles during the presentations, but some were notable. Increasing FICC revenues, for example, while driving down funding costs by $250 million out of $13.5 billion in quarterly interest expense over three years. No, talk to us about how much funding costs will rise in 2020. Fact is, GS is too small to be credible as a commercial bank and too big to just be a nonbank broker dealer. And still there is no talk – yet – about a transformational transaction to grow deposits and add real stability to the business. Recall that of $1 trillion or so in total assets, GS has less than $70 billion in true core deposits. Compare that with U.S. Bancorp (NYSE:USB) , for which we own the common and preferred, with half the assets, $400 billion in core deposits and among the lowest cost of funds of the top five money center banks. Yes, USB is a money center bank, GS is a customer of the larger banks. Source: FFIEC When GS talks about being competitive as a lender without growing the bank significantly – i.e hundreds of incremental percent of core deposits - that is your signal to call “bullshit” in a loud and clear voice. We’ve suggested acquiring Key Corp (NYSE:KEY) because of the $100 billion in core deposits and the focus on commercial real estate financing and servicing. But there was no significant discussion of a large acquisition/merger last week during GS investor day. To us, GS should display those famous corporate huevos and go cut a merger of equals deal with U.S. Bancorp. Let the bankers run the bank while the GS traders and investment bankers focus on advisory and asset management. Combined company would be more than big enough to go toe-to-toe with Jamie Dimon and JPMorgan (NYSE:JPM) . But do the Goldman bankers have the courage to just let go of the old club house? Combined USB+GS entity would trade above 2x book with the assurance of $500 billion in core deposits. Yet in the entire GS Investor Day there is no focus on real change which means becoming a big bank. Instead, there is a lot of consultant ya-ya that says that David Solomon and his colleagues intend to continue doing business as usual. The stock closed above book value on Friday, but only after giving up double digits on Thursday and Friday. Suffice to say that GS will remain in the IRA Bank Dead Pool for now. In related news, another member of the IRA Bank Dead Pool – Citigroup Inc. (NYSE:C) – is reported to be gearing up to re-enter the market for government insured mortgage loans. Bank have generally fled from the market for FHA/VA/USDA loans and GNMA securities because of poor profitability and the outsized risks involved in facing Uncle Sam as a business partner. Watching Citi diving back into the subprime mortgage market brings back some difficult memories, but also is relevant to a discussion of retail opportunities. In the early 1980s, as the nonbanks known as S&Ls were headed into the wood chipper of mortgage finance, Citi introduced a new global product called “Mortgage Power.” This no doc, no-income verification product was designed for the self-employed. This was the first truly subprime, no-doc mortgage product offered by a large US bank. By the early 1990s, Citi’s credit losses in mortgages were in double digits, not just in the US but in a number of other markets around the world where this subprime loan product was available. Mortgage Power was shuttered for a few years, but by 2000 Citi was ready to dive back into the subprime mosh pit. The bank acquired Associates First Capital Corporation for $31 billion in September of that year. Citi’s acquisition of the largest American consumer finance company set the stage for the bank’s collapse in 2008. ''This transaction really fits better than most anything that we could think about,'' said Sanford I. Weill , then chairman and chief executive of Citigroup, of the Associates acquisition. ''From the consumer finance point of view, the exciting thing is the global presence.'' Weill eventually would be forced out of Citi by the WorldCom scandal. The Associates transaction, which was approved by the Federal Reserve Board and other agencies, set the stage for the failure of Citigroup less than a decade later. So when these same federal regulators talk to us about the risks from nonbanks, which have never caused a systemic event, we point to banks like Citi and Wachovia and WaMU and Countrywide as the true examples of reckless, idiotic behavior in the world of residential mortgage lending. Citi, in particular, was responsible for socializing the no-doc, no-income verification subprime toxic loan into the world of commercial banks. In the 1980s, commercial banks did not make unsecured loans to consumers. But Citi blazed the subprime trail. Everything that followed, including Lehman Brothers and Bear, Stearns & Co came from that tainted subprime wellspring created by Citi two decades before with “Mortgage Power.” Should Citi actually re-enter subprime mortgage lending in the government-insured market, then we’d take that as a sign that the post-2008 cycle in mortgage credit has truly troughed. Source: FFIEC The moral of the story with respect to both Citi and Goldman Sachs is that there is no salvation awaiting either of these underperformers in the world of consumer finance or retail wealth management. The internal customer default rate target of C is a good bit higher than that of GS, probably “B”/”CCC” on average. But Citi at least gets paid double digits for taking risk on consumers, one reason that the underperforming commercial bank makes money overall. The story coming from GS is more dire. When the house built by Marcus Goldman, Samuel Sachs and Sidney Weinberg on institutional business tells you that it is going retail, meaning down market and down in average customer size, to find profits, there is good reason to be skeptical. Down is the land of Deutsche Bank AG (NYSE:DB) and HSBC Group (NYSE:HSBC) , two other members of The IRA Bank Dead pool that we shall discuss in a future comment. Coming to Dallas Next Week?

