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New York – Ever heard of the European Monetary Authority? Hold that thought. For more than a decade now, banks in Europe have been free-riding on sovereign credit support, a fact that has attracted more than a few foreign investors. With the political devolution now underway in Rome, however, Eurobanks have begun to trade again on their intrinsic credit. In an important new paper from The Institute for New Economic Thinking , Professor Ed Kane of Boston College states the problem succinctly using ratings from our friends at Kamakura: “[T]he recovery of European megabanks from the 2008-09 crisis has been incomplete. Creditors of Europe’s giant banks still seem to be relying on implicit guarantees. In particular, credit spreads on the bonds of these banks appear to be relatively insensitive to the level of the issuer’s longer-term probabilities of default. Coupled with the high pairwise correlation that KRIS default probabilities show between major US and European banks, this finding suggests that creditors do not expect the EU’s bail-in requirements to play much of a role in resolving megabank insolvencies during the next crisis.” Even before the 2008 financial crisis, global regulators were moving on a set of proposals that eventually became known as Basel III. When the discussions began in earnest, the ask from the US side was that Europe do something about non-performing loans in the banking system. The Europeans, for their part, insisted that housing assets – particularly evil mortgage servicing rights or MSRs -- be consigned to the bad bucket along with other supposed intangibles such as net loss carry forwards. Below is our discussion last week with Brian Sullivan of CNBC . The final Basel III document focused mostly on liquidity and capital, but neatly skirts the issue of credit quality. The US banking system is particularly strong when it comes to recognizing and liquidating defaulted loans, in large part because US banks generate strong profits and are able to resolve bad debts in reasonable periods. In Europe, however, banks are less profitable and debtors tend to have the upper hand. There are no bankruptcy courts in Europe. As a result, EU banks have tended to extended forbearance to defaulted obligors, particularly those with access to political influence. There are three pillars of the Basel bank supervision approach: (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. Most of these pillars are observed in the omission in Europe. Capital requirements, notably illustrated by the cases of Deutsche Bank AG (DB) and Montepaschi Group, are largely a fiction. Supervision is fragmented among the 28 EU member states. And market discipline in the EU is largely prohibited via explicit legal limits on short-selling and official “guidance” to banks, rating agencies and large investment firms. Since 2010 when the Basel III rules were announced, there has been a steady but painfully slow recognition by the Europeans that something needs to be done about credit quality and therefore bank solvency. In March of 2018, the European Central Bank announced that bank loans that become non-performing after January 1, 2018 must be adequately reserved, but left aside the issue of non-performing loans recognized prior to this year. The seemingly absurd ECB announcement about reserving loans that go bad from January 1st of this year is part of a larger political dance. The ECB is trying to perform damage control among and between member states that still control bank supervision at the national level while at the same time paying lip service to capital and Basel III. There is no mechanism for supervising EU banks on a unified basis, nor any agreement on loss sharing or even a retail deposit insurance safety net. And the biggest obstacle to moving forward with these initiatives is the enormous public antipathy toward banks. In Italy the government has managed to move significant amounts of bad loans off the books via securitizations with government guarantees on the senior tranches. “Huge volumes of NPLs (€37bn in 2016 and over €47bn in 2017, according to consultancy Deloitte, have been sold by banks, often to specialist American hedge funds like Cerberus Capital Management or Fortress Investment,” the Economist reports. The European Commission has agreed that these securitizations of bad loans do not constitute state aid “as the guarantee will be priced at market levels.” The latest official figure on bank NPLs from the Bank of Italy is 11 percent of total loans, an enormous figure but better than the mid-teens number reported in 2016. Banca Monte dei Paschi, for example, reported 14 percent NPLs at the end of Q1 ’18. By comparison, a bit over 1 percent of loans held by US banks are currently marked as past due. The peak of US NPLs was 5.5. percent in Q4 2009, when the US banking industry charged off $60 billion in bad credits in a single quarter. Such an act of financial housecleaning is impossible in Europe. Investors may gain some comfort from the upbeat views of consultancies such as Deloitte, who noted in a 2016 report on the early efforts to securitize Italian NPLs: “While these reforms may not be the all-encompassing panacea that is needed, any moves to cleanse bank balance sheets of distressed debt has to be welcomed.” But as we’ve told any number of investors over the past few years, there is no practical way to estimate loss resolution timelines or recoveries on non-performing commercial assets in Europe. Of course, auditors like Deloitte and the other major firms must operate in the world of stated financials and prudential regulation as it exists in Europe today. Because of issues with both the definitions behind and presentation of financial