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New York | Watching the meltdown of Tesla Motors (TSLA) founder and CEO Elon Musk last week unfold in the pages of The New York Times , we are reminded that enterprises need both vision and operating smarts to be successful. It was obvious years ago that Elon Musk needed help to build a new car company. Yet somehow the members of the board of directors of TSLA did nothing as Elon Musk led this extraordinary endeavor. We noted in Ford Men: From Inspiration to Enterprise that Henry Ford had the vision thing, but his partner James Couzens turned the idea into a successful business. So bad was his reputation for tinkering and racing that Ford was not even an officer of Ford Motor Co (F) when it was founded, but he had an idea. Thanks to Jim Couzens, in less than a decade that idea Henry Ford nurtured exploded into one of the great American fortunes, a transformational fortune built on manufacturing. The business was wildly successful and repaid its investors and more in the first year. And thanks to another Ford Man, engineer Charles Sorensen, Ford Motor Co invented the assembly line that enabled the company to meet the astronomical demand for cars a century ago. Musk is no Henry Ford, but TSLA is the latest case in point to the lesson that solitary leaders often fail. No matter how brilliant or inspired, most of us need the moderation and help of business partners, directors and investors to make an enterprise succeed and endure. Having Horace Dodge on the board of directors of Ford Motor Co, for example, certainly did not hurt the company’s prospects. The Dodge Brothers actually built the early Ford cars as kits until the Ford Motor Co had its own factory. When Couzens resigned as General Manager of Ford in 1915, the company was by then controlled solely by Henry Ford and would suffer for three decades from his distracted, idiosyncratic mismanagement. The fact that Ford Motor Co did not fail prior to WWII is a miracle. How difficult was Henry Ford? Think Steve Jobs squared. Of course, personalities and vision are essential to any enterprise, but the enterprise cannot be dependent upon just one person if it is to be enduring. Over the years there were many managers and bankers who kept Ford Motor Co afloat. But for the singular efforts of James Couzens, though, Ford Motor Co almost surely would have been Henry Ford’s third business failure. Personalities and vision are important in business, no doubt. Henry Ford II saved Ford Motor Co from bankruptcy after WWII, but he had a deep bench of managers and financial minds behind him and the Ford family. Yet fate plays a strange role in business. Ponder how different the auto industry would be today had Horace and his brother John Dodge not both died of the Spanish Flu in 1920. Dodge might be the number one US automaker followed by GM. Ford Motor Co might have already disappeared from view under the erratic leadership of Henry Ford. The Fords are celebrities but not magicians. You need a dose of techno buzz to achieve that. Had Bill Ford announced in 2003 a project to build all-electric Ford cars, he might have caused a bit of a stir. But Bill Ford never would have escaped the financial straight jacket of the existing auto business. Technology demigod Musk, on the other hand, was able to launch a “new” car company at a technology market multiple based upon the dubious promise of future profits from battery power. But Musk also is TSLA's single point of failure. The dependence upon Musk to maintain the nose-bleed valuation of TSLA seems a key reason why TSLA's timid board has not tolerated any competition in the CSUITE. Despite the tech sector pretensions, the impact of TSLA and Musk on the auto industry is enormous. Consider the fact that Geely expects to IPO Volvo Cars at a $30 billion valuation – more than 16x the $1.8 billion Ford received from the sale of the business in 2010. The Volvo IPO owes as much to the hype surrounding TSLA as it does to the credit market machinations of global central banks. Does a business that made half a million cars last year with a single digit profit margin really deserve a $30 billion valuation? Only if you really, really believe that TSLA is worth $52 billion or more with a fraction of that output. But if TSLA crashes, then the Volvo IPO very likely is toast as well. Just as Tesla had thrived due to the vision and passion of Musk, the company’s prospects and equity market valuation would suffer greatly in his absence. Tesla without Elon Musk is just another unprofitable car maker, albeit one that promises to “accelerate the world’s transition to sustainable energy.” Really? To us, Musk and his investors are stuck on the horns of a very nasty dilemma. In order to make TSLA a functioning car manufacturer, CEO Musk must bring in some operators before he burns out or worse. But to do so means destroying the techno hype that has fuled TSLA's forwad equity valuation, enabling Musk to burn through billions in debt and equity capital based upon a promise of “green” transportation. Anybody familiar with making lithium batteries knows that this technology is anything but green or sustainable. The most recent outburst by Musk about a fictional going private transaction illustrates that the reputation of a successful inventor may not necessarily translate into business acumen. Visionaries such as Musk and GM founder William Durant, on the other hand, are showmen. They are great at building new businesses so long as they are spending someone else’s money. Ultimately, the iron law of profit and loss destroyed the lofty dreams of Durant, forcing GM into the arms of JPMorgan and the DuPont zaibatsu twice prior to WWII. We suspect that the same fate awaits TSLA and its credulous shareholders. And as we've said before, the bond holders are the true owners of TSLA. Investors rightly love Elon Musk because he is more than a mere speculator like Durant. Musk imagines big ideas and turned many of them into reality, a proud achievement that he shares with another great American inventor, Thomas Edison. It was Edison, never forget, who loved the idea of electric vehicles. Yet ultimately when Henry Ford left Edison’s employ in 1900 to build cars, he chose to use gasoline instead of electricity. After creating and selling what would become the General Electric Co, Edison’s business fortunes declined. Merely being brilliant and having a vision of the future was not enough. Ford’s immensely powerful mind generated its own inspirations based on observing the industrial activity that was welling-up from the ground in and around the Detroit region in 1900. He took counsel with peers like Edison, Dodge and Harvey Firestone. Musk belongs to this same exclusive category of visionary inventors inspired by change. But Ford, Edison and Musk all stand as examples of why being a visionary is not sufficient to be successful in building and operating a business. As we noted in an earlier comment (" Should Elon Musk Sell Tesla? "), Musk has defined a market for electric cars and created a brand, but the better part of valor may be to declare success and sell his creation to a larger global manufacturer. Henry Ford called Edison “The world’s greatest inventor and the world’s worst businessman,” a telling assessment that was confirmed by the series of failed commercial ventures. Edison himself said that having an idea is not enough. But Ford’s criticism of his longtime friend and mentor was more than a bit ironic. Henry Ford’s fortune also required the efforts of many, many other people, as described in Ford Men . John Kenneth Galbraith summarized the basic truth when he wrote in Atlantic Monthly more than a half a century ago: “Although Ford conceived of the Model T, Couzens made the Ford Motor Company.” Elon Musk now faces this very same challenge of how to turn inspiration into an enduring and profitable commercial enterprise. Leaving aside the particular operational concerns of building an electric car, Elon Musk and Tesla face a more basic problem. In the century and more since Henry Ford, James Couzens and Horace Dodge began to build cars, the automobile has become a very relevant but entirely undifferentiated commodity good. There are basically three types of cars: small, mid-sized and full sized. Most of these are now styled outwardly as SUVs, but are designed to maximize efficiency and minimize price. And the companies that manufacturer these vehicles all barely make money. The fact that TSLA vehicles are driven by batteries is interesting, but there is nothing transformational about TSLA despite all of the hype about green transportation and "sustainability." Yes, electric motors and batteries are far more efficient today than a century ago, but strides made in internal combustion engines are impressive as well. Compared with the explosive event of the first Ford Model T, when Americans learned 110 years ago that they could get a gasoline powered car instead of a horse, today’s innovations in transportation are incremental. Electricity, gasoline engines, radios and semiconductors, are all the inventions of the past century, while the innovations of today are largely derivative. Seen is this harsh light, is TSLA really worth $50 billion as Friday’s close suggests? Is Volvo Cars worth $30 billion? Really? We shall see. #Tesla #ElonMusk #JPMorgan #Ford #GM

By any standard, credit spreads in the US bond and loan markets remain very tight. Now several years into a Fed interest rate tightening cycle, short-term interest rates are rising but spreads do not expand. A year ago the two year was yielding 1.35%, but today is 2.6%. The 10-year Treasury note, on the other hand, has barely moved in a year, 2.2% then vs 2.85% today. Last we looked, Treasury 2s vs 10s was 25bp compared to almost a point a year ago. What a flattening yield curve and tight spreads say to us is that while the FOMC may raise short-term rate targets, in fact the demand for longer duration assets remains very strong indeed. Turkey or not, the 10-year rejects three percent yield. The fact that the Treasury has greatly increased debt issuance also seems to have been shrugged off by the global debt markets. And the surging dollar is crushing global debt issuers like Turkey and Argentina, and the US benefits -- for now. High yield corporate spreads remain below 400bp over the Treasury yield curve, according to ICE BAML. Spreads for “BBB” rated issuers are inside of 200bp over the curve and “AAA” rated corporates are inside of 50bp over so-called risk free rates. As in 2007, all manner of idiocy is visible in the US credit markets today. Yet every news report about problems in the emerging economies seems to only increase demand for US sovereign risk. The combination of even moderately higher rates and credit crunch around the world has turned the US economy into a voracious, capital consuming black hole. The reason that credit spreads are important is that when spreads rise, lending and capital formation tend to slow down – a lot. When credit spreads for high yield issuers rise above 500bp over the curve, risk lending by banks, funds and bond investors basically slows to a stop. The chart below shows the credit spread indices from ICE BAML c/o FRED with our annotations