Washington | Last week, we released a paper rebutting the 2019 report by the Financial Stability Oversight Council (FSOC) , which claims rather incredibly that nonbank mortgage servicing companies could pose a “systemic risk” to the markets and the US economy. The FSOC report singles out potential risks arising from nonbanks servicing defaulted mortgages and also risk to banks providing loans to finance these activities. Do Nonbank Mortgage Companies Pose Systemic Risk to the US Economy? [ https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3519454 ] The notion that cash generating asset managers like mortgage loan servicers could cause a systemic risk event is pretty laughable. Read the FSOC paper and references if you want details, but the agency seems to be again ignoring market basics as well as the public record in formulating its dire pronouncements. We said as much in an interview in Real Vision , released yesterday. The Dodd-Frank agency FSOC asserts with respect to nonbank mortgage servicers that "if delinquency rates rise or nonbanks otherwise experience solvency or liquidity strains, their distress could transmit risk to the financial system." The FSOC report provides no analytical backing for this sweeping statement and ignores the highly detailed public record with respect to the insolvency of nonbank mortgage companies that goes back decades. The FSOC report states: "Widespread defaults or financial difficulties among nonbank mortgage companies could result in a decline in mortgage credit availability among these borrowers." Again, the FSOC offers no analytical backing for this statement and ignores the public record of defaults by nonbank finance companies. We’ve written several papers on the topic of muneris interruptio since our days at Kroll Bond Rating Agency . As with the unfortunate case of MetLife (NYSE:MET) , the FSOC report is based on “implausible, contrived scenarios” rather than “substantial evidence in the record” and “logical inferences from the record.” We don’t think that the FSOC articulates a credible scenario for the systemic failure of a nonbank residential loan servicer. Simply stated, the scenario advanced by staff from the Federal Reserve Board and the Conference of State Bank Supervisors seems disconnected from current commercial practice in the market for secured financing. Former New York Fed Chief Gerald Corrigan defined a systemic risk as when markets are surprised. The shock in 2008 caused such dismay among investors – and eliminated market liquidity in mortgage backed securities -- that Lehman Brothers, Bear Stearns, American International Group (NYSE:AIG) and Citigroup (NYSE:C) all failed as a result. Surprise in the financial markets stems from an asymmetry between information and risk. When the imbalance is repaired, money moves – sometimes violently -- to restore the balance between perception and actual risk. Banks such as Citi and Deutsche Bank (NYSE:DB) , which have in past hidden risk from investors, have suffered severe consequences and, in one case, failed and caused a systemic shock. Nonbank companies, by comparison, tend to die quietly in the hands of a US Bankruptcy Trustee. Concealing material information with respect to a security is still fraud in the US, thus the cause of a systemic risk event would seem likely to involve fraud. The tough part for the FSOC, of course, is identifying the particular information asymmetry and related mispricing of securities such that a systemic risk event might occur. Sadly, the mission of the FSOC strikes us as a fool’s errand. No agency is likely to predict the next market break. As we noted in our conversation with RealVision , the FSOC agencies will be the last to know about future market contagion. Because predicting a systemic market break is essentially impossible, the FSOC instead has decided to focus on companies or even whole industries that might be catalysts for market breaks. The 2019 FSOC report mischaracterizes the risk from nonbank mortgage companies and also does a disservice to the commercial banks operating in this sector as lenders. If a “systemic event” did not occur in 2018, when much of the mortgage lending industry was losing money, then it is not likely to occur dear colleagues. The FSOC report illustrates the intellectual bias against nonbank companies that exists in much of the regulatory community, both in the US and around the globe. The term “shadow banks” is pejorative and demeaning to private sector firms, but is frequently used by regulators and researchers when discussing nonbank financial firms. Nonbank companies represent the private