disclosure in Europe, particularly when it comes to credit, we still view the official numbers on NPLs in Italy and the rest of southern Europe as being deliberately understated. In Italy, for example, prudent investors proceed on the assumption that total NPLs are probably twice the official levels. Italian banks, owing to political and financial realities, are not prepared to bring their level of asset quality and disclosure to the levels of their US counterparts. When the new ECB rules on NPLs go into effect in 2021, it will be interesting to see if Italy and other Southern European nations actually comply. If you are doing business with a bank anywhere in Europe, the reality is that a foreign investor or ratings analyst or banker or regulator will never know if a given bank is sound or not. There is no culture of disclosure in the EU when it comes to banks. There is no SEC Edgar system for public banks, no FDIC and FFIEC for all US depositories. The disclosure by Monte dei Paschi of its bad loans is contained in a single table. Click here to see the Bank Holding Company Performance Report for Deutsche Bank Trust Corp, the top-tier unit of DB in the US that was recently red flagged by the Fed for operational issues. There is no similar public source of information in Europe for DB or any other depository. Instead in the EU there is a private network of data dissemination based upon 28 national accounting rules and national regulatory regimes. Your only indicators of risk are prices for a bank’s debt and equity and the relevant sovereign benchmarks. Since as Professor Kane observes many EU banks have been trading like quasi sovereign credits, recent market volatility begs the question as to both bond spreads and equity market valuations. Of note, the guarantee pricing mechanism for the Italian NPL securitizations depends upon the pricing for credit default swaps (CDS) for a basket of Italian issuers as well as the credit support of the Italian government. With the rise of the explicitly anti-euro coalition in Rome, the practical value of that Italian state guarantee certainly comes into question. One aspect of this situation that deserves attention from investors is the precarious nature of funding in the EU banking system. In the Euro zone, German banks make the system go by carrying over €900 billion euros of float in the form of unsettled credits for the rest of the system. This means that German banks enable payments by banks in Italy, Spain, Portugal, and Greece, notes former Fed counsel and researcher Walker Todd. Todd explains that the US Federal Reserve System avoids the buildup of large inter-district debit and credit balances by settling accounts systemwide on a weekly basis. “In the old days, that is why $10,000 notes existed -- to facilitate the clearings,” Todd avers. For whatever reason, when the euro was established in 1997, no provision for periodic intercountry clearing and settlement was included. This has led inexorably over time to the strongest member country extending a great deal of unintended credit to the rest of the EU system, especially the weakest countries' banking systems. As the M5S/Lega coalition engages with the other EU member states, they would do well to remember that the Germans ultimately are financing short-term borrowings via the ECB. Of note for investors in Italian banks, German chancellor Angela Merkel rejects any debt forgiveness schemes for Italy – one of the early demands from the M5S/Legal government that was apparently dropped – at least for now. Merkel stated flatly that solidarity among euro area members should not lead to "a debt union” – a concept that would spell political suicide for Merkel and her coalition. Yet it is some measure of the dire situation in Europe that the German leader leaves open the possibility of a bailout for Italy. French President Emmanuel Macron advocates the creation of a specific budget for the euro area, with the appointment of a finance minister, and the transformation of the European Stability Mechanism (ESM). ) into a European Monetary Fund (EMF). Merkel apparently agrees. "If the entire eurozone is in danger, the EMF must be able to provide long-term credit to help countries, Merkel said last week. “Such credits could be spread over 30 years and granted on the condition that the beneficiaries undertake structural reforms." The reality in Europe is that structural reforms never occur in large member states, only in the subordinate states such as Ireland, Greece and Spain. Italy, as Europe’s largest debtor state, lacks the political will to get its banks and fiscal situation in order. Thus Merkel seems to be preparing the way for a bailout for Italy if for no other reason than to protect German banks. Think of it as a larger version of the Greek project. The M5S/Lega coalition has explicitly threatened sovereign debt default, an explicit act of extortion focused on Germany and Angela Merkel. Is an EU bailout bullish for Italian banks? Maybe in the near term. But ultimately we think that Italy’s fiscal disarray will destroy the EU and lead to an Italian exit and currency devaluation with the reintroduction of the lira. In the event, banks in Italy and throughout the euro area will be severely impacted. #AngelaMerkel #DeutscheBank #EdKane #WalkerTodd #MontepaschiGroup #BaselIII #ECB #NPLs #BancaMontedeiPaschi