showing different policy actions by the FOMC over the past decade. Yardeni Research has a great annotated QE timeline . If you compare the market actions of the FOMC and coincident movements in credit spreads, with public statements by Fed officials, a fascinating and somewhat confused picture emerges. But let's start with some context. Spreads were actually quite elevated in the early 2000s, both before and after the 911 attacks, but responded to Fed ease by gradually falling until HY spreads bottomed out at 250bp over the curve in June 2007. Indeed, HY spreads today are unchanged from a decade ago, just before the financial crisis. With the failure of a REIT called New Century Financial and other private obligors in 2007, HY credit spreads exploded, hitting a near-term peak of 800bp over the curve in March 2008. By November of 2008, the failure of dozens of banks, non-banks and two of the four housing GSEs, caused HY spreads to soar more than 2,000bp over the Treasury curve and capital markets activity stopped. Private label mortgage paper was no-bid and even agency obligations were trading at a steep discount. When the FOMC initiated the first quantitative easing (QE), the objective was to re-liquefy the banking system and force credit spreads down. We credit Fed Chairman Ben Bernanke and the FOMC for understanding the important of getting credit spreads to fall so that the financial markets could again start to function. Indeed, by March of 2010 when QE1 ends, credit costs fell dramatically with HY spreads inside of 600bp over Treasury yields. Spreads rose again following the end of QE1, but over the summer the FOMC would announce the reinvestment of all securities purchased via QE1 and by year end announced further purchases via QE2 – even as credit spreads had begun to fall. By March of 2011, HY spreads had fallen to below 500bp over the curve. In September 2011, with credit spreads again starting to rise, the FOMC made a dreadful mistake. It decided to actively manipulate the Treasury yield curve via Operation Twist, selling short-dated paper and buying longer durations. Ironically, the Fed commenced Operation Twist even though conditions in the bond market were already starting to improve. The FOMC noted in June 2012: “This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.” By December 2012 when Operation Twist officially ended, HY spreads had fallen to relatively normal levels ~ 550bp over comparable Treasury yields. Investment grade and high IG bond spreads were likewise compressed. The FOMC then trippled down via QE3 and continued to reinvest principal repayments in the System Open Market Account (SOMA) until the end of 2017. Did the overt market manipulation of Operation Twist push down credit spreads as well as Treasury yields? Or did QE and the rollover of principal do the trick? We may never know which policy action was or was not effective. HY spreads bottomed out at 360bp over in June 2014. Credit spreads then spiked going into 2015 because of concerns about credit losses in the oil patch – losses which largely never materialized due to the surfeit of funds engineered by the Fed. Spreads rose further early in Q1 2016 over concerns about an overheating Chinese economy. These fears then gave way to concerns about the November election and, surprisingly, the win by Donald Trump. But, again, credit spreads quickly retreated because of the huge amount of liquidity chasing too few assets. By the start of 2017, HY and IG credit spreads were back to decade lows, a reflection of the extraordinarily low credit losses experienced since 2012. Did the overt purchases of securities and, via Twist, the deliberate manipulation of the yield curve, promote “a stronger economic recovery” that the FOMC promised? Maybe. But looking at credit spreads since 2015 when QE3 ended, a case can be made that the FOMC overshot the mark, first with QE3 and then by reinvesting principal through 2017. The Fed's action will leave the financial markets badly distorted for years to come and with little to show for it in terms of growth. In particular, the long period of suppressed credit losses in the private sector (which are mirrored in the remarkably good bank portfolio data) suggest that credit losses are now going to follow interest rates higher – at least without further FOMC market intervention. How long will it take to get to something like “normal” in the credit markets? Years. The chart above from Robert Eisenbeis, Chief Monetary Economist at Cumberland Advisors in Sarasota, shows the runoff of the FOMC’s system open market account or “SOMA.” “SOMA has actually bought some securities and sometimes on a weekly basis the portfolio has increased. MBS runoff has been slower than projected but they have not sold assets,” as Eisenbeis told us in a discussion last year . “If runoff is greater than the target, their policy calls for reinvestment, which they did, especially early on when the caps were small.” As the FOMC decreases their share of Treasury and agency securities relative to the portion held by private investors, credit spreads and loss rates more broadly should also revert to the mean. Newbie fintech lenders will cry terrible tears as the cost of credit appears in the portfolio of home improvement/flipper loans they’ve assembled using "artificial intelligence." And commercial as well as residential loss rates will also revert to the mean. Further Reading Projected Evolution of the SOMA Portfolio and the 10-year Treasury Term Premium Effect RealVision: Bank Earnings: Watch the Spread | Chris Whalen #Eisenbeis #Cumberland #Bernanke #FOMC #SOMA

New York | Which are the best performing banks in the US? Equity returns for the entire industry averaged 11.4% in Q1’18, up from 9.6% for all of 2017. There are some smaller banks, however, that generated returns on equity (ROEs) far higher than the average. Large banks tend to significantly underperform smaller peers. Growth rates, margins and equity returns all increase as size declines. In this issue of The Institutional Risk Analyst , we look at some of the better performers in the industry based on ROE. We use the Q1’18 financials from the Fed and FDIC for the comparison. Results in the first quarter featured significant noise due to the downward adjustment of tax loss assets, and upward adjustment in after-tax returns, so look for bank asset and equity returns to be even higher in the future. Among the large banks over $100 billion in total assets, the exemplars will surprise most investors. While the lead units of Bank of America (BAC) and JPMorgan (JPM) made it into the top ten, most of the names are new to our readers. Here are the top seven large bank units by return on equity (ROE) as shown from the TBS Bank Monitor published by Total Bank Solutions. Over $100 Billion Total Assets 1. Discover Bank 2. Charles Schwab Bank 3. Capital One Bank (USA), National Association 4. Morgan Stanley Bank, National Association 5. Fifth Third Bank 6. The Northern Trust Company 7. U.S. Bank National Association The best performer among large banks above $100 billion in total assets is the credit card unit of Discover Financial (DFS). The bank’s 371bp of default in Q1’18 earns it a “B” rating from the TBS Bank Monitor, but the 12.7% gross loan yield (3x its large bank peers) and resulting 24% ROE tell the tale. In second place is the $200 billion asset bank unit of Charles Schwab Financial (SCHW), Charles Schwab Bank in Henderson, NV. With a 21% ROE and zero credit losses it ranks “AAA” in the TBS Bank Monitor. Less than 10% of the bank's business involves lending, while 90% of the bank's risk taking is focused on non-interest income and investing. In third position is the lead bank unit of Capital One Financial (COF), Capital One Bank (USA), which sports a 17% ROE and 711bp of gross defaults in Q1’18, and thus gets a “B” default experience rating. Capital One Bank (USA) outperforms most larger banks by three-fold in terms of equity returns because of the high gross loan spread. Indeed, among the multi-line banks, only the lead bank units of Fifth-Third (FITB) and US Bancorp (USB) made the top seven among the largest US banks in Q1’18. FITB is a leader among the regionals in terms of ROE and stability overall. At $400 billion in total assets, USB is the smallest money center, with national lending and fiduciary businesses. To their credit, USB has stubbornly refused to heed the siren song of asset growth, the sure road to mediocrity. $10 Billion to $100 Billion Total Assets 1. American Express Centurion Bank 2. American Express Bank, FSB. 3. Comenity Bank 4. Stifel Bank and Trust 5. Sallie Mae Bank 6. MidFirst Bank 7. Silicon Valley Bank The next group of banks is between $10 billion and $100 billion in assets and features some strong performers. One and two on the list are the bank units of American Express (AXP). Sporting ROEs of 44% and 38%, respectively, the two bank subsidiaries of AXP have default rates in the BB-B range and asset returns that are four times the industry average. Now you know why the Centurion is smiling. No surprise that credit card specialist AXP trades at 4x book value, a multiple its larger bank peers could never achieve. Also notable among the top seven banks between $10 billion and $100 billion in assets are Stifel Bank & Trust with a 24% ROE, a unit of Stifel Financial (SF), and Silicon Valley Bank, the subsidiary of SVB Financial (SVB), at 20% ROE. The SF bank unit is evenly split between lending and investing, and has a very low efficiency ratio below 20%. The $14 billion total asset credit card specialization bank Comenity, a unit of Alliance Data Systems (ADS), is another solid performer in this size class with a 30% ROE. ADS trades at 6x book value by no coincidence. $1 Billion to $10 Billion Total Assets 1. WEX Bank 2. Cross River Bank 3. Metro City Bank 4. First National Bank of America 5. Merrick Bank 6. NexBank, SSB 7. Green Dot Bank DBA Bonneville Bank Once you go below $10 billion in assets, the equity returns tend to increase as well as the diversity of business models. Consider WEX Bank of Midvale, UT, a $2.6 billion asset commercial lender with a gross spread on its loan book of 23%, an ROE of 84% and a “BB” equivalent loan default rate, according to the latest data from the FDIC. The weighted average maturity (WAM) of the WEX Bank’s loan book is just 90 days. Asset returns are just a tad under 10% or 10x the industry average. Did we mention that half of the WEX loan book is funded with brokered deposits? First National Bank of America is a $1.4 billion residential mortgage lender based in East Lansing, MI. There are a lot of mortgage folks who have made Michigan their home: Quicken Mortgage, Flagstar Bank, Fay Servicing (well, OK, Chicago). Of note, the annual Fay Servicing event, which is held in late August down the street from Wrigley Field in a fine Chicago pub, is rapidly becoming the most interesting discussion in mortgage finance. Speaking of housing, here is a little chart from The Garrett, McAuley Report (August 5, 2018) that tells you all you need to know about the disastrous state of the mortgage sector in 2018. First National Bank of America, the bank unit of First National Bancshares (FNBI), has a 2.8% ROA and a 30% ROE, results that are