sector, while commercial banks are government sponsored entities (GSEs) that enjoy enormous subsidies such as federal deposit insurance, access to the Fed’s discount window and the Federal Home Loan Banks. Commercial banks operate with leverage ratios of 15:1 or higher, when off-balance sheet exposures and derivatives are considered. Even with these advantages, however, commercial banks are far less efficient than their nonbank peers when operating in the mortgage market. As a result, some regulators view nonbanks as a threat to commercial banks. We can think of lots of areas in the market today that warrant concern when it comes to systemic risk, but nonbank loan servicing is definitely not one of them. We work in the sector as advisors to a number of players in the world of mortgage finance, so call us biased. But the FSOC’s report is a bad piece of work and an embarrassment to Treasury Secretary Stephen Mnuchin . If we were talking about lenders or issuers of securities, for example, there might be a basis for an interesting conversation. But to focus the FSOC’s attention on mortgage servicing suggests a misunderstanding of the world of secured financing and the multi-trillion dollar “too be announced” or TBA market for mortgage agency collateral. Looking at the world of finance, the chief risk to the system is the growing atrophy of banks in the EU and Asia, particularly Japan, and related extensions of risk to compensate. Thus, came the world of transformation repo. Off-balance sheet dollar financing. And before that, off-balance sheet finance by US banks. All of these concessions to the zombie banks create systemic risk by the bucketload. When we asked Paul Volcker in 2017 about allowing banks into off-balance sheet finance, this after the Third World debt defaults of the 1970-80s, he answered: “They were broke. What else could we do?” At the end of the day, for all of us it’s all about hiding the risk, maximizing the rating and minimizing the spread over funding -- for the entire world. Thus we think that the next systemic risk event could very well originate outside of the regulated US market. So much for our Platonic guardians.

New York | In this issue of The Institutional Risk Analyst , we ponder the unfolding ninth sovereign debt default of progressive Argentina, this from the perspective of neighboring Uruguay. The convenient muñeca , President Alberto Fernandez , is steering the Argentine ship of state onto the rocks, again. The puppet master, Cristina Elisabet Fernández de Kirchner , holds the title of Vice President and is the power-in-fact in Buenos Aires. Bendict Mander , writing for the Financial Times , reports that the Fernandez government is content with a 40% inflation rate in 2020. A steady run of dollars from Argentine banks suggests that the situation is neither stable nor likely to be improving in the near term. The imposition of a 30% tax on foreign credit card transactions will further drive away dollars from the domestic economy. The Argentine peso has lost more than half its value since before the election of the Fernandez government, but Uruguay has largely held its ground and now its currency trades at a substantial premium to Argentina. But the Fernandez y Fernandez regime is fast burning through its remaining dollar reserves and a future, maxi currency devaluation may impend. The default of the province of Buenos Aires this past week, we note, could be the start of a more generalized default by Argentina and perhaps leading to other sympathetic events of default. Argentina was as much a beneficiary of “quantitative easing” as corporate bond issuers in the US. All manner of corporate and sovereign debt is mispriced by a least a full ratings category. A number of financial analysts fret about the corporate debt overhang, yet the state of the offshore dollar debt market strikes us as a bit more alarming. The assumption that there will be a new debt deal for Argentina by March deserves careful inspection. The International Monetary Fund , which less than a year ago touted the success of Argentina, has more than half of its total exposure tied to Buenos Aires. “This is the biggest single programme that they’ve ever put up, and their reputation is on the line,” said Bill Rhodes , a former top Citigroup (NYSE:C) executive, to the FT last year. Meanwhile across the Rio de la Plata in Montevideo, economic prospects are rising. The new government of Luis Lacalle Pou , the son of a former president of Uruguay, is planning to restore his nation’s role as the Switzerland of Latin America. Known as “ ququito ” in honor of his much-admired father, Luis Alberto