New York – Happy Memorial Day. "Let us have peace." Grant's Tomb The Mortgage Bankers Association Secondary Expo is always one of the more important events of the year for the housing finance industry and 2018 was no exception. MBA Chief Economist Mike Fratantoni delivered the expected bad news that the industry slipped into net loss on new loan origination for the first time since 2014. Soaring regulatory costs and shrinking spreads are the culprits. But the industry remains upbeat. Rob Chrisman summed it up: “I know many owners and CEOs of residential lenders… and would never bet against their success. They represent a very savvy, entrepreneurial, and street-smart group of individuals but are faced with many risks, with LO comp, technology, housing inventory, and shrinking margins in the forefront.” We could not help but be impressed by the innovation on display at the MBA event. A number of mortgage lenders are getting into new areas of credit such as “business lending” (aka funding fix n flip strategies) and other short-term credits. Reverse mortgage lenders are getting into forward jumbo lending, while jumbo shops now want to do reverses. REITs are buying lenders and old mortgage bankers are spawning new REITs. And there is even talk of non-bank construction and development (C&D) lending. The fact that the likes of Goldman Sachs (GS), Zillow and Redfin are in the market for financing fix-and-flip projects and single-family rentals gives some investors confidence. And yes, the market has grown significantly. But we worry the Bernanke-Yellen monetary joy juice known as "QE," which has pushed up home prices by multiples of the supposed PCE inflation rate, is behind this surge in demand for home improvement loans. Cool off the home price appreciation and this new credit market chills out as well. To give you an idea of the level of frenzy in bank C&D lending, in Q1 '18 US banks reported a negative cost of credit for this $350 billion asset class. Somehow we can’t see the opportunistic diversification into business lending ending well. And the fact that GS has decided to add fix n flip to crypto currencies in its portfolio of BIG IDEAS is most definitely a concern. Lending on collateral like a residential home is a far better of a business than unsecured lending to small, often unincorporated businesses focused on home flipping. Some shops will lend 90% on the purchase of the spec home and then fund 100% of the improvements on the asset as well. As and when home prices stabilize in high value MSAs, the rationale behind this business will evaporate. There are certainly signs that the credit market for residential exposures had matured. With the collateral under the residential mortgage sector showing continued signs of being “too good to be true,” loss rates actually rose in Q1 ’18 to 27% after falling into the twenties a year ago. This rate of loss given default (LGD) is still among the lowest levels seen in almost half a century for bank owned residential loans, as shown in the chart below. The average LGD for bank RESI loans going back to the early 1980s is 66%, of note. Source: FDIC Gillian Tett of the FT last week became the latest financial writer to call US housing a bubble. Tett confirms that the Federal Open Market Committee has manipulated US real estate prices to the point where a messy correction is inevitable. The downward skew in loss rates over the past several years certainly supports that view, but nobody on the FOMC seems to want to talk about real estate prices and how racing valuations have outrun conventional measures of inflation much less potential home buyers. National Association of Realtors (NAR) released a summary of existing-home sales data showing that housing market activity this April fell 2.5 percent from last month and dropped 1.4 percent from last year. The MBA has total loan origination flows basically flat at $1.6 trillion annually through 2020. In markets such as New York, Austin and San Francisco, volumes in high end properties are softening. Luxury prices in New York actually peaked several years ago. Tett writes: “But estate agents say that sales volumes in the first quarter of 2018 were at their lowest level for six years. Meanwhile the median price per square foot was 18 per cent lower than a year earlier, according to some reports. That leaves Manhattan estate agents nervously gossiping about the local outlook. However, it should prompt investors and policymakers to ask a bigger question: could New York’s jitters herald declines in other non-US real estate markets too?” Ditto Gillian. In fact, the increase in loss rates on 1-4 family loan defaults is not yet mirrored in actual rates of default and delinquency. Past due bank owned loans at 2.5% is at the lowest level since Q4 ’07, an unfortunate yet accurate historical coincidence. A decade ago as today, credit seemed to have no cost and banks were reporting negative rates of loss. That situation pertains in the $400 billion portfolio of bank owned multifamily loans, where recoveries continue to exceed cash losses due to the huge price increases in this popular asset class. The rates of delinquency and charge offs are near zero for bank owned multifamily loans, as shown in the chart below. Source: FDIC Most of the operators we polled think that the low profit margin environment in residential lending will persist for years, even as sales volumes flatten out. Of interest, the MBA has purchase mortgages growing steadily in its loan production estimates, while mortgage refinancing volumes steadily fall. Obviously mortgage refinancing is less attractive in a rising rate environment, But will home purchase transactions continue to grow in the post-QE world? This is the key question that will validate – or not -- expectations for businesses operating in the world of mortgage finance. No surprise then that yields for both conventional and government-insured mortgage servicing assets are trading briskly in single digits. During our discussion of mortgage servicing rights (MSRs), one of the panelists wondered if it would not be possible to see mortgage prepayments drop even below current low levels. From