indeed quite miraculous for a small residential mortgage lender. Even more interesting, this little bank has a 16% risk-adjusted return on capital or RAROC in the TBS economic capital simulation, again confirming our empirical observations that the RAROCs of small banks are better that that of the zombie dance queens of Wall Street. FNBI's bank unit has a 6% NIM, 2x the industry average and 3x large bank results. Loss given default is 85% of par and the bank boasts just 11bp of defaults, well-below peer. First National Bank of America has a collosal WAM of 14.5 years, which means that they are retaining a lot of long-duration mortgage loans. And the gross spreads on the FNBI real estate book are north of 800bp vs maybe half that amount for a large urban lender like JPM or Wells Fargo (WFC). Banks make money on spreads, not interest rates. Merrick Bank is a subsidiary of CardWorks, Inc., a non-bank financial firm in Draper Utah. The $3.5 billion asset bank is a top-20 issuer of Visa cards and also lends on boats and RVs. Despite the high default rate of 1,400bp, which results in a "CCC" loss experience rating, Merrick generates impressive asset (5.7%) and equity (29%) returns. As with WEX, the key to Merrick's success is a strong credit cutlure and a very short duration loan book with a WAM of well-less than a year. Then we have Metro City Bank, the $1.3 billion asset subsidiary on MetroCity Bancshares (MCBS). This small institution is generating in excess of 30% ROE's by charging twice the spread on real estate and consumer loans that a larger bank charges, with below-peer defaults and an efficiency ratio in the 37% range. The bank has 15% Tier 1 Risk Based Capital and a net interest margin in the mid-4% range. Total funding costs are just over 1% vs 3x that amount for larger banks. One of the best performers in the under $10 billion category is NexBank SSB of Dallas, TX. The $8.4 billion bank has a “AAA” rating from the TBS Bank Monitor due to the ultra-low default rate and a 29% ROE. The WAM of NexBank’s loan book is just shy of 10 years or almost two standard deviations above the industry average, reflecting a retained book of hand picked residential and other credits. The pristine credit performance – NexBank has not reported a charge-off since 2015 – pretty much says it all. Chairman James Dondero, Co-Founder and President of Highland Capital Management in Dallas, leads the bank's board. Most important, NexBank does not pay dividends and instead retains capital to fuel its impressive record of growth and credit management. NexBank Capital, the parent company, has a 41% retained capital ratio to total capital vs 8% for the bank's asset peers, according to the FFIEC . What all of these superior performers among large to mid sized banks have in common is that they are closer to the customer and thus better able to provide capital to fuel economic growth. The capital and asset returns of these top performers are indeed stellar because these banks know their customers and can thus better create and manage credit. Part of the reason that the US economy is growing so slowly is that there are far fewer small banks in the US than decades ago, meaning less capacity to provide risk capital, fuel new businesses and manage the credit of small enterprises. If we want faster economic growth, then we need more, smaller banks to provide the capital. Great place to start is by breaking up some of the largest, most poorly performing institutions to get the party started. More on that in a future comment. #FNBI #JPM #BAC #WFC #WAM #Nexbank

Dana Point | Since the lows of late-June, financials have rebounded more than 10% even as issues such as trade and the flattening Treasury yield curve have dominated the Wall Street narrative. Meanwhile, the bloom is clearly off of the rose in the world of real estate as prices for high-end residential and commercial assets have started to swoon. Lower prices mean higher loan-to-value (LTV) ratios, rising loss given default (LGD) and eventually increased loan default rates. While backward looking measures such as the Case-Shiller 20-City Composite Home Price Index do not yet show the turn, more granular measures such as the Weiss Residential Research index show the number of homes rising in price is decelerating rapidly. At the moment this trend seems to be mostly confined to high end properties, but past experience shows that market turns in home prices typically start at the top where there are relatively fewer buyers vs the available supply. In beautiful Orange County, for example, luxury home sales in expensive venues such as Newport and Laguna Beach have basically slowed to a trickle. As is the case in New York and Connecticut, luxury homes prices in Southern California have experiencing growing price compression, especially since the first quarter of this year. The chart below shows the S&P/Case-Shiller 20-City index and sub indices for New York, San Francisco and San Diego. Notice the extreme volatility of the San Francisco and San Diego indices. Anecdotal reports from the world of real estate brokerage suggest that the asset price bubble created by the Federal Open Market Committee is generally starting to deflate. In particular, the “aspirational pricing,” to paraphrase Jonathan Miller of Miller Samuel, is basically done. Prices for high-end homes are now being marked down rather than up as sellers are forced to capitulate in order to close the deal. It is worth reviewing the factors that led to this latest bubble in residential real estate prices. First and foremost we have the actions of the FOMC, which not only forced down short-term interest rates but also explicitly manipulated the shape of the yield curve via “Operation Twist.” In our previous comment in The IRA , we featured the comments of Senator Pat Toomey (R-PA) on same to Fed Chairman Jerome Powel. As several pundits have noted in recent days, Operation Twist is still affecting the markets, holding down long-term interest rates and causing the Treasury yield curve to flatten. The compression in credit spreads caused by the FOMC’s reckless and ill-advised market manipulation has also reduced profits for lenders and curtailed residential lending volumes. Literally hundreds of banks and non-banks focused on mortgage lending, confronted by mounting operating losses, are laying off employees and shutting down operations around the country. The 4% GDP print last week was definitely not a reflection of business realities in the mortgage sector. Q: Wasn’t Operation Twist supposed to help the housing market? Perhaps Senator Toomey ought to ask Chairman Powell to comment on the current dire situation facing many mortgage lenders and how the FOMC has contributed to this disaster. One industry veteran commented to The IRA last week that the poor financial performance of many mortgage lenders has caused them to blow through credit covenants with bank warehouse lenders. So far, the banks have not pulled the plug on these important commercial customers, but at some point prudential regulators will force the banks to act. As we have noted in past comments, in the current regulatory environment, when non-bank lenders eventually fail, the lender banks won’t buy the non-bank and take over the servicing portfolio as in days gone by. The non-bank will instead file bankruptcy and the secured creditor bank will simply take the loans pledged as collateral on warehouse lines and walk away. In 2018, new loan originations will be about $1.6 trillion – maybe – the lowest level since 2015. With new loan profitability negative in Q1’18, making up for operating losses with more volume is not an option. Of note, the Mortgage Bankers Association has been steadily revising down their estimates for future residential loan origination volumes, but remain optimistic about the out years as shown in the chart below. Source: MBA The other factor that has caused home prices to surge is increases subsidies from the government sponsored housing agencies, Fannie Mae, Freddie Mac and Ginnie Mae. Ed Pinto at the American Enterprise Institute lists several actions by the GSEs that have exacerbated the home price bubble and created greater risk for the US taxpayer, including: * Greater availability of income leverage, which is allowing borrowers to compensate for faster home price appreciation. This trend has been aided by the QM exemption for government agencies and Fannie Mae’s decision in August 2017 to raise its debt-to-income (DTI) limit. * A shift towards lower down payment loans. For FHA loans, often times such low down payment loans are combined with down payment assistance. * A greater presence of cash out (CO) refis; as homeowners’ equity has increased, the share of COs has increased in tandem. COs by nature are riskier than other loan products and they are rapidly getting riskier. “The multiyear surge in home prices, particularly for entry-level homebuyers continues unabated and is fueled by high-risk mortgages guaranteed by taxpayers,” notes Pinto, codirector of the AEI’s Center on Housing Markets and Finance. “We see no halt to this trend so long as FHA, the GSEs, and the VA continue offering easy mortgage credit terms which keep demand for homes well in excess of supply,” Pinto adds. Other factors that have driven the sharp upward move in home prices since 2012 include the increase in the number of people who can qualify for a mortgage under various government programs. Writing in The Scotsman Guide on the 10th anniversary of the failure of Lehman Brothers, industry veteran Dick Lepre of RPM reminds us that government programs to encourage home ownership begun in the 1990s caused the 2008 mortgage bust. Similar efforts in Washington are again setting the stage for a crisis in housing finance. He writes: “One cause of the 2008 financial fiasco was the vast expansion of the number of people who could borrow money to buy property. There are at least two things already happening that are allowing people to obtain loans who would not previously qualify. “One was instituted by the Consumer Financial Protection Bureau last year, which persuaded credit bureaus to remove most civil debt liens and tax liens from credit reports. The Wall Street Journal estimated this would improve credit scores for 12 million individuals, some by as much as 40 points. “Another is the expansion of Fannie Mae’s Home-Ready program, which is aimed at low- to moderate- income borrowers. One of the features of the program is its liberal interpretation of income, which allows lenders to consider the income of nonborrowers living with a borrower — such as adult children, friends or extended family. That nonborrower income can be viewed as a compensating factor in the loan-approval process for the program. “HomeReady is similar to the National Homeownership Strategy of 1995 in that it has a social goal. Under the Federal Housing Finance Agency’s housing goals for Fannie Mae for 2015 to 2017, at least 24 percent of the single-family, owner-occupied mortgage loans acquired by the government-sponsored enterprise (GSE) must involve low-income families. At least 6 percent must be to very low-income families. “Borrowers need at least a 620 credit score to qualify for the HomeReady program. Freddie Mac has a