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José Ignacio, Uruguay Punta del Este | As we head into Q4 2019 earnings this week, US financials have never been so expensive and risk indicators have never been so skewed. Just as last July we called the problems brewing in the short-term money markets in a discussion on CNBC's Halftime Report with Mike Mayo of Wells Fargo (NYSE:WFC) , today we want to put down a marker regarding the concealed credit risk inside US banks. Our favorite bank portfolio holding, U.S. Bancorp (NYSE:USB), closed Friday at 1.87x book value, down about 5% from the peak in December just over $60 and 2x book. Still a little too rich to add more to our portfolio of USB common, but we continue to accumulate a number of bank preferred issues. With the number of profitless unicorns dying at an accelerating rate, steady cash flow has a certain appeal right about now. More important, credit default swap (CDS) spreads for high quality issuers are also at all time lows. JPMorganChase (NYSE:JPM) is inside 40bp or around a “A” rating for the largest bank in the US. In 2015, JPM’s CDS was trading close to 120bp over sovereign swaps. Question is, does the market know, really, how much risk sits on Jamie Dimon’s books in the world of corporate CDS and more obscure credit products, like “transformation repo.” We think not. For those not familiar with the wonders of OTC derivatives and collateral swapping, see our 2019 comment “ HELOCs and Transformational REPO .” We wrote in March of last year: “The dealer bank trades corporate debt for cash (for a fee), but uses its own government or agency collateral to meet the margin call for the customer. The bank holds the crap and all of the market and credit risk – sometimes for its own book, sometimes for clients. Tales of MF Global . Recall that the margin rules in Dodd-Frank and other laws and regulations around the world are meant to increase the proverbial “skin in da game” for swaps customers, especially the non-bank customers of banks.” Outgoing Bank of England governor Mark Carney worries that the global economy is heading towards a “liquidity trap” that would undermine central banks’ efforts to avoid a future recession, according to the Financial Times . Former Fed Chairman Benjamin “QE” Bernanke is screaming for new fiscal policy measures to combat a non-existent recession – this as the negative after effects of “quantitative” monetary policy measures are growing. These central banksters may be right, but to us the bigger question is the unrecognized threat to the financial system from underpriced long-credit positions embedded on the balance sheets of global banks and bond funds. Bank interest earnings have long been subsidized by QE, but now banks are being squeezed by the same forces of market manipulation as credit starts to roll over. Suffice to say that the Street seems to finally understand that bank earnings are going to be a tad light, again, this quarter, due to the hangover from Uncle Ben’s QE electric KoolAid. The chart below shows net interest income for JPM. Source: FFIEC Despite the rosy economic outlook, bears continue to see reasons for despair in the world of credit – and we agree. The repo market sailed through year-end cushioned on a soft pillow of liquidity provided by Federal Open Market Committee . With the Fed announcing an end to the not-QE liquidity injection operations, though, we look forward to the next learning-by-doing adventure from Federal Reserve Chairman Jerome Powell . Should the repo markets again start to seize up when the Fed ends its extraordinary liquidity injections, then Chairman Powell’s job may actually be on the line – and not because of President Donald Trump . The looming threat to Powell and other members of the FOMC is the tightly coiled but largely invisible long credit/short put positions on the books of major banks. This is a largely hidden risk that arises from years of market manipulation by global central banks. But hold that thought... We appreciate the flow of questions and comments about the latest IRA Bank Profile on Deutsche Bank AG (NYSE:DB) . As we wrote in the profile: “We assign a negative outlook to DB and have little expectation that the situation will change in the near term. In our view, the most promising way to resolve what is an increasingly precarious situation would be for DB to sell its US operations in their entirety and wind up the remaining bank operations. Since Germany political leaders refuse to consider such a possibility, we expect that DB will stagger along, depleting capital and creating outsized risks, until such time as the bank’s poor management makes a mistake of sufficient magnitude to cause the bank to fail.” Just to review, DB is one of four value destroyers in The IRA Bank Dead Pool . Banks that are members of the IRA Dead Bank Pool have poor financial performance, inferior equity market valuations and no apparent plan to correct these deficiencies. Even with US financials at the highest equity market valuations in a decade, the four institutions in the IRA Dead Pool – DB, Goldman Sachs (NYSE:GS) , Citigroup (NYSE:C) and HSBC Holdings (NYSE:HSBC) – all trade at or below book value. DB has the lowest multiple of equity price to book value of any major bank. In a recent twitter post, our pal @Stimpyz1 reminds us that negative interest rates are not the only source of risk to global banks. “Deutsche bank might be in the crosshairs, but don't forget HSBC," he avers. “Hong Kong is looking like a black hole, and HSBC exposure to real estate on the island makes the DB balance sheet look like Microsoft .” Like DB, HSBC’s US operations are in pretty bad shape, with years of credit losses and poor operational performance. Once upon a time, HSBC was a good comp for Citigroup, but today we would not even bother running the numbers. But when it comes to risk, we are far more focused on the bond market than banks, which are generally under-leveraged but contain a lot of undisclosed credit risk. The lingering negative effect of the Bernanke-Yellen monetary benevolence is so pronounced in fixed income that a number of institutional managers we know have begun to lighten up on investment grade (IG) exposures based on the belief that a ratings-driven correction is coming. Michael Carrion of TCW wrote before the holiday: “Much ink has been spilled this year on the topic of how strong the technicals are within the investment grade credit market and for good reason as they have been the dominant underlying driver of overall IG spreads all year. The resurgent strength derives from this year’s re-expansion of central bank balance sheets, which has resulted in a relentless supply/demand imbalance for IG bonds. Demand for IG credit reached a year-to-date peak in November, particularly in the second half of month as the pace of primary market new issuance slowed.” Patti Domm of CNBC , quoting a research report from Hans Mikkelsen , head of investment grade corporate strategy at BofA Securities, wrote after the close on Friday: “ Lured by low rates, companies issue high grade debt at one of the fastest paces ever this week ,” this as interest rates touched a three-year low. The combination of market reaction to political uncertainty and central bank purchases of risk-free debt has created a credit trap for global banks and bond investors. One of the things we learned from our colleague Dennis Santiago years ago at Institutional Risk Analytics is that when a credit spread looks to good to be true, it probably is. In those days, we’d convert the apparent default rate of a bank portfolio into a bond rating equivalent, then look at loss given default (LGD) to try to figure out how much the rate was understated. Today LGDs in the real estate sector are so skewed as to suggest that default rates are understated by at least 100%. At the end of Q3 2019, the implied rating on the 0.51% of gross defaults for the $10.5 trillion in loans held by all US banks mapped to a “BBB” rating using the S&P default scale. If you believe that the aggregate rating of all obligors of US banks is investment grade, then we have some WeWork shares we’d like to sell you. Step right up. Source: FDIC The issuance of IG debt has set new records for the past several years, but most of this paper is clustered around “BBB" ratings. This suggests that the proverbial lemmings could fall off of the ratings cliff with little or no notice. As we all hopefully learned in the Adam McKay film “Big Short,” the major credit rating agencies don’t have the capacity or the courage to react quickly as and when economic and/or market conditions dictate a change for dozens of issuers. The investors that own long positions in underpriced corporate risk positions will be long dead before the ratings change. The potential ratings volatility embedded in corporate debt has huge implications for banks, which have been “transforming” crap collateral into high IG in order to partially satiate the investor demand for low- or no-risk paper. TCW confirms our earlier colloquy with @Stimpyz1 on Twitter the other day: This implies that there is an embedded credit put on the books of a lot of banks and funds as and when the QE party well and truly ends. Perhaps this is why John Carney and Ben Bernanke are so insistent of a shift to fiscal stimulus. But it needs to be said that no amount of fiscal push will fix the credit risk that the Fed and other central banks have created via "quantitative easing." We’ve been talking about the misalignment of credit ratings and corporate fundamentals for the past several years, but the continuation of QE in Europe and Asia has managed to prevent a reversion to the valuation mean. The divergence seen in junk rated collateral sold into collateralized loan obligations (CLOs) and superior credits suggests to us that an adjustment may finally be underway. The inferior assets always fall first. And to recall John Kenneth Galbraith's great book about the 1920s: "Genius comes after the fall." While interest rate movements are suppressing net interest margins at major US banks, the prospect of a wholesale slip below investment grade for literally hundreds of weak bond issuers may be a far more worrisome problem. Bad ratings concealed the true risk in billions of dollars-worth of mortgage backed securities prior to the 2008 crisis. The new area for securities fraud and ratings malfeasance is the corporate bond market. If you think the liquidity problems we saw last summer in plain vanilla repo were bad, imagine what happens when margin calls on collateral swaps start to swamp the dealer banks.