Lacalle, the new Uruguayan leader is facing a number of challenges and also some great opportunities. While Argentina and Brazil have defaulted on their debts in the past, little Uruguay has been remarkably stable and in years past was the domicile of choice for residents of surrounding countries. Prior to the Argentina debt crises of 2001, many US and European banks were deposit takers in Montevideo, including Republic National Bank and Israel Discount Bank of New York. Private banks and family offices proliferated in the 2000s. Even as Argentina defaulted on some $95 billion in debt, little Uruguay stood its ground and honored its commitments at par in those dark years, but got little credit for doing so. Lacalle Pou, who will take office on March 1, wants to loosen regulations to attract Argentine businesses and get them to bring their money and perhaps even settle permanently in Uruguay. But President-elect Luis Lacalle Pou’s proposal of attracting Argentine investment and immigration does not have the approval of one his predecessors, José ‘Pepe’ Mujica. Mujica, a former terrorist, served as president of Uruguay from 2010 through 2015. During his benevolent rule, the foreign media compared Mujica favorably with Jesus Christ. The cumulative negative impact of the policies followed by Mujica and his successor led to Lacalle Pou’s election late last year. Under two successive leftist regimes, the civil society in Uruguay was weakened and social insecurity was rising. Crime was on the increase and the government’s fiscal affairs were slipping, leading some analysts to predict that Uruguay would lose it coveted investment grade rating. But with the defeat of the “Frente Amplio,” as the Uruguayan left tendency is called, Uruguayans are hopeful that civil order and fiscal discipline will be restored to a nation that has one of the strongest civil societies in Latin America. The troubles in Argentina, however, will likely make Lachalle’s job of attracting new investment to Uruguay far easier. Over the Christmas holiday, which stretches from before the 25th of December to the Día de los Reyes Magos on January 6th, there were fewer Argentine’s in evidence at the beach or in the stores and cafes of Punta del Este. Yet the prospect of years of socialist misrule under the Vice President Fernandez will likely drive a good bit of cash and investment to Uruguay. Some of the major multifamily real estate projects in Montevideo and in Punta del Este are owned and managed by Argentine families with a long history of successful development projects from Chile to Miami. Several people close to this community of developers predicted that the flow of new capital is likely to be directed to Uruguay because of the change in government and the general economic success and stability that Uruguay has enjoyed in recent years. Indeed, during our trip to Uruguay we heard that the long-delayed project sponsored by the Trump Organization will now be completed. Moribund for some five years, the Trump Tower project was backed by Argentine investors and is located in a prime position on the ocean or “ playa brava ” side of Punta de Este. The Institutional Risk Analyst is told that, since the Argentine election, the money has been committed to finish the project. As the peso continues to lose value under the projected mid-double-digit inflation rate in 2020, Uruguay’s largely dollarized economy will continue to attract investment from a variety of investors around the globe. The Finnish forestry giant UPM-Kymmene Oyj and Swedish-Norwegian-Uruguayan businessman Alex Vik are just some of the global investors that have made substantial commitments to Uruguay in recent years. The situation in Argentina, however, may hold serious potential for systemic contagion in 2020. Many investors have been lulled to sleep when it comes to credit default risk. As it becomes apparent that the IMF is not going to rescue Argentina, and also that the US is not going to rescue the IMF from its folly under Director Christine Lagarde , investors may back away from Argentina. The combination of a default by Buenos Aires later this year and a potentially crippling loss to the IMF could be a bit more of a surprise than the financial markets have comes to expect in recent years. Further Reading Return of banks to government loan market still doubtful National Mortgage News https://www.nationalmortgagenews.com/opinion/return-of-banks-to-government-loan-market-still-doubtful Mexico: Policy Failure, Moral Hazard, and Market Solutions Cato Institute Policy Analysis No. 243 (1995) https://www.cato.org/sites/cato.org/files/pubs/pdf/pa243.pdf