similar program called Home Possible. If the Feds increase the percentage of such loans the GSEs must purchase, be concerned. Mortgages to folks with bad credit or high debt should stay inside the Federal Housing Administration (FHA) program. As long as the FHA mortgage insurance premiums cover the inevitable losses, the taxpayer is not picking up the bill.” These programs to expand home ownership by the GSEs have added to the buying pressure on moderately priced homes, but that may not continue for much longer. Indeed, a change in the behavior of the GSEs may come sooner than many investors realize. As and when Federal Housing Finance Administration (FHFA) Mel Watt leaves the agency, the Trump Administration intends to significantly cut back the loan guarantee activities of the GSEs. Loan size limits are likely to be reduced for Fannie Mae and Freddie Mac, financing for investment properties is likely to end and the pricing of GSE loan guarantees may also change. The mission creep into new areas, such as Freddie Mac’s initiative to provide financing for non-banks to acquire mortgage servicing rights (MSRs), is also targeted by Republican policy operatives. A final factors driving the next, downward leg in US home prices is the 2017 tax legislation, which has significantly increased the cost of home ownership in high tax states such as CA and NY. While the greatest pressure is felt on the luxury end of the market, the cost of living in the high-tax, blue states will over time tend to drive broader emigration to other states. With all of the different government programs put into place since the 2008 financial crisis to manipulate the credit markets and artificially boost home ownership, the fact of a bubble in home prices is no great surprise. Add to that the limitations on bank lending for new residential home construction and you have the perfect formula for killing the American dream of home ownership of American families. We believe that the year 2018 may be remembered as marking the peak in both bank equity valuations and residential home prices. Residential loan default rates are unlikely to rise very quickly given the shortagge of moderately priced homes, but as we note in The IRA Bank Book , bank net interest margins are likely to be as flat as the yield curve by year-end. And the embeded credit risk in the financial system will continue to build with each passing day and largely due to the conflicting policy decisions emanating from Washington. Further Reading Italy Succumbs (Again) to Mob Politics The American Conservative Letters: Private Loans Barron's

New York | President Donald Trump caused a bit of a stir last week when he suggested that rising interest rates are cause for concern . Pundits fretted about “Fed independence,” a concept rendered completely meaningless in the age of quantitative easing. We agree with the President that Federal Reserve Board Chairman Jerome Powell is “a good man,” yet we also think it is high time that elected officials started to hold the Federal Open Market Committee more accountable for its policy decisions. Powell nicely describes the concept of accountability. “We owe you and the public in general clear explanations about what we are doing and why we are doing it,” said the Fed Chairman to the Senate Banking Committee last week. “Monetary policy affects everyone and should be a mystery to no one.” With the yield curve also last week nearing a zero difference between short and long-term government debt, Powell’s comments are timely. In an exchange with Senator Bob Menendez (D-NJ), Powell essentially endorsed QE2 and Operation Twist, saying that he was “glad” that the FOMC continued to manipulate the bond market years longer than necessary in the quest for the holy grail of full employment. Agreeing with the position taken by Treasury Secretary Steven Mnuchin, Powell also endorsed the privatization of the GSEs. He told Senator Jon Tester (D-MT) that it was important to get the housing finance system “off of the federal government’s balance sheet” to foster long term economic growth. In the subsequent exchange with Senator Pat Toomey (D-PA) at ~ 2:05, Powell deflected a fairly pointed question about the Fed’s “deliberate” manipulation of the Treasury yield curve. “Historically, the Fed has just manipulated short-term rates, the discount rate and the fed funds rate, and let the markets decide other interest rates” said Senator Toomey. “That all changed with quantitative easing when the Fed became the biggest market participant in with respect to the purchase of Treasuries and it changed in an explicit way when the Fed decided that it would intentionally manipulate the shape of the yield curve with Operation Twist, which was very consciously and willfully designed to change the shape of the curve.” “Some people are concerned that a flattening curve or an inverted curve correlates with economic recession,” Toomey continued in a remarkably cogent question. When he asked Powell about whether the changing shape of the curve would alter Fed policy regarding the composition of the balance sheet, Chairman Powell responded: “What really matters is what the neutral rate of interest is. I think people look at the shape of the curve because they think there is a message in longer run rates, which reflect many things, but that longer rates tell us something about the longer run neutral rate. That is really why the slope of the yield curve matters. So I look directly at that. If you raise short-term rates higher than long-term rates, then maybe your policy is tighter than you think.” Powell may not be an economist by training, but he is sure starting to sound like one – to our great concern. Conceptually, the neutral (or natural) rate of interest (R* in economist lingo) is the rate at which real GDP is growing at its trend rate, and inflation is stable. This decidedly indefinite concept is widely attributed to Swedish economist Knut Wicksell and, it is alleged, “forms an important part of the Austrian theory of the business cycle.” In 2006, Joachim Fels and Manoj Pradhan put forward the case for using neutral interest rates in formulating monetary policy in the Financial Times : “Put simply, the natural rate of interest is the interest rate that keeps output at its potential and inflation stable, once any shocks to the economy have played out. Wicksell saw fluctuations of the interest rate set by the central bank around the natural rate as the main driver of the business cycle and swings in the price level. His work foreshadowed and influenced the Austrian monetary business cycle theorists in the early part of the last century, most notably Ludwig von Mises and Friedrich von Hayek.” Most adherents to free market economic ideas agree with the 20th Century American economist Irving Fisher (1867-1947) in rejecting the idea of a discernable “business cycle” along with speculations about natural or neutral interest rates. Concepts like neutral interest rates, equilibrium and full employment are, by definition, indefinite and speculative, much like calculating the position of an object moving through space-time, to borrow from the work of Stephen William Hawking (1942 - 2018). Irving Fisher put the issue nicely in his 1933 essay on debt deflation when he refuted the existence of business cycles: “The old and apparently still persistent notion of "the" business cycle, as a single, simple, self-generating cycle (analogous to that of a pendulum swinging under influence of the single force of gravity) and as actually realized historically in regularly recurring crises, is a myth. Instead of one force there are many forces. Specifically, instead of one cycle, there are many co-existing cycles, constantly aggravating or neutralizing each other, as well as co-existing with many non-cyclical forces. In other words, while a cycle, conceived as a fact, or historical event, is non-existent, there are always innumerable cycles, long and short, big and little, conceived as tendencies (as well as numerous noncyclical tendencies), any historical event being the resultant of all the tendencies then at work. Any one cycle, however perfect and like a sine curve it may tend to be, is sure to be interfered with by other tendencies.” Unlike market interest rates, the neutral rate or R* is the product of a model. The whole notion of “neutral” market rates goes hand in hand with neo-Keynesian concepts such as market equilibrium and full employment. Neither can be observed or even described scientifically, much less replicated via experimentation. This fact did not prevent Chairman Powell from telling Senator Toomey that he “looks at it” – namely the invisible and indiscernible natural rate of interest -- when assessing US monetary policy. Sadly, Senator Toomey ran out of time and was not able to follow-up with Chairman Powell on the rapidly flattening yield curve. One question he ought to ask is why the FOMC thinks that “deliberately” manipulating the prices of and yield spreads between different securities is OK but that the Committee is now justified in doing nothing to manage the process of normalization as the curve very deliberately inverts. Powell’s view of the neutral interest rate apparently includes doing nothing to raise long-term yields while we see a steady runoff of the System portfolio and an attendant decrease in excess reserves and, of necessity, bank deposits. A flat yield curve is apparently not a concern for the FOMC, parsing Powell’s comments, because the neutral interest rate is above current market rates. But nobody reall knows. As Tao Wu of the San Francisco Fed noted in 2005 : "The difficulty policymakers face is that it is not obvious exactly what the level of the neutral real rate is. It cannot be observed directly. There is no reliable way to estimate it. And it can change." Of course, in order to assess the “neutral” rate of interest, you need to have an accurate idea about the current level of inflation. As we’ve noted in past comments, key measures of inflation such as the PCE deflator seem to be distorted to the upside because of noise coming from, of all things, financial services. Strangely, nobody at the Fed seems to be worried that a key benchmark for describing inflation may be overstated – and this may be due to the financialization of the US economy described so eloquently by Senator Toomey last week. Our friend Brian Barnier of FedDashboard reports from a distant airport that he’s continuing to poke around to understand the weird behavior of financial services in the PCE deflator. “I am still tearing apart the time series,” he reports. “At the moment it seems the distortion comes from a combination of excess reserves and not accounting for how banks have become more digital. Will see what it looks like after they send me more specifics.” Chairman Powell and other FOMC members may think they know where the neutral interest rate is at present, but we’d like to see our esteemed Fed chief be a tad more specific about this key policy metric. Of note, in an April 2018 IMF working paper, "Estimates of Potential Output and the Neutral Rate for the U.S. Economy," the authors state that: “Estimates of potential output and the neutral short-term interest rate play important roles in policy making. However, such estimates are associated with significant uncertainty and subject to significant revisions.” If Chairman Powell is wrong about the neutral rate, and continues to ignore the market message contained in a flattening yield curve, then the consequences for markets and investors could be quite serious. We notice, for example, that Morgan Stanley (MS) saw a 76% increase in interest expense in Q2 ’18 compared with a year ago. (See the most recent edition of The IRA Bank Book for our view of how a flat curve will impact US banks.) At a minimum, the FOMC should consider engaging in open market intervention of the same magnitude as Operation Twist to manage the yield curve on the journey back to normal. As Powell stated last week, when short-term rates rise above long-term rates, then "maybe your policy is tighter than you think." Further Reading What the Fed Is Missing, Again Wall Street Journal Bullard Discusses R-Star: The Natural Real Rate of Interest Federal Reserve Bank of St Louis Do not overlook natural interest rates Financial Times