Quantitative Factors At some $1.5 trillion in total assets, Deutsche Bank AG (NYSE:DB) ranks 17th in the world by assets -- if you include the state-owned banks in communist China on the list of global depositories. At the end of 2019, DB closed below $8 per share, equating to 0.2x book value with a projected earnings growth (5 years) of negative 5%. DB is a bank that increasingly has no clear reason to exist. It has been shrinking its assets and off-balance sheet swap exposures as management attempts to rationalize the bank’s business model, but most recently management has backtracked and begun to again expand these activities. Like Citigroup (NYSE:C) and Goldman Sachs Group (NYSE:GS) , DB’s business is heavily focused on capital markets and derivatives trading, and equally light on traditional banking business and core deposits. In the Appendix to this report, we feature an interview with Achim Dübel , who discussed the origins and defects in the business model of DB and other German institutions. Only 30% of the bank’s revenue and funding come from operations in Germany, thus the future of DB as a going concern is largely based upon its foreign non-bank securities operations. Less than one third of DB’s balance sheet is funded with deposits with the remainder supported by borrowings in the capital markets. The table below shows the rough allocation of the assets and pre-tax revenue different business lines of DB: Source: Deutsche Bank The Corporate Bank has displayed relative stability in terms of revenue, but has slipped into loss periodically. The Investment Bank, DB’s largest and most variable business line, has been under pressure in recent quarters. In the nine months ended Q3 2019, the investment bank generated only €537 million in pre-profits or less than half the previous level. One of the difficulties of performing a financial analysis of DB is illustrated by the table above. The presentation of DB financials is opaque to put it mildly. Note that when you add up the total assets of the different business units in the DB Q3 2019 financials, the total is €400 billion less than the €1.501 trillion in “total assets” included in the Q3 financials. The difference is allocated to what DB management calls the “Capital Release Unit,” which is essentially the repository for the bad assets and non-core businesses accumulated over the past decade. There is little or no visibility into the contents of this business unit. One of the most important points to make about DB is that the bank is critically under-capitalized. The €1.5 trillion in total assets is supported by €58 billion in total shareholder equity for a “fully loaded” leverage ratio of less than 4% as of September 30, 2019. Tangible equity is just $51 billion and has been falling for several years. Virtually all of the intangible assets within DB, some $8.9 billion as of 9/30/19, is carried on the books of its top-tier US unit, DB USA Corporation (RSSD:2816906), a $120 billion asset bank holding company that ranks 37th by assets among US banks. The holding company has dozens of US and foreign affiliates, including Deutsche Bank Securities and Deutsche Bank Trust Company. When you subtract the intangibles from the reported total equity capital of DB USA Corporation of $13.5 billion, the common equity of the BHC is essentially wiped out. What’s left is a bit more than $4 billion in perpetual preferred stock. The US unit of DB includes several important business lines that provide administration and custody services to the US capital markets. The chart below shows the results of DB USA Corp as reported to the Federal Reserve Board. Source: FFIEC The management of DB generally does not talk very much about the capital shortfall in its investor presentations, preferring instead to focus on the fantasy view of “risk weighted assets” (RWA) afforded by the Basel framework. DB’s RWA is €344 billion, allowing the bank to report to investors and regulators a ratio of Common Equity Tier 1 (CET1) capital to RWA of 13%. But the reality is very different and raises basic questions as to how DB continues to do business in the US market, at least as a bank holding company subject to regulation by the Federal Reserve Board. Most European banks, like DB, largely play the game of referring to RWA in their financial disclosure to investors. EU bank regulators are entirely complicit in this charade. Indeed, since the end of 2017 DB’s total capital has actually fallen every quarter. The bank has sought for years to raise new common equity, but with the bank’s stock trading at 20% of book value, there is no real possibility of completing an offering of new common shares. The purchase of DB shares by HNA of China using substantial leverage was a ridiculous episode that provided no new common equity to the bank. HNA has largely sold its position in DB as the company has sought to reduce debt. When DB CEO Christian Sewing says that DB’s capital is “at the high end of our international peer group,” he is correct when the focus is only European banks. In comparison with its US peers, however, DB ranks toward the bottom of the list in terms of capital, efficiency and profitability. This is one of the key reasons that we include DB in the IRA Bank Dead Pool. Banks that are members of the IRA Dead Pool have poor financial performance, inferior equity market valuations and no apparent plan to correct these deficiencies. As this IRA Bank Profile was finalized, US financials were at the highest equity market valuations in a decade, but the four institutions in the IRA Dead Pool – DB, GS, C and HSBC Holdings (HSBC) – all trade at or below book value. DB has the lowest multiple of equity price to book value of any major bank. One area where DB has been hurt in Europe is the negative interest rates maintained by the European Central Bank. That said, however, it is important to note that the bank has a higher cost of funds than many of its peers. The chart below shows the cost of funds of DB USA Corporation vs some of the largest US banks and the 128 largest banks in Peer Group 1. At the end of Q3 2019, the cost of funds for DB USA Corporation was 250% of the average for Peer Group 1. Source: FFIEC DB has been mostly focused in recent quarters on decreasing leverage and releasing capital to placate frustrated investors, something that is a positive trend in credit terms but is unlikely to increase profitability in the near term unless accompanies by further cuts in overhead expenses. The transfer of the bank’s Prime Finance and Electronic Equities business to BNP Paribas (BNP) is a key part of this strategy, according to DB management. Qualitative Factors The fundamental issue when it comes to the qualitative analysis of DB is the business model and the bank’s execution of that strategy. Both the management team and the board of DB are culpable in this regard but frankly have few easy choices when it comes to repositioning the bank. Market Strategy First on the list of concerns is market strategy. In terms of management and corporate governance, DB has struggled for years to find a business approach to deliver consistent profitability, the key measure of stability for any bank. The supervising board of DB has likewise been unable or unwilling to make positive changes to the direction of the bank. For the full year 2017, the bank lost €735 million. In 2018, DB delivered a profit of just €341 million. In the first nine months of 2019, DB lost €832 million. As yet, the management team has been unable to articulate a coherent plan to move forward to avoid such poor results. Most recently, CEO Sewing has indicated that the bank wants to grow in private banking, a highly competitive area that is unlikely to yield quick results in terms of business volumes or profits. Of note, in the middle of 2019, DB announced that it was re-entering the market for credit default swaps (“CDS”) as a dealer, illustrating the bank’s desperate need for revenue and, again, raising questions as to the long-term business model of the bank. As noted above, DB shut down CDS trading in 2014 in an effort to de-risk the bank and focus on other areas of banking. “[The] return to CDS trading stands in contrast to the group’s ongoing disposals of assets as it retreats from parts of investment banking, Bloomberg News reported in September of 2019. “Sewing has marked the entire equities trading division and large parts of interest-rate trading for wind down.” While the bank is cutting back in some unprofitable areas such as equities trading, it continues to embrace high risk, highly leveraged activities such as investment banking and derivatives trading as a key part of its business. Risk Management The second factor to consider is risk management. The quantity and quality of DB’s earnings is inferior to that of other large banks operating in the global capital markets. From underwriting sub-prime mortgage loans to money laundering to inferior quality investment banking clients, DB has been willing to accept business from dubious sources in a desperate effort to boost earnings – creating oversize operational and reputation risks for the bank in the process. More, the bank has refused to make adequate disclosure of these risks to investors. One example of DB’s poor management and disclosure of risk is in the US market for subprime mortgages. In 2017, the US Justice Department, along with federal partners, announced a $7.2 billion settlement resolving federal civil claims that DB misled investors in the packaging, securitization, marketing, sale and issuance of residential mortgage-backed securities (RMBS) between 2006 and 2007. The poor quality of DB’s subprime mortgage lending and securitization activity is legendary among institutional investors. The $7.2 billion agreement represented the largest ever RMBS resolution for the conduct of a single entity and included a $3.1 billion cash payment and $4 billion in assistance to relief to underwater homeowners, distressed borrowers and affected communities. Consider another example. In February 2019, for example, the Wall Street Journal reported that DB had lost approximately $1.6 billion over a decade in a bond strategy gone awry, but failed to disclose the loss to investors in a timely fashion. “The loss, which hasn’t previously been reported, represents one of Deutsche Bank’s largest ever from a single wager—roughly quadruple its entire 2018 profit—and ranks as one of the banking industry’s biggest soured bets in the last decade,” Jenny Strasburg and Gretchen Morgenson of the Journal reported. The tendency of DB and other EU banks to fail to perform adequate risk management when it comes to market, operational and other hazards is a serious qualitative deficiency. In a prominent example, the role of DB in laundering billions of dollars for Russian criminals with links to the Kremlin, the old KGB and its main successor, the FSB, badly damaged the bank’s credibility. Last year, DB conceded that the “Global Laundromat” scandal hurt its “global brand” and is likely to cause “client attrition,” loss of investor confidence and a decline in its market value. DB is known on Wall Street as a bottom feeder that supports shoddy deals and is not afraid to use bribery and other questionable means to obtain business. As The New York Times reported in October 2019: “[T]he German lender used gifts and political maneuvers over 15 years to become a major player in China. More than 100 relatives of high-level Communist Party members were hired for jobs at the bank without meeting qualifications, and millions of dollars were paid to Chinese consultants with access to politicians.” Needless to say, there is in DB an appearance of a culture of corruption which carries with it enormous operational and reputation risk for the bank. In an interview with The Financial Times in July last year, CEO Sewing described DB as a business where “we lost our compass in the last two decades.” He accused his predecessors of a “culture of poor capital allocation” and chasing revenue, without concern for sustainable profits. Yet he has never mentioned the poor management and weak corporate governance that allowed these events to occur in the first instance. But perhaps more important than even seeking stable profits is the need to avoid investment banking business that threatens the bank’s reputation and ability to continue as a going concern. It is significant that even as Sewing has focused on reducing risk and leverage, DB has begun to rebuild its investment bank. At the end of 2019, in a change of tone that surprised many analysts, CEO Sewing revised upwards the 2022 financial guidance targets, signaling that the investment bank will again become DB’s fastest-growing business. Liquidity The third qualitative factor, namely liquidity, has been addressed above from a quantitative perspective, but is also a reflection of management and the bank’s reputation. The fact that DB has been willing to follow business strategies that hurt the bank’s reputation and standing with global regulators makes it difficult to convince counterparties to support the bank with either deposits or capital. The bank’s possible role in a vast money-laundering scandal at the Danish lender Danske Bank, for example, marks another instance where DB management and supervisory board failed to adequately oversee the bank’s operations and enforce anti-money laundering laws. These lapses, in turn, have damaged the bank’s reputation, which impacts the ability of DB to fund its operations. Given the clear quantitative evidence in the bank’s US disclosure that the cost of funds for DB is significantly higher than that of its peers, it is difficult not to conclude that poor management is the key contributing factor to this inferior market position. The failure to supervise the bank’s operations and, more important, the choices of business strategy have contributed not only to a sharp drop in the bank’s equity market valuations, but a related increased in the bank’s cost of funds. When an issuer has a deeply depressed stock price, this factor tends to affect debt spreads and credit derivatives markets such as CDS. Early in 2019, DB’s CDS was trading 200bp over the Treasury yield curve because of investor concerns about an imminent default. Since, the middle of 2019, however, the market expectations regarding a default by DB moderated and CDS prices have fallen dramatically. This welcome improvement, however, did not translate into a stronger price for the bank’s common stock. The fact of central bank action to drive down benchmark interest rates and credit spreads must also be factored into the analysis of DB’s improving pricing in CDS. Operating Environment Finally, the global market for universal banks is more competitive now than at any time since 2008. The fact of negative interest rates in Europe, combined with the competition from larger, better capitalized and managed institutions in the US, creates a very difficult operating environment for DB and other European banks. The fact that DB under current leadership thinks that it can grow in areas such as investment banking and CDS dealing suggests that the bank’s management is badly out of touch with reality. In 2019, EU commercial and investment banks across the board saw a significant decline in such areas as equity trading, prime brokerage and investment banking. This is one reason that DB made a decision to sell business units in these areas. In order to replace the lost revenue from these areas, DB decided to move back into CDS trading, albeit limited to cleared swap contracts that have lower capital and margin requirements. As the requirements of Basel III for posting initial margin for many derivatives contracts come into full effect in 2020, however, it remains to be seen whether DB will have the capital to grow or even maintain this business. More, the embedded risk in CDS contracts, which is ultimately tied to credit spreads on individual corporate exposures, creates the potential for future surprises that could put the stability of DB at risk. The huge number of sub-investment grade issuers such as SoftBank, which have traditionally been the sweet spot for DB’s investment banking clients, creates the potential for a negative credit event that could adversely impact the bank. Caught between regulatory requirements, much needed infrastructure investments and cost reduction initiatives, all of the major universal banks in Europe are being squeezed