left, Phil Laren of MCTrade, Charles Clark of Everbank, RC Whalen, Seth Sprague of Phoenix Capital & Mark Garland of Mountain View. The upward movement in prices for MSRs over the past year has been striking, with cash flow multiples for conventional MSRs north of five times annual cash flow and new issue GNMA MSRs in the mid-threes compared to half that level twelve months ago. This year marks five years running that yields on MSRs have fallen, a process now accelerating due to rising interest rates. Seth Sprague of Phoenix Capital told the audience that institutional cash focused on the MSR market has surged over the past year. “Liquidity has basically doubled along with the number of buyers compared to a year ago,” he noted and added that rising interest rates are making the escrow balances associated with MSRs increasingly valuable along with the expectation of low prepayment speeds. Mark Garland from Mountain View said that “We’ve all talked a lot about non-banks growing market share. We are starting to see the banks coming back to the MSR market. Banks are being very competitive. And we’ve seen new shops come to the marketplace. We traded a deal recently where the 30 year [cash flow] multiple went above 5.5 times. That would have been unimaginable six months ago.” As the mortgage industry struggles with the “benefits” of quantitative easing and ultra-low interest rates, current and former Fed officials travel around the country congratulating themselves on their cleverness and engaging in chest pounding demonstrations over the profits earned via QE -- profits that should have gone to private investors but instead were remitted back to the Treasury. Sadly for Bernanke, now the FOMC's System bond portfolio is badly under water to the tune of tens of billions of dollars. In fact, QE resulted in the transfer of trillions of dollars in income from private investors to the state and created grotesque distortions in asset prices like stocks and real estate. The acceleration in MRS valuations over the past year is as much about rising interest rates as it is due to Fed market manipulations. Instead of boosting job growth and home affordability, the good citizens at the Federal Reserve have through excessive regulation and QE engineered scarcity of homes and a declining market for mortgage finance – precisely the opposite of the goals they pretend to pursue. One thing that is pretty clear though is that over the past five years the cost of buying a home has soared faster than the official inflation rate, a fact that is likely to result in thousands of job losses in the mortgage sector over the next year and more. Consolidation is the name of the game in the world of mortgage banking, driven by sharply increased operating costs, falling loan origination profits and rising interest expenses. The concern of course is what happens when home prices inevitably weaken. Martin Feldstein, writing in the Wall Street Journal , warns similarly for stocks but would likely also add a bubble in housing to the list of FOMC accomplishments: “Year after year, the stock market has roared ahead, driven by the Federal Reserve’s excessively easy monetary policy. The result is a fragile financial situation—and potentially a steep drop somewhere up ahead.” Next week, the Institutional Risk Analyst will release the new edition of the Bank Book, including a discussion of current banking industry trends in credit and operating performance, and profiles of the top US banks. #BenBernanke #JanetYellen #inflationQE #MortgageBankersAssociation

New York – This week The IRA will be at the MBA Secondary Market Conference & Expo , as always held at the Marriott Marquis in Times Square. The 8th floor reception and bar is where folks generally hang out. Attendees should not miss the panel on mortgage servicing rights at 3:00 PM Monday. We’ll give our impressions of this important conference in the next edition of The Institutional Risk Analyst . Three takeaways from our meetings last week in Paris: First, we heard Banque de France Governor Villeroy de Galhau confirm that the European Central Bank intends to continue reinvesting its portfolio of securities indefinitely. This means continued low interest rates in Europe and, significantly, increasing monetary policy divergence between the EU and the US. Second and following from the first point, the banking system in Europe remains extremely fragile, this despite happy talk from various bankers we met during the trip. The fact of sustained quantitative easing by the ECB, however, is a tacit admission that the state must continue to tax savings in order to transfer value to debtors such as banks. Overall, the ECB clearly does not believe that economic growth has reached sufficiently robust levels such that extraordinary policy steps should end. Italian banks, for example, admit to bad loans equal to 14.5 percent of total loans. Double that number to capture the economic reality under so-called international accounting rules. Italian banks have packaged and securitized non-performing loans (NPLs) to sell them to investors, supported by Italian government guarantees on senior tranches. These NPL deals are said to be popular with foreign hedge funds, yet this explicit state bailout of the banks illustrates the core fiscal problem facing Italy. And third, the fact of agreement between the opposition parties in Italy means that the days of the Eurozone as we know it today may be numbered. The accord between the Five Star Movement (M5S) and the far-right League Party (Lega) of Silvio Berlusconi marks a deterioration in the commitment to fiscal discipline in Europe. Specifically, the M5S/Lega coalition wants EU assent to increased spending and cutting taxes – an explicit embrace of the Trumpian