New York | In the steamy days of July 2018, bank earnings are more interesting than usual, in part because our beloved friends and colleagues in the financial world continue to intone the false mantra that rising interest rates are good for banks. And our former colleague at Bear, Stearns & Co many years ago, David Solomon, took the baton at Goldman Sachs (GS). Break a leg David. First off, it is not true that rising rate rates are always good for banks. Increased interest rates, for example, have not helped GS in the past few quarters. "Banks make money on the spread, that's it. That's the story," said our friend Josh Brown on CNBC’s Fast Money this week. At the time, Brown was surrounded by a bunch of earnings happy pundits singing the praises of higher short-term interest rates for bank earnings. Banks make money on widening spreads, not because of a quarter point move in Fed funds. Spreads, of course, are not really widening as the Federal Open Market Committee pushes up short-term rates. After moving up about 75bp points over the past year, non-investment grade spreads started to fall after the most recent FOMC rate hike in June 2018. Indeed, the 10-year Treasury has declined about 30bp in yield over the past month, reflecting the continued tightness of credit spreads – at least for some issuers. Second comes the earnings themselves. The Q2’18 bank results released so far confirms the accelerating upward trend in bank funding costs. As we detail in the most recent, Q2’18 edition of The IRA Bank Book , the rate of increase in funding expense for all US banks should exceed the rate of growth in interest earnings by Q2’19. This will mean that net interest margin or “NIM” will be shrinking, an eventuality that most market analysts and institutional wealth managers really are not prepared to accept -- much less reflect in asset allocations. The extract below from The IRA Bank Book shows our projection for aggregate funding cost through Q4’19. Notice that we hold the growth rate in total interest income steady at 8% through the end of 2019, an admittedly generous assumption given the way that the FOMC has capped asset returns via QE. On the other hand, we limit the annualized rate of increase in funding costs to “only” 65%, a rate of change already more than reflected in the rising funding costs of names like First Republic Bank (FRC) and Bank of the Ozarks. Source: FDIC, WGA LLC Most of the largest US banks that reported earnings this week saw interest expense rise by mid-double digits even as interest earnings rose by single digits. Goldman Sachs, for example, saw its funding expenses increase 61% year-over-year (YOY) in Q2’18 while interest income rose just 50%. Citigroup (C), on the other hand, being already positioned in the world of institutional funding, saw interest expense rise only 28%. But the Q2’18 earnings seem to confirm a rising trend in funding costs that could see NIM flatten out and decline by 2019. When Solomon’s ascension to the top spot was announced at Goldman Sachs, our friend Bill Cohan commented on CNBC that this amounted to a takeover of GS by alumni of Bear, Stearns & Co. God does have a sense of humor. He also reminded Andrew Sorkin et al on Squawk Box that the freewheeling Goldman of old is long gone and that GS is now run and regulated as “a bank.” Well, no, not really. Goldman Sachs is basically a broker-dealer with a small bank in tow. When you compare the net interest margin of GS with its peers, for example, the other members of Peer Group 1 defined by the FFIEC reported NIM of 3.28% vs 0.41% for GS in Q1’18. Because the bank unit of GS is so small, the overall NIM for the group is 1/10th of its peers compared with total assets. Goldman makes less than 2% on earning assets vs almost 4% for its asset peers. So to paraphrase the wisdom of Josh Brown, GS does not make money on interest rates, up or down, but rather earns fees from trading and investment banking. GS profits from the spread, both in terms of price and volume. The basic problem confronting David Solomon and his colleagues is that GS really is not a bank. It is regulated like a bank and therefore constrained in terms of business activities, but it does not earn the carry on assets that most banks take for granted when they turn on the lights each morning. Talk of expanding the banking side of the business (aka “Marcus”) is fine, but progress in this regard is very slow indeed. Of the $9.4 billion in net revenues reported in Q2’18, just $1 billion represented net interest earnings. The gross yield on GS’s loan book (5.24%) is superior to its larger peers (4.68%), but the numbers are so small that they are not really significant in the overall picture. The total return on earning assets for GS at 1.85% is less than half of the 3.94% earned by its larger peers. Why the poor performance? Because GS pays up for non-deposit funding compared to its larger peers. Because it has such a small deposit base, Goldman’s total cost of funds is more than twice (2.45%) that of its larger bank peers (0.97%) as of the end of Q1’18. Organically growing GS into a true commercial bank will take time and a lot of work, a task that Solomon et al may or may not be able to accomplish. Building a bank starts first and foremost with stable funding in the form of customer deposits, particularly commercial deposits from small and mid-size businesses. With the intensifying competition for bank funding now very visible in the money markets as the FOMC shrinks reserves, don’t hold your breath waiting for GS to transform itself into a traditional depository. Such a transfiguration is possible, but not very likely in today’s markets. Thus the question for David Solomon and his colleagues: Do you really want to be a bank? Really?

New York | Last week we posted a snippet from Rob Chrisman’s housing finance blog about former Fed Chair Janet’s Yellen being "puzzled" due to the lack of home ownership by Millennials. The ensuing reaction was an order of magnitude above our normal level of discourse, leading us to think that there is a raw nerve among Americans when it comes to home prices. Here is the Chrisman excerpt: I found this note sent to me a few years ago by John Hudson by Roy DeLoach of the DC Strategies Group titled, "Hang-in there, Millennials - The New Sub-Prime Mortgage Wave Is Coming." Roy is a former CEO of the National Association of Mortgage Brokers. "Hang in there, Millennials and all you other wanna-be first-time buyers still residing in Mom's basement. The Federal Reserve, Fannie Mae and Freddie Mac could soon be riding to your rescue. Well, not just your rescue, but perhaps more importantly, to save the economy, too. Which is the real reason they want you to take your 'rightful' place in the chain of life known far and wide as the 'Housing Ladder.' "Actually, Fed Chairwoman Janet Yellen is perplexed 'why so many Millennials choose to rent' rather than purchase a home. There was a collective chuckle in the room when I heard her make that statement at a recent House Financial Services Committee hearing. I only pray there are some in Washington who are not only not as confused as the Fed Chair, but also are seeing the very same statistics I am looking at and coming up with the same answer. The way I read the tea leaves, housing is in deep trouble and will likely fall apart sometime in late spring 2016 -- just in time to become an election year issue." In terms of housing market operating dynamics, De Loach was accurately describing the internals in the world of lending and servicing residential loans. But like many of us in the industry, he could not know just how high the Fed’s bond market manipulation via QE would take home prices. In the new edition of The IRA Bank Book , we describe the continued distortion of credit loss metrics in both residential and multifamily asset classes. Eventually, these metrics will revert to the mean and beyond. The importance of the fact that US bank credit metrics are showing essentially zero cost in residential lending from portfolio loans is that it begs the question as to home price valuations and thus loan-to-value (LTV) ratios. A number of analysts have predicted an imminent reset in terms of home prices, but this has not happened for several reasons. The chart below shows the Case-Shiller average for US home price appreciation. First, real estate is a local market, so generalizations such as Case-Shiller are dangerous. New York City has been slumping for the past two years, but other markets around the country such as Denver remain hot. The work of Weiss Residential Research clearly shows a turn in some major urban markets that have been moving higher since 2012 and before. But these moves seem more a function of buyer exhaustion than a permanent move to a buyers market. They key factor is cheap money chasing a limited supply of homes. Second, the US home market is in a classic supply squeeze. Referring to the work of Laurie Goodman at Urban Institute, the US is adding less than 1 million new units per year net of attrition of obsolete homes. Basically, new household formation is 50% higher than the growth in new housing units. More, the Fed’s manipulation of interest rates and credit spreads encouraged Wall Street to allocate capital to buying residential homes as rental properties, further limiting supply of homes available for sale. Net, net, Millennials have been priced out of the housing market because the omniscient souls on the Federal Open Market Committee think that boosting asset prices will lead to more spending and job creation. Instead, low interest rates and help from the GSEs (Fannie, Freddie and Ginnie) have driven up home prices beyond the reach of many home owners in major metro areas. Ed Pinto and Paul Kupiec wrote in The Wall Street Journal in March 2018: “Since mid-2012, real home prices have increased 28%, according to data from the American Enterprise Institute. Entry-level home prices are up about double that rate. In contrast, over the same period household income has barely kept pace with inflation. The current pace of home-price inflation is increasing the risk of another housing bubble.” Lenders will be happy to hear that home owners are not even