in terms of profitability and are being forced to downsize. Eurogroup Consulting noted in a 2019 report: “US CIBs have strengthened their position outside their home borders notably as a result of a strong domestic market with a more favourable regulatory landscape. European CIBs have been crippled by stringent regulation and scarce resources, whilst attempting to implement cost reductions programmes to address their cost base European CIBs must now consider drastic structural changes and address the fundamental constraints the industry is currently facing: cost inelasticity and revenue decline. They should focus on Asset Industrialisation and Structured Finance opportunities.” Translated into plain terms, DB and other EU banks need to shed high-risk business such as trading and traditional investment banking, and instead become asset managers and originators of structured finance transactions. Models such as UBS Group (NYSE:UBS) , Credit Suisse Group (NYSE:CS) and Morgan Stanley (NYSE:MS) come to mind, but DB simply seems to lack the tools and the vision to make this type of dramatic change. We view the prospect of DB doubling down in markets such as investment banking and CDS trading with alarm and wonder whether prudential regulators in the EU and the US fully understand the implications of the latest strategy pronouncements by DB’s leadership. Assessment After considering the quantitative and qualitative factors affecting DB, its is relatively easy to reach an overall assessment for the bank which is negative. But perhaps the most significant and disturbing factor facing DB is the feebleness of the bank’s management and corporate governance. DB exhibits a striking weakness in terms of business model selection and internal systems and controls, yet the bank seems unable or unwilling to change. Putting scarce capital into growing market share in investment banking, OTC derivatives, leveraged loans and collateralized loan obligations (CLOs), for example, strikes us a distinctly unattractive at the present times. But the fact is that for the past decade or more, DB has made a living of sorts by advising inferior banking clients and underwriting equally suspect assets that other global banks will not touch. The legal and reputational risk from these activities have been enormously costly to the bank and its shareholders. Despite this and other examples of the toxic nature of the DB business, the management of DB, along with the supervisory board as well as senior German politicians up to the highest-level, refuse to accept that the bank has fundament problems. CEO Sewing told investors last year: “[w]e are seen as one of the better banks in this business and, therefore, we see increasing volume.” The vision of DB inside the executive suite as well as in German business circles seems to be taken from a parallel universe where bad intentions and equally bad actions are somehow seen in a positive light. We assign a negative outlook to DB and have little expectation that the situation will change in the near term. In our view, the most promising way to resolve what is an increasingly precarious situation would be for DB to sell its US operations in their entirety and wind up the remaining bank operations. Since Germany political leaders refuse to consider such a possibility, we expect that DB will stagger along, depleting capital and creating outsized risks, until such time as the bank’s poor management makes a mistake of sufficient magnitude to cause the bank to fail. Appendix: Interview with Achim Dübel Achim Dübel on Deutsche Bank AG The Institutional Risk Analyst May 6, 2019 New York | In this issue of The Institutional Risk Analyst , we talk to our friend Hans-Joachim (Achim) Dübel of FINPOLCONSULT in Berlin to provide some context for the latest troubles affecting Deutsche Bank AG (DB) and the German banking system more broadly. Dübel is one of those rare independent analysts of the banking sector in the EU and has worked on a number of internal and external debt restructurings. In our conversation, Dübel reminds us of the obvious, namely that the largest “bank” in Germany is not really a bank at all when compared with US institutions. Even the $2 trillion asset JPMorgan Chase (JPM) is still more than half core deposit funded and boasts a significant loan book focused on small and medium size enterprises (SMEs). A fatal flaw in the business model of Deutsche and many other private German lenders has led to the present juncture. Deutsche seems so toxic due to bad loans and inadequate disclosure that it cannot raise new equity capital or combine with another institution. “In a nutshell, German (and Japanese) banks are traditionally bond buyers and not lenders, notes Duebel. “All of them, not just Deutsche and Commerzbank AG. Germany doesn’t have a pension system, so much of our surplus has to go through bank deposits and bonds bought by banks.” He notes some of the structural differences between banks in Germany and the US, but cautions that these disparities are not sufficient to explain the decline of German banks. “Structurally they didn’t build up international retail and SME lending as opposed to, for example, BNP Paribas (BNP). As their corporate client base increasingly became banks themselves, Deutsche thought they could compensate through trading income,” he notes. “Of course the strong cooperative and public banking system made the domestic retail/SME market difficult, but that is no excuse. Consider the international success of BNP or Société General (SG) against strong domestic co-operative bank competition. German banks used to be internationally strong in Latin America, Russia and the Middle East, these markets are history today.” Once the focus on traditional corporate and SME lending started to fade, Deutsche Bank and others were lured by the big returns of global investment banking, notes Dübel. “Being securities-overweight, they jumped into extremely crowded investment banking, where banking is dominated by the soccer model (most profits end up with staff, not shareholders),” he relates. Dübel notes that Deutsche and other German banks reaped a large share of their profits from taking market as opposed to credit risk, which is extremely curve- and volatility-sensitive. In addition, due to weak regulations, the German banks pushed up risk levels across their portfolio, with disastrous results. “Where they ventured into credit risk especially,” Dübel notes, “Deutsche focused on the synthetic market where it didn’t have a natural hedge due to the absence of a real credit portfolio. They ran into legal troubles when seeking those opportunities in local governments, retail investors, etc. They were brutally hit by adverse selection in bonds from Anglo investment banks during the crisis. And they contributed to inflating the economy of our neighbors and the U.S. via the bond markets. With ZIRP and only low-yield alternatives in the bond market, Deutsche effectively was bailed out by American and German governments without any consequences.” Dübel believes that the key issue as first mentioned is the unhealthy structural development, that is, management mistakes at Deutsche. “Achleitner (Allianz, Goldman) fired Cryan because he wanted to correct the investment banking bias. Now he trapped himself into something worse,” says Dübel. “I believe in contrast that the money laundering allegations against Deutsche Bank are mostly politically driven. Look who is talking. Details are very hard to verify.” Dübel adds: “Also let us not forget that international banking is as brutal as international oil. German banks were strong for example in Russia and Iran – these countries were lost as clients due to political pressure. One serious mistake they made is to leave everything in between Central/Eastern Europe to Italian and Austrian banks. So bizarrely, today Unicredit (CRIN) of Italy is a more serious contender for a Commerzbank takeover today than Deutsche.” As we’ve noted in The IRA previously, Deutsche has been struggling to make a bad business model work for over a decade. Faced with the fatal structural flaws in the business, the bank has drifted without clear direction from its board of directors and management. German pride makes it impossible for the government of Chancellor Angela Merkel to admit the obvious, namely that Deutsche Bank needs to be wound down and sold. And the public anger at big banks makes it politically impossible for the German government to take an example from Italy and lead this process. Thus we wait to see a solution to the financial and operations problems at Deutsche Bank as the moral hazard risk facing the markets grows. The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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In this issue of The Institutional Risk Analyst , we ponder the world of fintech, a term everyone in business and finance knows but few can define with any particular detail. There are many companies that claim to be fintech firms, or at least have some components that have these characteristics, but there are very few that we can point to as being truly revolutionary. The term “fintech” is a contraction of two words -- “financial technology.” In a recent paper published by the University of New South Wales , Douglas W. Arner, Jànos Barberis and Ross P. Buckley note that the term fintech “refers to technology enabled financial solutions” that have evolved over the past 150 years. They continue: “It is often seen today as the new marriage of financial services and information technology. However, the interlinkage of finance and technology has a long history and has evolved over three distinct eras, during which finance and technology have evolved together.” Buy the Risk profile of Deutsche Bank AG in The Institutional Risk Analyst online store! The largest strides in the use to technology in the world of finance came many decades ago, when sending physical mail was supplanted by the telegraph and later the telephone. In the 1970s, when the first computers were introduced to banking, the time required to process financing transactions began to fall dramatically. Then, as today, what computers do best is count . Just as the invention of electricity changed industrial processes, the advent of computers to enable automated reconciliation tasks forever transformed finance. Fifty years ago, when some of today’s leaders in the consumer finance sector first entered the business of lending on residential homes, getting a mortgage could take months as data was assembled and validated. Payments were made using checks, which were then manually reconciled and presented to the originating bank. When this writer worked at the Federal Reserve Bank of New York in the 1980s, there were three shifts working 24 hours a day, five days a week, processing cash and checks across the banking system. Airplanes flew bags of paper checks around the country to be processed by the regional Federal Reserve Banks. It is interesting to note that, decades later, the Federal Reserve System still has not extended the hours of the FedWire to evenings or weekends. As we noted in our previous comment (" The Fed Takes a Baby Step Forward in Payments "), the Federal Reserve Board is only slowing bringing the bank-centric payment system in the US up to current technology. Yet despite such impediments, the evolution of technology is changing the way in which finance operates. Obtaining a mortgage today takes just days instead of months. Perhaps the biggest single task in the process is validating the information obtained from the borrower, including checking for fraud. The actual task of documenting the loan and the collateral has been greatly accelerated to the point where it is normally done in days or even hours. A great many of the advances in lending today are more incremental than revolutionary. Eliminating mistakes and the attendant legal and regulatory risks that process faults inevitably create is perhaps as important as speeding the volume of loan applications through the system. Mortgage lenders, for example, profit by making more loans, but making a single bad mortgage can wipe out the profit from hundreds of good loans. Last year, the average time it takes for homebuyers in the United States to close on home purchases was 47 days across all loan types, according to mortgage software company Ellie Mae . But there is natural tension between the desire for more sales and the imperative to avoid costly mistakes. Removing the possibility of mistakes in the loan underwriting process has become perhaps the single biggest goal in the mortgage industry, but is also important across all consumer loan categories. Enhanced productivity with fewer errors is the common goal of any lender facing consumers. For example, many consumer loan vendors provide tools to speed the validation of employment (VOE) by eliminating the transmission of personal financial data through email or fax. Lenders are able to complete more loans in less time. The laborious process of manually reviewing borrower-provided employment data has been replaced by an entirely deterministic process. Other technology providers focused on mortgage lending offer secure environments to assemble and validate all of the information in a loan file, focusing activity within a common digital workspace. Again, the object here is to improve the time required to complete a loan, reduce cost and also avoid errors and fraud that can result in costly credit events. All of these changes are important, but they are hardly revolutionary. Do the companies providing these banal tools deserve nose-bleed valuations? Hardly. As the benefits of technology to all aspects of credit and payments have become increasingly incremental, the hype surrounding the use of technology in finance has soared exponentially. Private equity funds and established companies tout the payback from fintech as though we were all witnessing the invention of electricity or silicon-based computing. But in fact most changes seen in finance today are incremental at best. One of our favorite examples of the ambiguous benefits of what we know as “fintech” is the payments company Square, Inc. (SQ) . Touted as a “disruptive” provider of payment processing for retailers small and large, Square in fact is an overlay of off-the-shelf tools and functionality that operates atop the legacy world of banking and payments. We owned the stock early on when it traded in single digits, but got out when SQ touched $100 per share. Despite the millions of words written about the disruptive aspects of fintech, companies like Square simply provide modern software that sits atop legacy banking systems. Today Square’s equity trades at almost 70 times forward earnings. This is not to say that evolution is unwelcome or without worth, but the value claimed by many "fintech" firms is an exaggeration. The Sell-Side hype surrounding fintech was largely responsible for the rise and fall of SQ, which today trades in the $60s. Lest we forget, payment processing is a legacy bank monopoly jealously protected by the Federal Reserve System and other central banks. Much of payments today follows a linear process map that harkens back to the days of paper before the invention of the telegraph. Fintech companies such as Square are not so much providers of new technology as they are the newest players among commodity payment providers such as Visa (V) and Mastercard (MA) . There is nothing “new” about payments companies such as Square or PayPal (PYPL) , they are simply more nimble than big dumb banks. But the banks will figure it out. There is nothing really new under the sun when it comes to technology, only new packaging and hype in the world of media and investments. Just as today's automobiles are merely evolutions from the original horseless carriages of a century ago, much of FinTech today is merely an evolution of existing technology. Virtually every fintech company we have examined over the past five years represents more a progression from existing tools rather than a fundamentally new process or technique. The next evolutionary step from computers enabling old, linear production processes such as lending will be data-centric applications. In the meantime, maybe it is time for us to stop writing terms like fintech with capital letters and focus instead on how “new” uses of existing technology add value for lenders, investors and consumers as measured in dollars and cents.