economic model operating in the US. The M5S/Lega coalition is essentially asking (or rather blackmailing) the EU into waiving the community’s fiscal rules as a concession to keep Italy in the Union. The M5S/Lega coalition manifesto, entitled appropriately “Government for Change,” suggests plans have been made for Italy to leave the single currency, calls for sanctions against Russia to be scrapped and reveals plans to ask the European Central Bank to forgive all of the Italian debt the ECB purchased as part of QE. John Dizard, writing in the Financial Times on Friday , notes the new spending in Italy will be funded via “mini-BoTs,” referring to Italian T-bills. The M5S/Lega coalition apparently wishes to issue small (euro) denomination, non-interest-bearing Treasury bills. The paper would be in the form of bearer securities that would be secured by Italian state tax revenues. Dizard notes that the logical conclusion of the Italian scheme, which allows the printing of a de facto fiat currency in the form of bearer bonds, will result in either Germany or Italy leaving the EU. The Italian evolution suggests that Ben Bernanke, Mario Draghi and their counterparts in Japan, by embracing mass purchases of securities via Quantitative Easing, have opened Pandora’s Box when it comes to sovereign debt forgiveness. We especially like the fact that mini-BOTs will be in physical form, printed like lottery tickets. The spread on Italy is now trading 1.65 percent over German Bunds vs 1.5 percent last week and is likely to widen further. Among the biggest challenges facing Italy’s new government and all EU heads of state is the growing economic policy divergence between the US and Europe. Again, to repeat point two above, the Europeans have no intention of raising interest rates anytime soon and, to this end, will continue to reinvest returns of principal from the ECB’s securities portfolio. Given the Fed’s focus on raising interest rates in 2018, it seems reasonable to assume that the euro is headed lower vs the dollar. The assumption on the Federal Open Market Committee, of course, is that US inflation is near 2 percent, giving us a real interest rate measured against LIBOR at 3 percent, for example, of one hundred basis points. But what if the FOMC is wrong about inflation and, particularly, if the favorite inflation measure used by American economists is overstated? Is the ​broadly defined ​personal consumption expenditure (PCE) index, which the FOMC relies upon for​ assessing economic conditions and fiscal policy, inflation, and employment​, really the best measure of price change? And is the FOMC currently making a rather gigantic mistake in raising interest rates further? Our friend Brian Barnier at Fed Dashboard has done some interesting work on this question over the past several years, including his May 10, 2018 missive (“ Concentrated price changes mean less control for the Fed ”). The chart below from Fed Dashboard shows the components of PCE. The chart illustrates how difficult it is to discern a central tendency in the bundle of data that goes into inflation indicators such as PCE. As Barnier writes: “’Inflation is back’ has been a big headline. Is that true? Yes, if ‘inflation’ means the weighted-average price change of products No, if ‘inflation’ means price increases caused by monetary factors or widespread price increases.” The San Francisco Fed has also done some great work on this issue of "PCE diffusion." If you are indeed a data dependent monetary agency, the idea of using the center point average of the diverse factors in PCE as a bellwether for monetary inflation is a bit odd. Notice, for example, that increases in the cost of financial services such as banks, auto insurance and financial advice are among the biggest positive factors in the PCE index. Increases in interest paid on excess reserves (IOER) by the Fed also positively impacts PCE, Barnier tells The IRA . Important for Europe, the Fed’s use of PCE is leading to rising interest rates, which in turn is driving up dollar borrowing costs in Europe, as shown in the FRED chart below of three month LIBOR vs three month Treasury bills. The FOMC’s view of inflation also is supporting a rally in the much battered dollar. But what if the Fed’s favorite indicator, namely PCE, is overstating the actual rate of price change? Economists on both sides of the Atlantic like to neatly separate “real-world” indicators like interest rates and debt from supposed monetary factors such as PCE. But the divergence of monetary policy in the US and Europe suggests this is difficult in practice. There seems to be a basic conflict in how inflation is perceived in Washington and Brussels. This conflict of visions promises to be increasingly problematic in the weeks and months ahead with a stronger dollar and higher US interest rates pressuring emerging nations. The big risk we see both for Europe is that the narrative being followed by the FOMC assumes that inflation is rising, at least as measured by PCE, when in fact deflation driven by excessive debt may still be the central tendency of aggregate price change. If PCE is overstating monetary price change, then the FOMC should not raise rates further. So the good news is that Europe is showing some signs of life in terms of economic growth. A weaker euro may help in the near term. The bad news is that the EU’s banks remain largely crippled by non-performing loans accumulated during previous economic slumps. And the level of debt held by nations such as Italy is growing steadily. With the UK already headed for the door, the latest political developments in Italy may presage the end of the EU as it stands today. How the Germans and other euro nations deal with the new government in Italy will tell the tale.