tapping the increased equity in their homes as in the 2000s, one reason why home equity loans (HELOCs) continue to shrink by double digits as a bank asset class. CNBC’s Diana Olick had a good segment “ More homeowners leaving home equity untapped ” on Monday. Given the Yellen Inflation in home prices, the question for lenders, of course, is how much to discount home prices over a 15 or 30 year time horizon? This week we got to sit with one of the leaders of the mortgage finance world. The conversation eventually turned to credit. The consensus was that a recession in 2020 was not necessarily going to bring significantly elevated credit loss rates, but that by the mid-20s credit costs would be rising appreciably. We continue to point to 2015 as the trough for credit costs at US banks generally and note that more normal portfolios like commercial and industrial loans (C&I) are showing rising defaults and loss rates, what you would expect at the end of a Fed-induced boom. But meanwhile in the world of mortgage finance, things are anything but normal. Just look at the intense competition among JPMorgan (JPM) and the other megabanks for non-bank fiduciary balances in the commercial deposit market. The FOMC has indicated that short-term interest rates are rising, but long-term benchmark rates such as the 10-year Treasury bond are falling. Because of this move in long-term yields, modeled valuations for mortgage servicing rights (MSRs) will likely fall this quarter, requiring “fair value” adjustments to capital and income. Meanwhile, MSRs are trading in the secondary market at record cash flow spreads, in excess of 5.5x annual cash flow for conventional servicing. And the cost to originate and service loans has never been higher. If this environment of extraordinary high prices and low operating spreads is intended to be helpful to the housing finance sector, then we respectfully suggest that our friends on the FOMC ought to think again. Sadly, even as home prices have surged, none of the FOMC’s promised benefits have materialized when it comes to jobs, income or overall GDP growth. Indeed, the increase in home prices has locked-in many empty nesters in states like CA and NY. The big question: Is the Yellen Inflation in home prices permanent? Further Reading Bank Earnings & QT: Mysterious Shrinking NIM https://www.zerohedge.com/news/2018-07-04/bank-earnings-qt-mysterious-shrinking-nim

New York | Last week The Institutional Risk Analyst attended an evening presentation by Professor Edward Altman of NYU Stern School of Business at The Lotos Club of New York. Entitled “The Altman Z-Score After 50 Years: What is it Saying About Current Conditions & Outlook for Global Credit Markets,” Professor Altman’s comments were as usual understated and entirely on point. “Fifty years ago, we published the Altman Z-Score,” Dr. Altman told the audience of friends, colleagues and former students. “Frankly I am as surprised as anyone that it is still around.” The five factor Z-Score model published by Dr. Altman in 1968 is shown below: Dr. Altman attributes the longevity and, indeed, growing popularity of the Z-Score to the fact that the model is simple and easily replicated, and the fact that is works. “Empirical finance models generally have a half life of a couple of years…. But if the model is simple, easy to replicate – and replication is really important in scholarly finance – and is accurate, then other researchers start to compare their models to the simple model.” “The other reason that the model is still around is that it is free,” Dr. Altman notes. According to its founder, the Altman-Z Score has predicted roughly 80-90% of all non-financial bankruptcies since it was first published. The Z-Score is entirely public source and is used without commercial restriction in business, corporate finance and investing. Needless to say, the Z-Score and its derivatives generate a lot of traffic online at portals such as Bloomberg , Credit Risk Monitor and S&P . “All I wanted was one penny [per hit],” Dr. Altman says of his elegant creation, which is “simple, accurate and free.” Invoking author Malcom Gladwell’s book “Outliers,” Altman says that his work would have been created by another researcher as computers became more wisely available in the 1960s. “It is really important to be in the right place at the right time,” he observed. This confirms our judgment in “Ford Men: From Inspiration to Enterprise that luck is the most important thing in life. Dr. Altman witnessed the birth of the high yield or “junk” bond market in the early 1980s, a market that encompassed the world of sub-investment grade credits. “The market in 1982 was about $10 billion and comprised of fallen angels, companies that were beautiful at birth and investment grade, but like all of us as we get older we get ugly,” says Altman. “We lose our hair, we get wrinkles and we get downgraded.” Since that time, the Z-Score has been incorporated in corporate and bank risk models for corporate default or “mortality” as Dr. Altman likes to say. In particular, the three zones of “safe,” “grey” and “distress” in terms of credit originally defined by Dr. Altman are now widely disseminated and accepted as benchmarks. He explains the evolution of the model and its use: “The guidelines we established back in 1968 were the so-called zones. Above 2.99 the firm was in the safe zone. Below 1.8, in the distressed zone with a highly likely probability of bankruptcy. By the way, above 3.0 and below 1.8 the Z-Score had a 100% accuracy back in 1968. The model was built for manufacturing companies and in those days big companies did not go bankrupt. Things have changed. The zones are enshrined on the Internet, on Google and Wikipedia, but the problem is that they are no longer appropriate. But that doesn’t keep people from using it because its on the Internet and the Internet is always right.” Dr. Altman explains that there has been an incredible migration of risk in the US economy over the past fifty years reflected in the increased debt leverage in the system. He notes that when the high yield debt market was born, the market was measured in single digit billions, but today the total junk debt outstanding is $3 trillion globally and more than half in the US. Likewise leveraged loans did not exist, but today this is a $1 trillion market that fuels much of the total non-investment grade debt issuance. Altman also believes that the fact of global competition and capital markets has led to more, larger bankruptcies. “In a good year there are roughly 50 bankruptcies of companies with assets more than $1 billion, what we call billion dollar babies,” notes Altman. “As a scientist in this area, I love bankruptcies. Already this year, in this benign credit cycle, we’ve had 14 billion dollar bankruptcies.” Altman states that as the amount of debt leverage has increased in the global economy there has been a compression of credit ratings: “How many 'AAA' rated companies in the US? Two. Johnson & Johnson and Microsoft. Two left. Why is it that there are not more 'AAA' rated companies? Leverage.” The migration of companies down to “BBB” ratings simply reflects the fact of more debt and the desire to stay this side of the line of investment grade. “What rating would you like to be as the chief financial officer of a company,” ask Altman. “We did a survey many years ago and the answer was ‘A.’ What is it today? ‘BBB’ The ‘BBB’ category is exploding. That is the preferred rating. Why? Because if you are ‘A’ it means that you are not exploiting low cost debt. If you are ‘BBB,’ it means that you have higher effective returns for your shareholders. This is why over the past fifty years credit risk has migrated from very low to very high. It has exploded into a global debt bubble and this is not just companies. It's governments and households.” Turning back to mortality, Altman spoke about how “life expectancy changes over the life of a person or a company – what we call contingent probability. In financial markets much like real life, promises are made to be broken. How do you break a promise? You default. You don’t pay back as promised. When assessing default probability, we’ve got gorgeous ‘AAA’s, handsome ‘AA’s, decent looking ‘BBB’s, not so good looking ‘BB’s, and downright disgusting ‘CCC’s. And people have been buying those disgusting ‘CCC’ bonds with great frequency over the past five years.” Dr Altman notes that “we are in a benign credit cycle” and that non-financial corporate debt levels vs. GDP are back to 2008 levels, yet default rates remain low – below 2%. Indeed, the Z-Scores for corporate issuers have risen from 4.8 in 2007 to 5.1 in 2017 even as debt levels have grown. He also notes that high recovery rates for bond and loan investors, plus low interest rates and credit spreads, and ample liquidity, are all signs of benign credit cycle “that has gone on, incredibly, for eight years.” And yet Professor Altman is hardly sanguine about the immediate outlook. “We have been in a ‘risk on’ cycle, meaning easy money and brisk buying,” Altman observes. “Risk on means that people forget risk and take a lot more exposure to get higher yields in this low-rate environment. Using a baseball metaphor, we are in extra innings with respect to the benign credit cycle. Investment grade debt has been exploding since 2007 and high yield debt is also up. A lot of this money is being used for corporate stock buybacks.” “Shrinking equity and exploding debt is a disaster waiting to happen – and it will happen if we have another recession,” Altman concludes. “And we will. Its just a matter of when. I’m not a forecaster of economic activity, but surely given the accumulation of debt, if we have a recession then we will have another credit crisis. It may not be as big as 2008, which was more focused on households. This time the risk is more in the corporate area. But unless things change in terms of market discipline, we are going to have some very nasty repercussions in the debt markets.” #ZScore #Altman #Credit #Default