"In the last analysis, no mechanical system can be entirely 'fail safe' and also be commercially viable." Paul Volcker 1985 Punta del Este | In the waning days of 2019, the Federal Reserve Board took what is perhaps its most positive and significant policy action of the year – but not by providing liquidity to the money markets or adjusting monetary policy. Rather, the Board of Governors approved modifications to the Federal Reserve Banks' National Settlement Service (NSS) and Fedwire® Funds Service to support enhancements to the same-day automated clearinghouse (ACH) service. Specifically: The National Settlement Service will close at 6:30 p.m. ET, one hour later than its current closing at 5:30 p.m. ET. The opening time for the National Settlement Service will remain at 7:30 a.m. ET. The Fedwire Funds Service will close at 7:00 p.m. ET, 30 minutes later than its current cutoff at 6:30 p.m. ET. The Fedwire Funds third-party cutoff will occur at 6:45 p.m. ET, 45 minutes later than its current cutoff at 6:00 p.m. ET. The opening time for the Fedwire Funds Service will remain at 9 p.m. ET on the previous calendar day. The Reserve Banks will modify their current practice of maintaining a two-hour window between the closing and the reopening of the Fedwire Funds Service to maintain only a 90-minute window. The Reserve Banks will raise the threshold for granting extensions to the Fedwire Funds Service closing time from $1 billion to $3 billion. The Reserve Banks, in consultation with the Board, will determine whether further increases to the threshold are warranted to maintain the regular and consistent open of the Fedwire Funds Service at 9:00 p.m. ET. The Board is amending part II of the Payment System Risk (PSR) policy to add a new 6:00 p.m. ET posting time for same-day ACH transactions, remove the current 5:30 p.m. ET posting time for ACH return transactions, and make conforming changes to the daylight overdraft fee calculation. In a previous issue of The Institutional Risk Analyst , “ George Selgin on Frozen Money Markets & Competing With the Fed in Payments ,” we discussed the possibility of the Fed doing even more to support greater access to real time payments via ACH. While these changes fall short of what we discussed with Dr. Selgin, the additional time allowed for same-day ACH transfers should provide very tangible benefits to consumers and the US economy as a whole. This evolutionary process is difficult for the Fed, in part because of the key role it plays as the hub in the multi-trillion-dollar world of global payments and as liquidity provider to US banks. For many years, the Fed has crafted policy regarding the FedWire and NSS with risk foremost in mind, but advances in technology are forcing the US central bank to move faster in terms of modernizing the world of payments. Many readers of The Institutional Risk Analyst are too young to remember the fateful day in November 1985, when a computer glitch prevented the Bank of New York, predecessor of Bank of New York Mellon (BK) , from settling its daily securities sales and financing positions with the Federal Reserve Bank of New York . A similar problem had almost brought Manufacturers Hanover Trust Co to its knees earlier in the week, forcing the Fed to make an extraordinary $4 billion discount window loan to that entity. In those days, $4 billion was a great deal of money. Jay Rosenstein and Bartlett Naylor described the event in American Banker in December 1985: “The Bank of New York is the primary clearing agent for a number of major Wall Street brokers that buy and sell US Treasury instruments and other government securities. Last month, following a busy day processing transactions, the bank’s computerized link to the government securities network broke down and disrupted processing throughout the market. And since the Bank of New York was unable to transfer securities and collect payment from buyers before the end of the day, it had a deficit in its account at the New York Fed that had to be funded by the $22.6 billion overnight loan.” In 1985, the total assets of Bank of New York were not quite $30 billion, forcing the institution to pledge all of its assets to the Fed as collateral on the discount window loan – the largest emergency advance ever made by the Fed up to that time. The swift action by the New York Fed under President E. Gerald Corrigan averted a calamity, but the event caused great consternation in Congress. In the wake of the Fed’s rescue of Bank of New York, the Board placed additional controls and penalties upon daylight overdrafts on the FedWire. “I am concerned about the apparent concentration of responsibility for government securities transactions among the 35 or so primary dealers,” stated Ferdinand St Germain (D-RI) , Chairman of the House Banking Committee. In a reference to the failure of Continental Illinois Bank only a year before, he asked: “Are we not courting Continental-scale problems by permitting financial operations of such enormous magnitude and significance to be handled by so few institutions?” But the more immediate problem facing the Fed of New York that day was that the 90 minute breakdown in communications between Bank of New York and other firms had caused investors to start turning away from the bank and its clients. The disruption at Bank of New York, while brief, was enough to disrupt the securities markets and cause firms to stop honoring trades. "Most importantly," Corrigan told John Berry of the Washington Post , "there was also some evidence that investors were seeking to break trades and financing transactions with firms serviced by the Bank of New York." At the time there were four large clearing banks in New York, including Irving Trust and Manufacturers Hanover, both of which have since been acquired by BK and J PMorgan Chase (JPM) , respectively. Today the securities markets are even more concentrated and therefore brittle than they were 35 years ago. As the Fed moves forward with efforts to accommodate the ever-growing volume of financial payments and the related need for financing, the institutional memory of not just 2008 but of other, more idiosyncratic risk events such as the near collapse of Bank of New York haunt the dreams of Fed officials responsible for clearing and payments. One senior Congressional staffer focused on payments told The Institutional Risk Analyst : "It is great that the Federal Reserve is preparing to enter the 21st-century just as the rest of us are preparing to enter the third decade of the 21st-century." Suffice to say that the changes implemented by the Fed last week are perhaps less than we'd like to see, but nonetheless are an important step forward in making the dream of same day payments a reality for million of consumers, businesses and financial institutions around the world. ¡ Feliz Año Nuevo !

Montevideo | In this issue of The Institutional Risk Analyst, we feature the comments of Dr. Robert Eisenbeis, Vice Chairman & Chief Monetary Economist at Cumberland Advisors in Sarasota, FL . Reading a number of the tributes to Paul Volcker, who passed away last week, and recitations of his contributions brought back my own experiences with him when I was on the staff of the Federal Reserve Board from 1976–1981.  Among his key attributes were his integrity, the quality of his public service, his concern for the independence of the Fed, and his commitment to break the back of inflation despite the personal and political attacks he incurred in response to his policies designed to achieve that end. By way of background, prior to Volcker’s ascending from being president of the Federal Reserve Bank of New York to becoming Board and FOMC chairman in August 1979, the FOMC had been raising rates fairly steadily by 25 to 50 basis points from the fall of 1977 through August, at which point inflation was running at an annual rate of about 8%. One month later, after Volcker assumed the chairmanship, the fed funds rate was at 11.5% for September, and inflation was at 11.9%. By late October 1979, the funds rate was at 15.5%, before it declined to 14% in late November. A recession started in January 1980, and the funds rate peaked at 20% in March.  What we forget is that at that time the FOMC was not pursuing a funds rate target per se, but rather had in 1978 and through the period focused on specifying growth rates for the monetary aggregates through bank reserve control while articulating target ranges for the funds rate, given growth in the aggregates.  Today, of course, there is no mention in either the minutes or transcripts of monetary aggregates. Volcker was not unmindful that his policies of trying to slow the growth of the money supply would have implications for interest rates, but in addition he was concerned about the effects of interest rates on bank safety and soundness, since the banks tended to fund longer-term assets with short-term liabilities whose costs could increase to the point that earnings might go negative and eat up banks’ capital cushion. I was not involved at all in monetary policy during the time Volcker was chairman, but I was the senior officer in the research division responsible for bank and bank holding company research and policy, as well as research support on bank supervisory issues, consumer affairs concerns, and payments system issues.  Because of these duties, in late 1979 I was summoned to Volcker’s office together with another colleague and told that we were to attempt to determine how much pressure money center banks could stand on their capital positions should interest rates move higher.  Moreover, we were instructed not to tell anyone that we were working on that issue, not even the other governors. Needless to say, this task put both of us in a very uncomfortable position, since the culture of the Fed was that we worked for the Board and not individual governors or the chairman. This experience showed the depth of Volcker’s concerns about the possible unintended consequences of his attempt to break the back of inflation. Volcker’s policies were extremely unpopular both politically with the White House and with the general public.  The Board was bombarded with shipments of 18-inch two by fours from the houses that weren’t being built and received many nail kegs filled with keys from cars and houses that had not been sold. Constitution Avenue in front of the Board building was the scene of parades of farmers on tractors protesting the policies. In fact, Volcker was reluctant to go out to dinner because people would recognize him and harangue him about his policies. In the end, however, he was successful; and the negatives expressed at the time have long disappeared as his contribution has been recognized. Volcker had economic views that extended far beyond monetary policy.  For example, he was quite conservative when it came bank holding company policies. He was, for example, against permitting bank holding companies from acquiring thrift institutions. Remember that the thrift crisis of the 1980s was a creature of the combination of binding Reg Q ceilings and the run-up in interest rates that caused many thrifts to fail. Volker’s view was that keeping certain institutions balkanized in market segments would provide a safety net should one part of an industry experience financial difficulties. The problems would not infect other financial market sectors, causing a broad financial crisis. This view was what was behind the so-called “Volcker Rule” that was included in the Dodd-Frank legislation, designed to limit banks’ ability to engage in proprietary trading of securities, derivatives, options, and commodity futures. It also barred banks or insured institutions from acquiring ownership in hedge funds and private equity funds.  The aim was to prevent excessive risk taking by federally insured banking institutions and to limit speculative trading that might pose undue risks to bank customers. To Volcker, segmentation meant protection and financial stability. Finally, when we remember Volcker’s tenure at the Fed, it is also important to note that he tended to be relatively secluded when it came to policy. He relied mainly on just a handful of advisors, which included Jerry Corrigan. Corrigan had been a senior officer at the New York Fed, and Volcker had brought him along at the beginning of his tenure. Corrigan subsequently became president of the Federal Reserve Bank of Minneapolis before moving to the presidency of the New York Fed. Another confidant was the general counsel Mike Bradfield, whom Volcker hired. Bradfield was not attuned to the Fed culture and was a pit bull when it came to pursuing issues and asserting power. Bradfield surfaced in the aftermath of the financial crisis as a proponent of the Volcker Rule and also played a role as the driving force that uncovered dormant Swiss bank accounts that had been owned by victims of Nazi persecutions. Bradfield was known as Volcker’s enforcer, and he never fully adjusted while at the Fed to being a lawyer in an institution controlled by economists. To that point, on his first trip to the Fed of Kansas City’s Jackson Hole conference, Bradfield went on a whitewater rafting trip the first day, during which he fell off the raft and lost his glasses. I had several staff claim to me during the conference that they were the ones who pushed him. Volcker’s final key confidant was Steve Axelrod, who was Staff Director for Monetary Policy, a position in the office of the Board members that does not exist now. Steve was in charge of coordinating monetary policy for the Board. He was not a division director but because of his position he could order any of the research staff to do his bidding. Despite Volcker’s tendency to listen to only a few close associates when it came to key policy issues, but unlike Arthur Burns, he was respectful and tolerant of staff. I was fortunate enough to have a chance five years or so ago to sit down with Paul at a Federal Reserve Bank of Chicago conference and discuss the past. Despite my previous position as one of just many Fed staffers, he was cordial and more than willing to talk about old times and experiences. The qualities noted at the beginning of this piece were still as strong as ever. That conversation was a real treat that I will always remember.