Paris | Why is economic growth so modest in the United States given the low levels of interest rates? Or as Jim Glassman of JPMorganChase (JPM) wrote last week: "According to popular theory, Treasury yields should be much higher than they are, given the current rate of GDP growth." Remember when regulators talked about a nonsense called "macroprudential" policy? The short answer to the riddle of growth vs interest rates posed by Jim Glassman is excessive regulation. Sadly when we hear from a number central bank officials and economists tomorrow at the Banque de France, there won’t be any discussion from the assembled expertsof a conflict between monetary policy and regulation. Perhaps the single most oppressive factor in the US economy today is the Federal Open Market Committee. Since the 2008 financial crisis, the FOMC has subsidized the US banking systems to the tune of about half a trillion dollars per year, yet the committee members insist that their policies are intended to promote job creation and economic expansion. Most of the benefit of lower interest rates have flowed to the largest banks and leveraged investors while the US economy has largely healed itself. Do the math: $100 billion per quarter in subsidies to banks in terms of low deposit rates and bond yields, plus billions more per month paid by the Fed risk free in interest on excess reserves (IOER). Bank net interest margins shrank dramatically in the past year as market rates have risen, yet the subsidies continue to flow because deposit rates have barely moved. And the sad part is that, even as the FOMC effectively competes with the US Treasury by paying IOER, it is also encouraging banks not to lend to support real economic activity. We illustrated the mathematics of financial repression in The IRA last month (“ Bank Earnings & Financial Repression” ). The dirty little secret kept by the FOMC is that were it to actually stop paying IOER tomorrow, the Fed funds rate would probably be cut in half. That would not fit into the macroprudential fantasy that justifies the actions of the Fed over the past decade. Within the strange, neo-Keynesian logic that operates within the US central bank, the FOMC believes that it must use IOER to manage interest rates upward to prepare for the next recession. But by pushing up short-term interest rates when there is so little real demand for credit, the FOMC may actually cause the next recession. So why does the central bank feel compelled to force short-term interest rates higher? Didn’t the FOMC buy $4 trillion in Treasury debt and mortgage backed securities in order to promote risk taking and investment to boost employment? Well, sort of yes and sort of no. The fact is that demand for short term credit is much weaker than the FOMC is willing to admit. And as we have discussed previously, the FOMC refuses to take losses on the System portfolio by actually selling bonds. Thus, to Glassman's point, there is an effective cap on long-term interest rates. Even as the Fed was manipulating credit spreads and credit markets via quantitative easing, prudential regulators were increasing capital requirements for banks and discouraging lenders from taking risk. Specifically, bank capital levels have basically doubled since 2008, which leaves less of the bank balance sheet available for lending. We discussed this asset allocation issue with Dennis Santiago of Total Bank Solutions a couple of weeks back (“ The Interview: Dennis Santiago on Banks, Blockchain and the Goddess of NIM ”). More important, the supervisory guidance to banks from prudential regulators, in particular the officials at the Federal Reserve Board and the Office of the Comptroller of the Currency, has been to avoid risk taking. Hard ceilings have been placed on all manner of bank loan exposures, from commercial and industrial loans to construction finance and multifamily and residential real estate. As with the increased capital levels, the guidance from US regulators makes it effectively impossible for banks to maintain levels of credit needed to fuel higher economic growth. In addition to limiting overall bank loan exposures for much of the US economy, federal regulators have specifically limited lending to consumers, particularly the bottom third or so of Americans in terms of credit scores. Roughly one third of all Americans who can actually qualify for a FICO score have score below 650. This puts them out of reach for most bank lenders, especially the largest banks. Even as the overall credit quality of US consumers has been rising over the past decade, banks have effectively been told to only lend to consumers with credit scores north of 680-700. According to the company formerly known as Fair, Isaac & Co, the average FICO score rose to over 700 last year. The chart below from FICO Blog shows the distribution of FICO scores through 2017 and is republished with permission. The reason that non-banks have come to control more than half of the US mortgage market is that the depositories were told to avoid any default and/or reputational risks involving US consumers, who are viewed by federal regulators as being toxic. This guidance is not written down anywhere the public may