Grand Lake Stream | During our fishing trip to Leen's Lodge last week, there was a lot of discussion about the markets and whether the Fed is going to successfully manage the return to normalcy. Our bet on that question is “no” as we noted in a missive yesterday by Jeff Cox of CNBC: “ The Fed's effort to control the rise of its key interest rate is running into some problems .” Dr. George Selgin of Cato Institute has a timely new paper appropriately entitled "Floored" that discusses this issue of the FOMC using interest on excess reserves as a “floor” for the Federal funds rate. In the paper, Selgin talks about “how the Fed’s floor-system experiment came about, what its intended and actual consequences have been, and why either the Fed itself or Congress should bring the experiment to an end as rapidly as can be done without causing further economic damage.” Instead of reviving the private market for Fed Funds, the FOMC has used Basel III and paying interest on excess reserves or “IOER” to turn the trading of short term funds into a lab experiment. Instead of creating a traditionl “corridor” system for managing short-term rates, with IOER near the bottom of the policy range and the discount window rate at the top, the FOMC opted for a more radical experiment. Selgin notes: “Had [the FOMC] actually employed interest on reserves to establish a proper corridor system, as it planned to do in 2006, and even had it allowed interest to be paid on excess reserves with that aim alone in mind, paying interest on reserves wouldn’t have constituted a radical change. But as we shall see, when the Fed actually put its new tool to work, a corridor system was no longer what it had in mind.” Selgin cites some revealing passages from former Fed Chairman Ben Bernanke, who justifies the need for paying interest on excess reserves to prevent interest rates from falling too low. “[By] setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much [emergency] lending we did,” stated Bernanke in 2015. Was Bernanke’s comment an admission that negative rates are as a general matter undesirable? Perhaps. Selgin notes: “Although they were keen on providing emergency support to particular firms and markets, Fed officials recognized no general liquidity shortage calling for further monetary accommodation. The challenge, as they saw it, was that of extending credit to particular recipients without letting that credit result in any general increase in lending and spending…. for the most part the Fed was counting on IOER to encourage banks to accumulate excess reserves instead of lending them.” So even though the FOMC saw "no general liquidity shortage," they continued with extraordinary measures. Selgin’s paper makes clear that the FOMC had no firm idea how the use of IOER as a floor for interest rates would impact the markets and the US economy. In particular, the idea of using IOER as a way to dissuade banks from lending illustrates the speculative and, indeed, irrational nature of FOMC deliberations. As the renowned physicist Richard Feynman states: “It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong. In that simple statement is the key to science.” But of course economics is not a science, a fact illustrated by the Fed’s decision to pay IOER in combination with massive open market purchases of Treasury paper and mortgage backed securities. There is some support for the idea that the decision by the Fed to use IOER as a floor for interest rates negatively impacted bank lending and economic growth, as shown in the chart below. Source: FDIC There are many factors affecting the growth rate for loan portfolios, but what the data from the FDIC clearly suggests is that the surge in bank deposits seen from 2012 onward was not matched by a commensurate increase in bank lending. Also, as we’ve discussed previously, sales of loans by US banks have declined 10 fold since the mid-2000s. Again, Selgin: “The Fed’s decision to switch to a floor system at a time when equilibrium market interest rates were collapsing, and to do so with the aim of propping-up its policy rate to keep it above the zero lower bound, contributed to the severity of the recession, while limiting the Fed’s options for promoting recovery. Thanks to it, the U.S. economy has been in the grip of an above-zero liquidity trap since the trough of the Great Recession.” Although the impact of the Fed’s policies with respect to paying interest on excess reserves has generated a great deal of debate in the economics community, the other aspect which has received far too little attention is how quantitative easing impacts long-term interest rates. The Federal Open Market Committee was sold a bill of goods by the staff of the Board of Governors and FRBNY chief Bill Dudley. Specifically, we hear that Simon Potter, Head of the Markets Group at the Federal Reserve Bank of New York, (and Dudley) told the FOMC that they could hold any quantity of reserves indefinitely as long as they could do reverse repo operations to set a rate floor to accompany the ceiling rate system (interest on excess reserves or IOER). The Potter-Dudley assertion that short-term REPOS can suffice to manage any amount of excess reserves seems to be refuted by experience, however, especially given the combination of IOER with aggressive open market operations (aka “QE”). “The correct strategy all along would have been for the Committee to pause at 1.5% for Fed funds (2 hikes ago),” notes former Fed researcher officer Walker Todd. “The Fed could then begin to sell off the mortgage backed securities until the resulting long end rate increases began to put upward pressure on the Fed funds rate. Then the Fed would be in the more comfortable situation of following the market upward instead of trying to lead against market résistance, which is what is happening now.” As Chairman Powell and the FOMC raise the interest rate floor, the size of the Fed’s portfolio seemingly prevent long-term interest rates from rising. The securities holdings of the Fed and other global central banks are entirely passive, with no trading or hedging operations to influence long rates to rise, thus the spread between short term rates and longer maturities is shrinking rapidly. Unless the FOMC relents and starts to actively manage longer-term rates by selling securities and/or swaps and futures, the Treasury yield curve is likely to invert by year-end. In the event, the financial markets will react negatively and force the FOMC to delay any further rate hikes until long-term interest rates actually start to rise of their own volition. Until then, the short-term liquidity trap created by the Fed’s misuse of IOER will be a continued obstacle to policy normalization, on the one hand, while the Fed’s massive QE portfolio will act as a cap on long-term bond yields. And the FOMC has yet to admit publicly that they indeed have a problem of their own special creation. http://is.gd/FordMen #GeorgeSelgin #WalkerTodd #CATO #IOER

Boston | Even as the Federal Open Market Committee raised short-term interest rates last week, the Trump Administration doubled down on trade war to gain leverage in the mid-term elections loom. The markets have not reacted well to the bellicose language coming from the White House, with financials in particularly under-performing the markets. But you don’t need to look very far to understand the travails affecting the US banking sector. One reason why banks are selling off is the prospect of significant layoffs and operating losses in the mortgage sector. Rising costs and tight production spreads have driven the mortgage industry into the red this quarter, with many shops not even meeting minimum production levels to achieve break even. Rob Chrisman warned in his weekly comment that he expects to see at least one large bank shedding “thousands” of people this summer because of the combination of tight spreads and the over $8,000 per loan cost of new residential originations. Another, more important reason for fading on the US large cap financials, particularly given the extraordinary run last year, is that the easy growth for the industry is at an end, both in terms of loans and deposits. We had a fascinating conversation last week with Lee Adler, proprietor of The Wall Street Examiner , about the “extinguishment” of reserves as the Fed’s Quantitative Easing treasure trove runs off. Adler contends that the runoff of QE means an end to the easy deposit growth seen by US banks over the past half decade. “Under QE Fed lent money to Treasury in the form of note and bond purchases,” Adler explains. “By redeeming the notes and bonds as they mature, the Fed is effectively calling in those loans at the pace of $30 billion per month now, going to $40 billion in July, and 50 in October. Treasury pays the Fed off with cash it raises in additional note and bond sales. Investors bought the bonds with their bank deposits." "Those deposits are extinguished when they are withdrawn from the investors' accounts, go into Treasury account, then from Treasury account to Fed to pay off the maturing paper," Adler continues. "The asset disappears from the Fed's balance sheet, and so does the bank reserve deposit because the bank's customer used it to buy the new bonds. The new bonds now exist, but the money used to purchase them was extinguished when the Treasury used it to pay off the Fed.” “Deposit growth is slowly grinding to a halt, adds Adler. “It should go negative in the next couple months, especially if ECB makes more cuts in QE. Some of the ECB QE money was flowing instantly to US. Since ECB went from 60 to 30B QE their deposit growth has also slowed and less money flowed to US to buy bonds and stocks.” And sure enough, Alder’s prognosis is confirmed by the data from the FDIC, which shows that bank deposit growth has basically dropped to near zero over the past year. The chart below shows quarterly deposit growth rates going back to the mid-1980s. Notice that even during the years of aggressive Fed asset purchases, bank deposit growth rates were modest after the initial fear surge in non-interest bearing deposits after the 2008 debacle. Source: FDIC Of course, weak loan demand is another reason why deposit growth has been relatively restrained in this cycle. What demand has existed was focused on the hotter metro markets, which are starting to evidence late stage buyers fatigue. And as we’ve noted previously, bank regulators have been tapping the breaks on residential and multifamily credit for several years now. We also are reminded once again that there is no national market for residential real estate in the US. The folks at Weiss Analytics, in fact, confirm that with their latest data. Weiss Analytics reports that red hot metros such as Las Vegas, Seattle-Tacoma and Denver-Aurora are starting to see a decline in the number of transactions with rising home prices. In 2015-2016, these markets were at one stage showing virtually all home sales with rising prices, a measure of the enormous asset price distortions caused by the FOMC in the real estate sector. Just by coincidence, credit costs of the decidedly prime residential loans owned by US banks bottomed in 2015. Performance of first-lien mortgages remained unchanged during the first quarter of 2018 compared with a year earlier, according to the Office of the Comptroller of the Currency’s (OCC) quarterly report on mortgages. But what the data from Weiss Analytics suggest is that the heady sellers market of 2016 is rapidly changing two years later. The table below shows the percentage of sales in different markets where prices were rising. If our colleagues at the Fed and OCC want a list of markets where banks are likely to face credit challenges in the next few years, they could do well to ponder the list above, which features some of the highest price volatility numbers of any residential asset markets in the US. And notice that the exurbs north of Washington DC are in a state of collapse, a sure sign that these recession proof venues are about to flop into a tenants market. We’ll bet dinner at 21 Club that the loss given default (LGD) for these hyperbolic residential markets is close to zero or lower, as is the case currently with bank-owned multifamily exposures. With LGDs nationally for US bank owned residential exposures still in the 20% range vs the long-term average of 65%, it is pretty clear that credit costs in residential will rise in the future as the Fed continues to tighten credit and the US economy slows.