New York | In this issue of The Institutional Risk Analyst , we feature a timely conversation with Dr. George Selgin , senior fellow and director of the Center for Monetary and Financial Alternatives at the Cato Institute and Professor Emeritus of Economics at the University of Georgia. He is the author of a number of books, including Floored! How a Misguided Fed Experiment Deepened and Prolonged the Great Recession (The Cato Institute, 2018) and writes frequently on monetary policy, payments and related topics for Alt-M . We spoke to Dr. Selgin last week from his office in Washington. The IRA: George, thank you for taking the time to speak with us today. Let’s start with the snafu in the world of repurchase agreements and short-term money markets and then move to the equally important question of payments. First thing, how do you explain the liquidity problems seen in the REPO market over the past year to ordinary citizens and particularly members of Congress? More important, how do you link the policy narrative coming from the Federal Open Market Committee with what the Fed is actually doing in the markets? The two often seem disconnected. Selgin: Those are some big questions. You start by observing that for some decades now the Fed like other central banks has insisted that its task is to regulate short-term interest rates. So, when interest rates do something that the Fed has not planned for them to do, that’s a problem. If the Fed isn’t able to control interest rates, then what is it doing and what is it able to do? I’d start with that premise, that the Fed is supposed to be able to keep interest rates on the desired target or target range, but in fact has been having trouble doing so. It had trouble keeping rates in line in September and it may soon have trouble doing so again. The IRA: Well, investors may not cooperate. The whole idea of targeting interest rates, as you noted in your book “Floored,” essentially amounts to the nationalization of a heretofore private financial market. But do continue. Selgin: The second point to make is that under the post 2008 system, banks are supposed to have all kinds of liquidity; they should have so much liquidity that they never have to resort to borrowing from other banks to cover shortfalls in reserves. But things haven’t turned out that way. It was the desire of some banks to cover reserve shortfalls, for example, plus the unwillingness of other banks to lend was the proximate cause of problems in September and may become one again. The IRA: Indeed. Isn’t it remarkable to see Fed Governor Randal Quarles at the Fed and Zoltan Pozsar at Credit Suisse (CS) each put various pieces of the puzzle forward for our consideration, but no one really talks about your point namely the idiosyncratic behavior of individual banks. Wells Fargo (WFC) , for example, has 15% more liquidity than it needs to fulfill the liquidity coverage ratio (LCR) and other tests. JPMorgan Chase (JPM) likewise is no longer providing liquidity to the markets as year-end approaches. Trillions of dollars in liquidity is essentially out of the market. Selgin: That’s right. There are two ways to understand why reserves ended up in short supply. One which the Fed has tended to emphasize is that the Fed miscalculated how many reserves would be required to keep the system flush, particularly in making plans for reducing the size of the balance sheet starting in October 2017. Consequently, it seems to have overdone things a little bit. The IRA: Ya think? Do our colleagues in the Fed system appreciate just how close we came to running the ship aground? Last December particularly? Selgin: I think they do now! What they don’t appreciate enough, but are coming around to appreciating, is that the problem is not simply that there are not enough total reserves in the system, but that those reserves are concentrated in a few large banks, including Wells but also others. And they failed to reckon with the fact that, even though these banks on paper had sufficient liquidity to meet the LCR rule and other liquidity requirements, in fact they did not feel comfortable lending out what seems to be a surfeit of reserves—not even in response to high rates and for short periods. The IRA: Or even to their own people. We reported on one case where the bank side of a certain money center essentially told the capital markets desk of the same bank that they had to pay those elevated market rates. Selgin: There are subtle regulatory constraints, including some rules that are unwritten, or written as it were on the margins of the regulations. Those rules are constraining banks more than the Fed and other regulatory authorities, or the bankers’ themselves, expected. The Fed is learning that the banks are interpreting the rules in such as way that they really need to keep more liquidity than was once thought necessary. The IRA: To that point, isn’t the “island of liquidity” notion adopted by the Fed and other prudential regulators, where a large money center bank need not transact with the market for 30 days or more, a little extreme? It reminds us of the ridiculous requirement in the Volcker Rule that banks not trade around their treasury portfolios, a requirement that killed liquidity in the bond market. The cumulative effect of all of these rules is to reduce market liquidity. Selgin: I think it probably is a little excessive. After every major financial crisis, the tendency isn’t just for the regulatory authorities to shut the barn gate after the horses have bolted. They slam the gate shut so tight that you can’t get new horses out for exercise. That’s what’s happened since the 2008 crisis; that the regulatory pendulum has swung too far in the direction of stringency. Now we have a system where in theory there are plenty of reserves, way more than 2008, but various requirements, some interacting in subtle ways, mean that all of that liquidity is frozen. It does not move around that way it did pre-2008. So, you have large amounts of reserves that can’t go where they’re needed. As I said in a Tweet recently, something can be liquid or it can be frozen. Today the liquid reserves of the banking system aren’t really liquid because they’re frozen. The IRA: Hasn’t this been the approach all along, going back to the 1990s to reduce liquidity via regulation? In the 1990s, when the SEC changed Rule 2a-7 and essentially made it impossible for nonbanks to sell pass through securities to money market funds, we created a monopoly on short-term funding for banks. The regulators keep taking functionality out of the money markets, then they wonder why there is a liquidity problem to your point. Selgin: That’s right. But you can go back a lot further than the 1990s. You can go back to the 19th century, when countries, including the United States, started to experiment with various types of reserve requirements. What most nations eventually discovered is that, when you make these requirements strict enough, the reserves simply don’t do what you want them to do. That is, the banks can’t use them when it would benefit them and the economy for them to do so. Uniquely among industrialized nations, the United States still has nominally fixed reserve requirements for banks. Most other nations got smart and dispensed with them years ago. They came around to the view that, while liquidity is very important, rigidly enforced reserve requirements did not make banks more liquid. If anything, they made them less liquid. History now seems to be repeating itself in the US, where Basel and other rules have made banks less rather than more liquid. The IRA: Based upon the Fed’s clumsy handling of the liquidity issue, we’ll not hold our breath waiting for a comprehensive fix of the problem you describe. Moving now from the money markets to payments, let’s talk about why the Fed seems intent upon creating a new payments system to compete with the Clearing House Association. The Fed today enforces a monopoly on payments reserved exclusively for insured depository institutions, but now the central bank seemingly wants to compete with the private sector. Selgin: It’s generally true that if you want to have innovation in payments, you must have a system that interacts with the established banking system payments network. That is the big one. There are other networks out there that could potentially support important payments systems, such as Facebook (FB) with its proposed Libra exchange medium. Still, the banking system has a huge advantage when it comes to dollar-based payments, and when it comes to dollar payments would-be non-bank innovators must be able to tap into the bank-based payments network. This creates a huge problem for non-banks that want to get a piece of the action in payments without needing the cooperation of a potential rival. That’s one challenge. The other challenge for innovation is that banks themselves have to work with the Fed. The big challenge for banks is that the Fed can itself compete with their efforts to expedite payments. Everybody is talking about FedNow , the Fed’s plan for a new real-time retail payments system. FedNow will compete with RTP, a private real-time payments network created by The Clearing House (TCH) . which has been up and running since 2017. Another challenge is getting the Fed to improve those portions of the dollar payments system that it monopolizes upon which other payments service providers depend. This is really the elephant in the room when it comes to payments. The IRA: Well, the future of payments is FedNow, right? The Fed is a GSE just like Ginnie Mae and the Federal Home Loan Banks. No private entity, even a big bank, can compete with a GSE. Selgin: Not easily. And the Fed regulates the banks behind RTP, the system FedNow will compete with TCH.. Does competition from the Fed help or hurt consumers of payments services? There is a fundamental conflict of interest for the Fed to be competing with the banks that it regulates. But the bigger issue is not FedNow or the huge amounts of money that the Fed is likely to spend creating its alternative instant payments system. It’s what the Fed is not planning to do. There needs to be more discussion of how the Fed can improve the payment services it already provides, especially by extending the operating hours of its wholesale payments services, FedWire and the National Settlement Service. By enhancing those systems it would help to support private-system payment system innovations, like RTP. Instead of competing with RTP, the Fed would do more good by improving the speed and efficiency of the wholesale payment services upon which all existing non-cash retail dollar payments depend. All of the payments systems that exist or are contemplated depend upon one or both of the Fed’s wholesale payment services. The IRA: So how should the Fed proceed? Selgin: The entire legacy payments system sits atop the FedWire and the National Settlement Service foundation. All ACH payments, all check payments, are settled using one or both of those services. Why is it that ordinary payments between two US banks can take days to clear? Hold onto your hat: FedWire and the National Settlement Service are not open on weekends or holidays. In fact, the business-day hours are so limited as to substantially reduce the extent to which ACH payments can be completed on a single day.. Simply extending those services’ hours, including keeping them open on weekends and holidays, would enormously enhance the speed and efficiency of traditional payments. Just keeping the system open another 30 minutes each weekday would make a great difference. Instead of working on a controversial, expensive and possibly redundant FedNow system, why doesn’t the Fed first improve its existing, core payments services? The IRA: And who knows, accelerating the velocity of payments might even have economic benefits! Imagine that! Thanks George.