see it, but the effect on credit availability from banks is stifling economic expansion and arguably offsets much of the positive benefit from the FOMC’s manipulation of interest rates. If all of this seems a little bit crazy, it is. The folks on the FOMC bend the rules of monetary mechanics and more, but prudential regulators have put in place guidelines and unpublished rules that effectively freeze out millions of Americans from getting loans for their new business or to buy a home. If you think that the 2010 Dodd-Frank law was meant to protect consumers, then you’re right. It protects them from gaining access to credit on reasonable terms from federally insured banks. Of course you’re probably thinking that the non-bank lenders are picking up the slack with less affluent Americans, but not really. Banks may be levered 10-15 times on equity, but non-banks lever their capital just 1-3 times -- if they want to access the investment grade sector of the capital markets. So even if non-banks are willing to lend to borrowers with inferior credit, their ability to support lending volumes is constrained by limited balance sheets. One reason why lending volumes for the US residential mortgage market have fallen for the past three years is that there simply is not enough capacity to support these less attractive borrowers. More, the Fed’s manipulation of asset prices has pushed the cost of a home beyond the reach of many American families. Meanwhile, the competition among banks and non-banks for loans to more affluent borrowers has driven loan spreads for assets such as mortgages and auto loans down to all-time lows or even negative. So what is to be done? In simple terms, we need to moderate the oppressive bank regulatory environment to allow banks to lend on reasonable terms to creditworthy borrowers. At the same time, the FOMC needs to realize that pushing up short-term rates much above current levels in the near term is going to be counterproductive and could lead the US down the path to a recession. There is simply not enough leverage available in the US economy to support higher growth at today's interest rates – especially given the regulatory restrictions placed upon banks when it comes to capital and lending. If we proceed with the FOMC’s planned rate hikes, the proverbial aircraft runs the risk of stalling at the end of the runway rather than taking off. Until we can somehow harmonize regulation of private credit with public monetary policy, this conflict of visions between the FOMC and federal bank regulators poses a serious risk to the US economy.

New York | We were in the car last week heading to Washington for the gala celebration for The American Conservative’s 15 years in existence. During the trip, we heard former auto industry executive Bob Lutz take down Tesla’s (TSLA) economic model live on CNBC . Talking to Carl Quintanilla, Lutz – who worked in senior management for all three US automakers – basically made two interesting points: that Tesla spends too much for its larger batteries and that the company’s labor costs are six times the industry average. Lutz repeated his view that examination of the company’s financials by “anybody who knows anything about the automobile business” must lead to the conclusion that “this cannot possibly work” with reference to TSLA’s costs and revenues. He predicted bankruptcy for the company. “[Musk] doesn’t want to talk about the numbers, which are a disaster,” former GM Vice Chairman Lutz told CNBC (“ Elon's costs are way higher than his revenues: Bob Lutz ”). He says let’s talk about the future… He wants to talk about anything but the disastrous business.” Suffice to say that Lutz generates a LOT of controversy, both from the supporters of Tesla and its charismatic CEO Elon Musk and from auto industry aficionados, as we discovered on our twitter thread upon posting his interview. But Musk does not cut a very impressive figure as a corporate CEO, behaving like a cranky child a la Facebook’s (FB) Mark Zuckerberg. He either needs to play the role as CEO of a public company or stand down. Come to think of it, Musk reminds us a lot of Henry Ford, a difficult man who had a vision and largely kept his own counsel. Ford was not known for his patience with mere mortals, preferring the company of other visionaries like Thomas Edison, Harvey Firestone and Charles Lindbergh. In fact, Henry Ford was an appalling manager who was not even an officer when Ford Motor Co was started. He would have failed for a third time in business but for his partners like James Couzens, Horace Dodge and Charles Sorenson. What we can definitely say about autos having researched Ford Men: From Inspiration to Enterprise over many years is that manufacturing passenger vehicles in the 21st Century is a very tough, often times irrational business with modest and frequently negative equity returns. Watching Ford Motor (F) decide last week to stop making “cars” is a reflection of this economic reality. Ford and all the global automakers must follow the evolving preferences of consumers when it comes to product design and discard products that don’t fit that target. Green is good, but consumer preferences for SUVs are really about