New York | Dale Hemmerdinger is the consummate New Yorker. He is a real estate executive and active public citizen. He oversees the properties and service subsidiaries of his family real estate company, ATCO , as well as its parent company, The Hemmerdinger Corporation and The Hemmerdinger Foundation. In 2007 Governor Eliot Spitzer nominated Dale to serve as Chairman of New York’s Metropolitan Transportation Authority. He formerly served as Commissioner of the New York City Conciliation and Appeals Board during the Administration of Mayor Ed Koch. Dale is active in many public and private organizations in New York and is known for his honest and incisive perspective on the political economy. The IRA: Dale, thank you for taking the time. Let’s start with your perspective on the New York real estate scene. How do you put the boom of the past decade into perspective? Hemmerdinger: There have been a number of cycles over the years. New York tends to follow the direction of the national economy but it also has its own real estate cycle. Like many other businesses, when times are good the lenders tend to lend and the builders tend to build – often too many buildings all at once for the demand. Demand for any type of real estate at a given moment is difficult to determine. What tends to happen, when there is a real need for office space or residential space, we all tend to build together and therefore we build too much. The IRA: Certainly looks that way. Are landlords actually getting squeezed at the moment and contrary to the popular press? Hemmerdinger: In the 2008 down cycle, we had a squeeze on rents for almost everything in New York. In the financial business, the situation was even worse. The overhang of office space in New York that was no longer needed by banks, insurance companies and financial firms was huge. All of these constituencies were cutting headcount and reducing space. As the economy improved and we started to come out of the slump, there was a presumption that rents were going to rise at a very steep angle, which has been the history of New York real estate. In previous cycles, rents went up fast and higher than before. This time that really didn’t happen. The slope was very gradual if positive at all. The IRA: That certainly does not track with the rising rent narrative in other markets around the U.S. What happened to make New York different? Hemmerdinger: A decade ago the City and New York State changed the law regarding what you could build with how much state subsidy, etc. The threat of further change to things like the 421a exemption for affordable housing caused many developers with buildable plots to decide that this was the moment to build. The combination of this need for space together with a change in the law, these two things coming together, gave us the building boom you see today. All you need do is walk around the city to see the construction activity. And it is not only in Manhattan, but in Long Island City and the other boroughs. There is a huge amount of building for New York at a given time. The IRA: Long Island City is certainly amazing. Multifamily buildings, hotels and even retail along some of the side streets. Does this construction make sense economically in terms of the market for this new space? Hemmerdinger: It costs a lot to build in New York. The problem is whether there are enough people who can afford to move into this new space. There is no question that there is demand for the space, but at what price? That gap between cost to build and the rental market is going to be a big problem in terms of new residential construction. On the commercial side, we started this cycle with double digit vacancy rates already. Anything over 10% vacancy is what I call a renters market. Keep in mind that vacancy rates are determined by estimates from real estate brokers… The IRA: You mean like the way bankers in the City of London used to determine LIBOR? Hemmerdinger: It is an approximate number determined by the major brokerage firms. Thus anything over 10% in terms of published vacancy rates for commercial space is a tenants market. So we started this cycle with 11% vacancy and no surprise there is a lot of pressure on high-end commercial rents. The IRA: Are you referring to the Third Avenue corridor, for example, where there is ample vacancy for office space? Hemmerdinger: Glad you asked. That is one of the myths of real estate. The old buildings are actually terrific. It’s the middle layer of buildings in terms of age that have problems. Older buildings built before the age of air conditioning have high ceilings and windows that open. Very attractive for tenants. There’s a middle layer of buildings from the 1960s and 1970s where the ceilings were very low and are difficult to retrofit. That’s why you see some of the lovely older building around town being renovated. They are really wonderful properties and affordable for the tenants and amenable to modernization. You give me Rockefeller Center, which has high ceilings and beautiful windows, and we can make it as modern and attractive as any new building. The IRA: Agreed. Look at the renovation of the old New York Times building as another example. The location of older properties also tends to be better in terms of proximity to transportation. We started talking the other day about the new developments over on the West Side of Manhattan, which are absolutely beautiful buildings but a hike even from Penn Station. How do you see those properties positioning in an already glutted commercial market? Hemmerdinger: First thing, the public transportation to Hudson Yards is not adequate to make it work. It’s great for the chiefs who have cars or drivers, but it will be very tough for the regular people who go there every day for work. When I was on the MTA Board, I argued with Governor Spitzer that we should demolish the Jacob Javits Convention Center , which is now too small for events, and then redevelop the entire area with more transportation. We should have residential where Javits Center sits today and then a new convention center and business space going east towards Penn Station. But again the construction cost and also the politics intervened. The assumption that the area on Eleventh Avenue will gentrify and attract businesses is going to be very tough to achieve. They are doing a lot of deals to fill the space, but will these deals work over the medium to long-term? The West Side is very different from what Larry Silverstein is building downtown at the Freedom Tower. Everything is there; shops, amenities, transportation. The presentation is fabulous. The IRA: Given the amount of empty storefronts visible in midtown Manhattan, we agree that growing a healthy street level economy on Eleventh Avenue will be a challenge. But what about other areas of the City that are seeing a construction boom? Hemmerdinger: Ultimately it is the peripheral stuff that always has trouble. Its already starting in Long Island City where we have 16,000 new apartments. That is a lot. We are already dealing with an overcrowded subway system coming in from Queens, so there will be a transportation squeeze in Long Island City over time. The IRA: Long Island City is a barren urban landscape. Not much natural pedestrian traffic and the dominating shadow of the Queensboro Bridge. Very much like the West Side and particularly the High Line Park in some respects. There is only so much you can do to beautify Eleventh Avenue or Queens Plaza without a total redevelopment, correct? Hemmerdinger: Most of the most precious public spaces in New York like Central Park have evolved their own support networks over time. There are a lot of rich people who live around Central Park and pay directly though taxes and by donating to the Central Park Conservancy to maintain it. The Conservancy has done a fabulous job. Public fixtures like the High Line have a much smaller base of supporters, but funding from the community and also from real businesses, above and beyond public funds, is needed to make any neighborhood work long-term. The IRA: But why did we see the enormous scale of development in New York over the past 10 years? Even with the legal changes, it seems like the scale of development has soared compared with past cycles. How did the low level of interest rates contribute? Hemmerdinger: The first thing was the legal changes we mentioned before. Owners did not want to take the chance that future laws would be less permissive. Then interest rates were really low when all of these projects started. Also, there was an awareness that you could purchase air rights and create buildings that were really remarkable. The view of Central Park from the 80th floor is fabulous. You’re in the clouds sometime. So they were producing a product that was limited and very desirable. The problem is that you don’t make money selling the penthouse to a Saudi prince. The IRA: No? Hemmerdinger: No. You have to sell the middle of the building as well. Selling the properties that are not so glamorous at premium prices is the key. There is a real question as to whether there are enough people who can afford these new developments, which will likely put downward pressure on rents. My sense is that there has been enormous overbuilding at the price. You can already see the pressure on rents as unsold condo properties go onto the rental market. The IRA: So what is the outlook for New York City high end residential over the next 18-24 months? Our friend Jonathan Miller at Miller Samuel refers to it as “aspirational pricing” in the current market when it comes to offered prices. And he says capitulation could take years. Hemmerdinger: It is not a question of whether there is demand for the space. The question is can you afford to live there given the cost of rent, which is a function of the cost of construction? Building in New York is very expensive. I think things will get worse as more of these new condo projects come on line, are unsold and they end up in the rental market. If you remember three and four years ago, almost half of condominium sales were to out of town buyers. That flow of cash has slowed. Our experience is that the purchase market for high end properties is down about 10% from peaks of two years ago. When these condos don’t sell, the banks will force the developer to put them into the market as rentals. You will see increasing concession to buyers and falling rents for tenants as landlords try to at least fill buildings so they don’t feel like mausoleums. And then we will have a normal recession. The IRA: Nice. So what is coming in the event of rising interest rates and perhaps a slower economy? Do we have a crisis in commercial real estate in New York? Hemmerdinger: For projects that are not yet completed, they will be facing an increasingly hostile financing market. You can’t get out of a construction loan until you have a certificate of occupancy. Hopefully the developer has a take out for the construction loan, but the debt market is going to be very tough if rentals are soft and the purchase market is even softer. When it comes to prices, think of it as a cake. The top part of the market can squish the most while the bottom of the market will barely move. The higher the initial price of the property, the bigger the potential percentage drop in a down market. In the suburbs, for example, there’s a vigorous market up to a million dollars or so, then the volumes drop dramatically. Greenwich has a ten year supply of homes available for sale. But as you know I like to be optimistic, both about the property market and New York in general. The IRA: Thanks Dale #Hemmerdinger #NewYorkCity #realestate

Back in April we published a comment, " Bank Earnings & Financial Repression ," that introduced the concept of the Financial Repression Index. In a related working paper available on SSRN, " The Financial Repression Index: U.S Banking System Since 1984 ," we define the index, which essentially shows the distribution of bank interest income between debt investors and bank shareholders. At the end of Q1 2018, almost 84% of all income earned by banks on leverage went to bank shareholders as a result of the Fed's policy of "Quantitative Easing," while the remainder went to depositors and bond investors. Thirty years ago, that situation was reversed. The secular decline in US interest rates has very clearly been paid for by depositors and debt investors, while the share of interest earnings apportioned to bank equity investors has grown. In the 1980s, almost three quarters of bank earnings on loans and investments flowed to depositors and bond investors. As recently as 2008, the distribution of profits was roughly 50/50. The chart belows shows the Financial Repression Index updated through Q1 '18. Notice that the index has now turned downward after peaking at 90% of bank interest income allocated to equity holders. With bank interest expense growing more than 50% year over year, net interest margin for banks will flatten and eventually turn negative in 18-24 months -- perfect timing for the next recession in the US. The chart below shows the components of net interest income for all US banks through Q1 '18. Source: FDIC Craig Torres of Bloomberg reported last week that former Fed Chairman Ben Bernanke, the father of QE, predicted that the US economy is headed for a recession by 2020 . Thanks Mr. Chairman. #netinterestincome #financialrepressionindex