New York | Over the past several months, news reports have suggested that the global auto industry is about to disappear. Ford Motor (F) announced a 10 percent reduction in executive ranks earlier this year. Daimler AG (DAI) has just announced additional job cuts. Analysts blame consumer angst regarding global warming and the imminent conversion of the industry to battery-powered electric motors. But sad to say, we think that politically motivated climate change hype inspires unwarranted pessimism about the prospects for autos, a skew in thinking which seems to color every discussion about every industry. A better explanation of downsizing in the auto industry is the end of a massive credit expansion and the continued industry rationalization that defies efforts to reduce overcapacity. That is, the same old story. Everybody wants to have a domestic auto industry. Many times, these industries are heavily subsidized, as in the case of electric cars in the US, Europe and China. Private producers in the US and EU are constantly forced to cut costs to keep pace. In regions like western Europe, where regulation and taxation are extreme, operating auto manufacturing operations is increasingly problematic. But if you want a real example of global deflation, forget the autos. Instead, take a gander at the earnings prospects facing global banks and particularly banks in Europe. The good news for American investors is that US banks are still easily the leaders in terms of capital and profits, but the outlook for global financial institutions is dreadful. Read about the most recent results for the US banking sector in The IRA Bank Book Q4 2019 , which is for sale now in our online store. Credit is strong, but the outlook for earnings not so much. The bad news is that banks in Europe and Asia face a period of restructuring and consolidation unlike any time in the century since WWI. Indeed, the vast demographic and financial expansion that drove global economic growth for the past 100 years appears to be ebbing around the globe. Markets outside the US seem to be particularly at risk. One chief risk officer tells The IRA that just about every major European and Asian bank will be forced to downsize or eliminate their capital markets arms in 2020. "Everyone has the same problem," he demurs. EUROGROUP Consulting, for example, reports that European banks are “struggling and losing out to American banks,” which have managed to strengthen their position in Europe, notably by relying on a large domestic market and a more favorable regulatory landscape. Simple stated, the insane, anti-growth regulatory and tax regime in the EU is killing the continent’s banks. And another big part of the problem facing EU banks and industrial companies alike, of course, is the tax known as negative interest rates. When Fiat Chrysler (FCAU) and Groupe PSA , the owner of Peugeot, agreed in October to combine forces to create the world's fourth-largest carmaker by production volume, this was not a sign of the impact of global warming on consumer preferences. Instead, two of the least efficient players in the auto industry in Europe were finally forced to consolidate in an industry with chronic overcapacity. Look for more combinations in coming months, particularly in Europe. Sales in the global auto industry peaked two years ago over 80 million vehicles, leading many observers to predict the imminent collapse of the sector. But what really seems to be at work here, in our view, is more of a normalization of production and demand to lower levels. The past decade of manic increases in vehicle sales were driven by low or negative interest rates, but the impetus for further growth seems to be ebbing fast. Notice that US sales of cars and light trucks has gone sideways since 2016. A decade ago, when US auto sales were limping along at 10 million units annually, the US auto sector was in danger of extinction. The fixed costs involved in making vehicles could not support three independent US automakers at this level of volume. As we wrote in “Ford Men: From Inspiration to Enterprise,” the departure of Lee Iacocca from Ford Motor in 1978 led to Chrysler surviving as an independent producer for another three decades. The persistence of Chrysler and the acquisition by Fiat in 2014, in turn, weakened Ford Motor and General Motors (GM) . With the US auto industry now operating at over 17 million vehicles per year, however, many observers have come to believe that this level of production is “normal” and sustainable for North American sales of light vehicles. That may not be the case. The expansion of non-housing debt helped to fuel the boom in auto sales since 2014. The availability of credit has driven the surge in auto production in North America to almost 18 million units. Source: FDIC The FRBNY reported in November that total auto debt, including $475 billion in bank owned auto loans, is $1.3 trillion. The auto loan asset class has basically grown by one third over the past decade. Or to put it another way, subprime auto loans account for about half of the $1.6 trillion in asset-backed securities tracked by SIFMA. Total household debt is now $1.3 trillion higher, in nominal terms, than the previous peak of $12.68 trillion in the third quarter of 2008, according to the FRBNY. “New credit extensions were strong in the third quarter of 2019, with auto loan originations reaching near-record highs and mortgage originations increasing significantly year-over-year,” said Donghoon Lee , research officer at the New York Fed. “The data suggest that households are taking advantage of a low-interest rate environment to secure credit.” So, is the US auto sector facing the apocalypse? No, but you may indeed see sales dip back toward 16-17 million units in North America. And expect some frightful restructuring of automakers in Europe, including the operations of US automakers. Auto makers globally are reducing headcount at the fastest rate since the 2008 financial crisis, a year before both GM and Chrysler filed bankruptcy. We may indeed see further acquisitions and some restructurings in the auto sector in 2020. Our bet: Look for Ford to eventually cut a deal to combine with a major European automaker. The ongoing restructuring of the global auto sector will be accompanied by an accelerating consolidation of the banks, particularly outside the US. The hostile business and regulatory environment in the EU is killing the banking system in Europe, but the politicians there seem to be largely indifferent. Unless and until leaders in Europe and Asia reject the insanity of negative interest rates and start to focus on the real problem -- namely excessive public sector debt -- banks in Europe will remain an endangered species and, to us, unsuitable for investors of any stripe. #Ford #Daimler #autos

New York | Even as a record 50 million Americans hit the road for Thanksgiving last week, the Federal Deposit Insurance Corp released the Q3 2019 financial results for the US banking industry, reminding us why reading the press on holidays is essential. Headline: Bank earnings are falling and have been since last year. But hold that thought… Below we look at several charts that tell the story as the US heads into year end 2019. And just a reminder that registered readers of The Institutional Risk Analyst can still take advantage of the " Black Friday Sale " through Monday December 2nd. The code we sent readers on Friday gives you a 30% discount off of the list price for our bank profiles. Perhaps the most significant change from last quarter was the fact that loss given default (LGD) for the $2.5 trillion in 1-4 family mortgage loans owned by banks reversed direction as home prices surged again, reaching a record low of -38% in the third quarter. Think of falling resolution costs as the inverse of home price appreciation. Memo: Send another thank you note to Fed Chairman Jay Powell. Gross charge-offs in 1-4s also fell to a post 2008 financial crisis low, confirming that credit conditions in the housing sector continue to appear benevolent, but also badly skewed compared. Of note, the long-term average LGD for bank owned 1-4 family mortgage notes over the past half century is 65%. The impact of monetary policy, a shortage of new and existing dwellings and a change in the behavior of older home owners has created a perfect storm of rising home prices and declining affordability. As a result of the increase in home prices, when those rare residential mortgage default events actually occur, the lenders profit on the resolution of the asset, as shown in the chart below. For many Americans, the dream of home ownership is simply no longer possible. A future of tenancy and insecurity awaits. Source: FDIC/Whalen Global Advisors LLC The chart above suggests that lending on prime 1-4 family homes has no cost in terms of credit, clearly an erroneous statement. Yet looking at the extraordinarily good credit performance of bank-owned 1-4s, it seems that those bearish warnings from some quarters of an impending recession in 2020 may have been a tad overstated. In prime auto loans held by banks, to look at another consumer facing sector, there is likewise evidence of stability in credit metrics. LGDs for auto loans fell below 50% for the first time since 2014. The average LGDs for bank owned auto loans is 56% going back to 2012, when the FDIC started requiring banks to break out this important consumer loan category in their quarterly disclosure. All that said, the trend in terms of net charge-offs and past due of bank owned auto loans continues to move higher, as shown in the chart below. Source: FDIC/Whalen Global Advisors LLC The next chart we selected from the Q3 2019 data from the FDIC is the net growth of total deposits and total loans, one of the most important relationships in terms of the overall condition of the US economy. In the period immediately leading up to the 2008 financial crisis, the rate of growth in deposits and therefore loans were quite high by historical standards. Then, following the 2008 crisis, the level of loans and deposits fell sharply as the industry took over $100 billion in losses that year, destroying both bad loans and the related deposit liabilities. Notice the huge downward skew in loans in Q4 2009, when the industry charged off $60 billion in bad loans in a single quarter. Since then however, despite or even because of the radical policies followed by the Federal Reserve Board, the level of deposit and lending growth rates have fallen, as shown in the chart below. The graphic shows the period end portfolio levels of loans and deposits, net of redemptions and new originations. Source: FDIC/Whalen Global Advisors LLC Finally, to return to that question about bank earnings, we take a look at after-tax bank results, both in terms of asset and equity returns. As we have been writing for almost two years in The Institutional Risk Analyst , the steady increase in bank funding costs have slowed and now reversed the steady growth in bank income since 2008. The one time increase in “returns to us” caused by the 2017 tax legislation is now long behind bank stock investors. Our friends in the worlds of asset management and financial journalism have trouble describing a decline in income to their various constituencies, but the numbers tell the tale very simply. US banking Industry net income peaked at almost $62 billion in Q3 2018 and has now fallen to $57.3 billion last quarter. That’s a ten percent decline, but you rarely read or hear that fact in the financial press. We must always be constructive, even if it means misleading the investing public. While the rate of increase in bank interest expense has slowed since Q2 2019, the deterioration in bank asset and equity returns is clear. Including large markdowns of mortgage servicing assets, "the average return on assets declined from 1.41 percent in third quarter 2018 to 1.25 percent," notes the FDIC. But the "one-time" events do not explain the downward trend in bank earnings. The peak of bank asset and equity returns was Q3 2018 at 14.8% and 1.4%, respectively. Income is falling, but the total assets of the industry continue to rise. The chart below shows asset and equity returns for all US banks. Source: FDIC/Whalen Global Advisors LLC The bottom line is credit quality in the US banking industry remains strong -- if you believe the data. The skew in home prices for the reasons described above raise doubts about the long-term credit cost of loans being originated today. It is interesting, of note, to see the LGDs for Commercial & Industrial loans and Total Bank Loans climbing, suggesting a slow but steady deterioration in credit quality is underway outside of the badly skewed world of residential housing. More troubling, however, is the lack of net growth in spreads on new lending and the secular decline in deposit growth rates since the Fed instituted “quantitative tightening” two years ago. The cessation in QT and the sharp reversal by the FOMC to add back liquidity to the money markets has not yet delivered an increase in domestic bank deposit growth rates. Without deposit growth, you cannot have strong loan growth – contrary to what many economists seem to believe. The continued increase in bank funding costs, regardless of what the Fed does or does not do, will remain a negative factor affecting bank earnings. Even with the change in direction of US monetary policy since the end of 2018, the pressure on bank earnings continues both due to rising funding costs and secular pressure on asset returns in the age of negative interest rates. A decade since the financial crisis, US banks have still not recovered to previous levels of asset and equity returns and are now losing ground. We will be covering many of these issues in greater detail inside the next edition of The IRA Bank Book and in our individual bank profiles .

New York | News reports suggest that The Charles Schwab Corporation (SCHW) may acquire TD Ameritrade Holding Corporation (AMTD) . SCHW is a $280 billion thrift holding company ( RSSD:1026632 ) that ranks 14th in the US among large depositories. With $3.2 trillion in assets under management (AUM), SCHW also has a dominant position in the world of providing clearing and custody services to registered investment advisors (RIAs). Darren Fonda notes in Barron’s that this fact – and the float that it generates – enables the banking side of SCHW to generate 70% of the firm’s combined revenue. It's all about the float kiddies. In our note in ZeroHedge last week (“ Schwab + TD Ameritrade: Banks Always Win ”) we opine that this gives SCHW an overall cost of funds just 40% of the average of Peer Group 1, as shown in the chart below. Source: FFIEC The fact that a combined SCHW and AMTD would have $5 trillion in AUM allow us to estimate that the combined deposit base would be over $300 billion, including customer balances and fiduciary float. Today Charles Schwab Bank, an S&L domiciled in Henderson, NV, has $200 billion in core deposits. This abundance of liquidity – and fee income – raises an interesting possibility, namely a counter-offer by The Toronto-Dominion Bank (TD), which is the custodian bank for AMTD. Barron’s notes that TD, which owns 43% of AMTD, is presently the bank custodian for the millions of RIAs and individual investors of the smaller non-bank brokerage firm. TD earns the interest on the float, minus a very legal rebate paid to AMTD. This is a similar arrangement to any non-bank company, which must deposit client balances with an investment grade insured depository institution and then borrow them back if needed. SO, the question arises: Does the management of TD in Toronto really want to see AMTD acquired by a competitor and another large bank at that? As Barron’s notes rather astutely (and the rest of financial journalism largely missed), the relationship between TD and AMTD is quite lucrative for the $1.3 trillion TD. Again, it’s all about the banking business. The brokerage side of the business is largely a commodity that does not matter in the grand calculus of valuation. But what supports the lofty valuations of both SCHW and AMTD? One word: AUM. With AMTD trading around a $26 billion market cap and SCHW at $60 billion, acquiring the 60% of the former it does not own would cost TD something on the order of $15-20 billion. TD trades in line with its large bank peers at ~ 2x book as of Friday, meaning a bid to acquire the rest of AMTD would be very expensive. News reports speculate that SCHW may cut a deal with TD to allow the Canadian bank to continue to service the deposit business of AMTD until the agreement expires in 2021. We think, however, that SCHW will be anxious to gain full control of the AMTD float as soon as possible. Telis Demos writes in The Wall Street Journal : “Schwab has long operated its own bank. Ameritrade partners with Toronto-Dominion Bank (a roughly 40% owner of the company) and others to distribute customer cash and earn what is, in effect, a net interest margin on that cash. Schwab currently generates a higher net interest margin than Ameritrade, so in theory that same customer cash could be more lucrative if deposited at Schwab’s bank.” Ditto Telis. And one veteran wealth manager tells The IRA that a counter-bid is unlikely because most of TD’s revenue comes from Canada, where it operates both a banking franchise and a large wealth management business. TD also has Waterhouse Securities, another discount brokerage which TD acquired two decades ago. Despite the prospect of losing the AMTD business, the manager views a possible counter-offer by TD for AMTD as a low probability event. TD has benefited from the entire float controlled by AMTD by owning just 40% of the company, but buying the other 60% at north of 3.5x book or higher is a bridge too far for the risk averse Canadians. TD has a very large core deposit base in Canada and, like most banks, suffers from a dearth of earning assets rather than a shortage of liquidity. A more likely scenario, the manager offers, comes with TD rebranding the Waterhouse brokerage business and taking the gain on the AMTD equity stake off the table. And, to the headlines about SCHW possibly “surging” above 3.5x book in the event the deal closes, validating the correlation between the SCHW deposit base and the premium valuation is not a straightforward exercise. The SCHW bank is low risk and provides stability to the business, but again, we’re not sure how that works into a 3.5x book equity multiple for the whole business, as shown in the chart below. Is the off-balance sheet AUM of SCHW more valuable than the huge mortgage and commercial payments float of U.S. Bancorp (USB) at 2x book value?? Source: FFIEC Liquidity: Please Sir, May We Have Some More? Despite all of this talk about banks awash in core deposit liquidity, we note with growing concern that we are repeating the scenario seen last year in the short-term money markets. Bids are adequate for overnight funds and a couple of weeks out, but there remains a reluctance to offer cash over the year-end. As the chart below from the DTCC suggests , the volumes for GCF repos of Treasury and conventional Fannie Mae and Freddie Mac collateral are falling as they did last year. Just saying. Black Friday Sale We’ll be pushing a 30% off coupon to registered readers of The Institutional Risk Analyst so that you can spend the holiday season pondering the truly extraordinary business model attributes of Citigroup (C) and Goldman Sachs (GS) . Yeah, SCHW has 3x the core deposits of GS. Think about that for a moment. Is there a correlation between strong levels of core deposits and premium equity market multiples? Maybe. And to celebrate the holiday season and shareholder value destruction, we’ve added HSBC Holdings plc (HSBC) to The IRA Bank Dead Pool , as shown in the table below. Trading on a price/book of 0.8x and a beta of 0.6, HSBC has effectively died as a stock – one of the negative side effects of macro prudential regulation. Were this $2.5 trillion asset zombie not a regulated depository, it would have been acquired and broken up years ago. But cowardly regulators refuse to break up the true zombie franchises with no hope of revival. Happy holiday. #HSBC #GS #C #DB #DarrenFonda #TelisDemos

New York | Did Goldman Sachs (GS) and Apple Inc. (AAPL) discriminate against women in the provision of credit on the new accounts for the Apple Card? Probably not deliberately, but credit scoring systems generally see women as being inferior credit risks – both internal and external to the actual underwriting process. When you apply for consumer credit, your individual score and credit utilization history are the primary criteria considered. “Several husbands — including Apple co-founder Steve Wozniak — have complained that their wives were offered dramatically lower lines of credit than they were,” reports CBS.com . Sadly, the new reports did not disclose the FICO score and credit histories of the offended spouses. A June 2018 paper by Federal Reserve Board researcher Geng Li , “Gender-Related Differences in Credit Use and Credit Scores,” outlines some of the difficulty faced when asking questions about gender bias in consumer lending. First and foremost, lenders are not permitted to gather or use gender related information, thus the public research in this area is limited. Li notes: “The Equal Opportunity Credit Act largely prohibits the use of demographic information, including gender, in credit underwriting, pricing, reporting, and scoring.4 As a result, information on credit histories and demographic characteristics has rarely been collected in the same data source, making evaluation of gender-related differences in the credit market challenging.” The mere fact that one spouse gets more credit than another does not necessarily indicate a problem in the credit scoring system. One spouse may be more active financially than the other, resulting in a higher rate of utilization of credit. Current usage of revolving credit lines such as a mortgage or a car lease is a major factor that drives credit scores and the availability of credit. Also, each bank has an internal default rate score for the “ideal” customer for a given product. As we noted in our recent profile of GS , the bank currently has about 40bp of gross defaults or just inside the breakpoint for a “BBB” portfolio default rating. Applicants below the “ideal” credit profile for a bank credit card product, for example, are likely to see lower initial credit limits or be denied credit entirely. But the real question raised by the consumer advocate wah-wah aimed at GS and AAPL is whether the lender reverse engineered the gender of the applicant during or after the underwriting process. Wall Street has for years wanted and tried to be able to track the obligor and the related assets and information in real time, particularly in areas such as mortgage lending. The early efforts backed by Buy Side hedge funds were massive, very expensive undertakings. But whereas a decade ago and more it was too laborious to manually merge credit profiles with a given individual’s personal information, today that data is commonplace and ubiquitous. Merging third-party demographic information with a loan file is a very simple matter. Indeed, some of the major consumer data repositories reportedly have begun to offer permissioned clients such as lenders and servicers secure access to merged data sets. Just imagine a confidential, non-public dashboard that merges credit, the value of the consumer’s home and behavioral data gleaned by Google and Facebook (FB) . Once a lender or investor can determine whether or not you are a single parent and a biological male or female, the credit analysis changes. Why? Because there is a correlation between gender and default probabilities. Again Li: “[S]ingle females tend to have higher installment loan balances, higher revolving credit utilization rates, and greater prevalence of delinquency and bankruptcy histories than otherwise comparable single males. Reflecting such differences in debt usage and credit history, on average, single female consumers have lower credit scores than comparable single male consumers.” Now here’s the catch. GS and other lenders don’t necessarily even need to hack your complete profile because the FICO score largely captures the gender difference. This is one reason that consumer advocates have been pushing for “competition” among credit scores. Calling for “competition” in credit scores is another way of saying that we’ll “democratize credit” and stick the losses to bond investors and the taxpayer. Just because you pay your utilities on time does not mean that you can service a 30-year mortgage. Of course, given the past track record of GS in other domains, it is easy to imagine the firm trying to limit default risk by reverse engineering the demographic attributes of their retail customers. As noted above, creating a comprehensive profile of an obligor is so easy in today’s market for behavioral data that it would almost be negligent for a lender or servicer not to have the information. And since there are any number of vendors happy to maintain such data remotely, away from the bank’s IT platform, it would be almost impossible to disprove such an allegation. So ask not whether you should be soiling your nappies because Google is caching your search results or playing with the algorithm that determines what you see online. Ask instead how you feel about unregulated third-party data providers and consumer credit repositories maintaining profiles of all of your consumer spending behavior, by name, gender and other attributes, as well as the behavior of your family. #GoldmanSachs #FICO #FederalReserveBoard #AAPL #GS #Li #SteveWozniak

New York | Fed Chairman Jerome Powell confirmed this week that the FOMC is unlikely to make any further reductions in interest rates for the balance of 2019. Various market observers have offered opinions about whether the interest rate environment is good for banks and those with leverage or not. Suffice to say that the spreads between rates in dollars and different currencies – specifically euro and yen -- are more important than the notional "neutral rate” of interest in dollars that fills the imaginings of many economists. In that regard, we have posted a new assessment for Citigroup Inc. (C) in The IRA online store . Like the other members of the Bank Dead Pool, our view of the quantitative and qualitative factors affecting C is decidedly negative. Poor asset returns, expensive funding, geographic diversity in all of the wrong places, limited liquidity and the world’s biggest derivatives book somehow just doesn’t do it for us. To paraphrase Jim Grant’s observation about Fed Chairman Powell, Citigroup CEO Michael Corbat is a prisoner of history. With Citi's battered currency trading barely at par, there is nobody among large banks with stable, core deposit liquidity out there for sale at a price that Citi can pay. We write in the most recent assessment: “Unless and until the management team led by Michael Corbat finds a way to enhance the bank’s financial performance and/or funding, we expect the bank to continue to underperform its asset peers in terms of market valuations. We believe that a change in the operational path of C is unlikely to occur in the near term and is only likely to occur at all as and when regulators compel a combination with another large bank.” We compare Citigroup with JPMorgan Chase (JPM) , U.S. Bancorp (USB) , American Express Company (AXP) , Capital One Financial (COF) and the 125 largest US banks in Peer Group 1 . Suffice to say that the head-to-head with AXP, which is the best performing large bank in the US and trades over 4x book value, isn’t too pretty. Even though the smaller AXP has a higher cost of funds than C, it delivers far better asset and equity returns than the $1.9 trillion zombie bank. Source: FFIEC In other news around the financial markets, Chairman Powell appeared on Capitol Hill this week and confirmed that the FOMC has fixed the liquidity problem in the repo market, at least for now. It is no accident that the VIX and other measures of volatility have basically collapsed since the FOMC opened the monetary spigot back in September. The correlation between adverse changes in the financial market stress and the subsequent launch of a new QE program has been widely remarked, but not it seems inside the FOMC. It is pretty clear that the markets globally cannot tolerate any meaningful decrease in the Fed’s balance sheet without the short-term credit markets seizing up. From the end of 2017 to July of 2019, the Fed’s System Open Market Account (SOMA) shrank by just over $400 billion or 10% of the Fed’s total assets. Yet the impact on the financial markets was dire indeed, as shown in the chart below. Notice that liquidity related stress due to QT pushed the VIX to 35 last December. Then seasonal factors lulled us all back to sleep, even as the contraction of the SOMA continued. Over the summer, however, idiosyncratic factors combined with ebbing liquidity to cause an increase in visible volatility. The quarter-end in June, however, saw significant problems in repo land. By August, the increased perturbations in the VIX, to borrow a favorite term of our colleague Dennis Santiago, then caused the equity markets to become unstable. When the word “repo” started to appear in headlines on CNBC and in The Wall Street Journal , that signaled a change in the direction of Fed policy. When President Donald Trump gives Powell a hard time about interest rates, the Fed Chairman need only point to the VIX and the S&P 500 for the proof of the efficacy of monetary policy. But the more important point to make is that the US central bank now is in the position of defending both the bond and equity markets (and, indirectly, the dollar) by maintaining minimum levels of liquidity in the credit markets. So how does this impact banks? The good news is that the rate of increase in bank funding costs slowed after Q2 2019. Also, banks have made some progress in the past several years in getting some increase in loan spreads, but the competition for assets at all levels of the banking industry effectively caps the asset return upside. If you take the five-year Treasury less Fed funds as a surrogate for net bank loan spreads, the spread was negative from March through September, when the easing and liquidity operations of the FOMC widened spreads dramatically. But the FF-to-5s spread only just crossed back into positive territory in late October. The good news is that the direction of monetary policy or at least liquidity policy, seems to support a gradual widening of spreads. After two years of tightening during the Fed’s ill-considered balance sheet contraction, the message of the markets is that an inverted yield curve is bad. As the imperative of the Fed has shifted from stoking inflation to maintaining liquidity, the ability to tighten monetary policy at all has been lost. The public narrative from the FOMC is still a tangled confusion of econometric bullshit that has no relationship to the Fed's actions in the marketplace. The practical task facing the Fed is to defend the all-important liquidity vs VIX relationship. So long as volatility remains muted, monetary policy will remain in neutral. But when volatility starts to climb, look for more liquidity measures from the Powell FOMC. #Citigroup #AmericanExpress #USB #JPM #UBS #JeromePowell #BankDeadPool #SOMA

New York | Last week we pondered the fate of Citigroup (C) and several other global banks that have lost their raison d'être with a group of veteran treasury and operations managers. Will the bank built over the years to service the political inhabitants of the post-war Pax Americana survive another decade? Or will the relentless consolidation of the banking industry at the top continue by forcing the sale or breakup of C? During the Cold War years and after, Citi was a very convenient institution indeed, a favorite haunt for intelligence operatives and central bankers. But the fact of official support did not prevent Citibank N.A. from making some truly epic operational errors, mostly tied to exotic offshore venues where the bank chose to do business. In many ways, Citi was the successor to famed institutions such as Pakistan’s Bank of Credit and Commerce International (BCCI) . The Mexico City money laundering scandal involving Citibank Private Banking and Raul Salinas de Gortari in the late 1990s resulted in years of litigation and the eventual ouster of John Reed as head of Citigroup. The removal of Reed ushered in the era of Chuck Prince , Sandy Weill and Robert Rubin , setting the stage for Citi’s 2008 collapse and government rescue. A series of international and domestic fiascos have followed since the 1990s, including the WorldCom scandal, rigging LIBOR and various other infractions of anti-money laundering laws and regulations around the world. The incompetence and deception displayed by Citibank officials so grotesquely in Mexico in the 1990s was repeated over and over again in the US and foreign venues such as Buenos Aires, Lagos and London. The cost of these errors and omissions to C shareholders stretches into the tens of billions of dollars . As the official international support for Citibank ebbed, however, the bank’s patchwork business model began to show strain. Today, after selling its Smith Barney asset management arm to Morgan Stanley (MS) , Citi lacks a clear path for the future. The bank has limited domestic deposits to support its $2 trillion in assets and the largest OTC derivatives book of any US bank – at least in sheer dollar terms. The prize for the largest derivatives exposure of any large US bank per dollar of assets goes to Goldman Sachs (GS) . But hold that thought. We actually heard Jim Cramer last week encourage his viewers on “Mad Money” to have a look at C as an equity investment. No way Jose. With due regard to Jim, we’d say the Citi stock is toxic. We own the C TRUPs, but the common is dead money IOHO. Citi trades below book for a reason. As Dennis “Mr. Wonderful” O’Leary said this summer on CNBC’s Squawk Box about the large banks generally: “Dead Money.” Investors are not paid nearly enough to take the outsize financial and operational risk that comes along with owning the Citigroup enchilada or risk and return. Simply stated, there is a reason why this stock trades below book, while asset peers such as JPMorgan (JPM) and U.S. Bancorp (USB) trade at a premium. The chart below illustrates the fact that C actually under-performs the average of the 125 large and smaller banks above $10 billion in assets that are included in Peer Group 1. Source: FFIEC To help focus our minds on the future, below we list the initial members of The Bank Dead Pool for 2020. This new feature from The Institutional Risk Analyst is inspired by the 1998 film entitled “The Dead Pool,” an American action movie directed by Buddy Van Horn and starring Clint Eastwood as Inspector "Dirty" Harry Callahan. The banks included in The Dead Pool are large, mediocre performers with weak business models, poor disclosure of risks, feeble equity market performance and a history of outsized operational risk events. Indeed, these banks are so problematic in terms of financial performance and the frequency of idiosyncratic op-risk events as to be uninvestable, either by individual investors or another bank. Here is the initial list: Deutsche Bank AG The Goldman Sachs Group Citigroup To be in The Dead Pool does not mean that a bank is in danger of imminent failure. In today’s world, the most likely outcome of a large bank liquidity crisis is a government takeover and conservatorship by the FDIC as per Dodd-Frank. If our friends at the FDIC were not going to liquidate IndyMac in 2008, then they sure as hell aren’t going to liquidate a money center bank now. That said, the members of The IRA Bank Dead Pool are basically dead money from an investment perspective. Zombies. Muertos . 死亡證書. Without significant business model changes and/or increases in capital and liquidity, we don’t expect to see these institutions operating in their current form five years hence. The institutions in The Bank Dead Pool underperform their asset peers among global universal banks. They are unlikely to be acquired except in the context of a fire sale or government intervention. And all of these names have been given a “negative” assessment of qualitative and quantitative factors by Whalen Global Advisors LLC, using the standardized data published by the Federal Reserve Board and other agencies via the FFIEC . The first of a series of IRA Bank Profiles is available for sale in our online store . The first profile is focused on Goldman Sachs. We write: “The primary focus on the brokerage unit and on non-interest sources of income as part of the firm’s business model places GS at a distinct disadvantage compared with core deposit rich institutions like JPM and USB. Even Citigroup (C) and CapitalOne Financial (COF) , which use brokered deposits to fund their consumer loan books, have cheaper funding costs than GS.” Sure, there are other global banks that could be added to The Bank Dead Pool list. Screen for big universal banks with common shares trading at a discount to book value and little or no growth. As we go forward into 2020, we’ll be updating The Bank Dead Pool and publishing new profiles about these zombies as well as some of the exemplars among large US banks. #GoldmanSachs #DeutscheBank #Citigroup #RaulSalinas #FFIEC #JimCramer