utility, a trend Ford itself helped shape by introducing truck-based passenger vehicles like the Bronco and Explorer several decades ago. When Toyota responded in 1998 with the Lexus RX300, that marked a key step in the evolution and feminization of luxury sports utility vehicles. The 2000 model year Ford Explorer was still a big, dangerous truck, but the Lexus RX was a round, beautifully finished, if underpowered, passenger vehicle that rode high, had a big cabin, rear hatch and great visibility. The Lexus also had good gas mileage. The fact that TSLA has embraced traditional sedans rather than some sleek kind of vision for the hybrid SUV is notable. As we discussed with Bloomberg Intelligence auto analyst Kevin Tynan in February in The IRA (" The Interview: Kevin Tynan on Autos and Mobility " ), the global industry is headed towards a mix of SUVs and true trucks with traditional passenger cars getting a rapidly declining share of the production pie. Makers like Tesla and Audi, for example, are atypical in their continued focus on passenger cars vs SUVs of varying shades. Tynan said in February: “A decade ago most SUVs were being built on a truck platform, but that is not the case at all today. These were full frame vehicles. Today there are very few SUVs that are built on the same platform as the pickups.” Or to put it another way, Ford still makes “cars” that look like SUVs on the outside. And please don’t take your Audi Q-7 off-road in Maine or even off pavement during the June Camp Kotok fishing trip (there are a couple of spots left, BTW). Take the Ford F-250 Super Duty with the double cab and short bed to tow the grand lake canoe (see below). Toma Stream Tynan also noted that SUVs and trucks tend to be more profitable than cars, but here is where the problem comes for TSLA. According to Lutz, the delivered price for the Tesla Model 3 is in the $50k range as opposed to original price tag of $30k. That big delta in terms of the delivered price for a Tesla Model 3 will take out a lot of demand for the vehicle, Lutz concludes. More important, at that $50k price point, Tesla is up against Toyota, Audi, BMW and Daimler Benz, all of whom have full electric and hybrid offerings that can be reasonably profitable today. And the rest of the auto industry is right behind the premium marques in terms of features at lower price points. Elon Musk has achieved two huge goals: First, he validated the concept of electric cars in the public mind and with the auto industry. The entire global auto industry is desperately chasing Tesla’s vision of the electric future of personal transportation. Second, Musk has created a premium brand in Tesla, but this brand needs to be managed to be competitive. As Tynan noted: “Tesla is valued as a tech company, but as a car maker they are in precisely the wrong place in terms of consumer who want a higher ride and other attributes of a truck or crossover… Tesla could at least build a car that consumers want.” To us, Musk needs to declare victory and move on to his real passion, namely selling the future, space travel, shuttle to Neptune, whatever. Making cars of whichever propulsion type is about today and those few global designer/assembler/marketers that can compete for market share. Like Henry Ford, Musk’s considerable talent as a visionary and salesman may not be matched by his operating skills. He should just admit as much and put Tesla up for sale. Tesla ought to hold an auction among the top global automakers and pick a partner to build TSLA autos and especially small and mid-size hybrid Tesla SUVs. The continuing surfeit of global capital may still enable Musk to extract himself whole from the Tesla project and avoid facing the fate of some previous automotive entrepreneurs. We’re thinking not so much about the habitually conservative Henry Ford as much as William Durant of General Motors (GM) fame. One of the greatest speculators of a century ago, Durant built GM into the largest corporation in history during the first decade of the auto industry. Ford, GM and the Dodge Brothers were all fabulously successful and profitable businesses in the 1900s with returns to shareholders measured in the thousands of percent annually. Durant brought Buick, Oldsmobile, Pontiac, Cadillac, Champion ignition, AC spark plug and other companies into GM, sales soared, but earnings lagged. By 1910, however, Durant became over-extended and lost control of GM to the creditor banks led by JPMorgan (JPM). Durant was ousted by the bankers as his company sank into bankruptcy. By 1915, aided by the du Pont family and other investors, Durant regained control of GM and began “an enormous program of expansion,” to quote Earl Sparling’s 1930 classic, “Mystery Men of Wall Street.” The E.I du Pont Nemours Powder Company put $50 million of war profits into GM to support Durant. In the Spring of 1920, Durant tried to float $64 million in new stock to finance the excess of expenses over revenue at GM. The stock was trading at $38.50, but new investors were coming in at half that valuation – just $20 per share. The situation went from bad to disaster quickly, when several large stockholders, concerned about the misalignment of costs and revenue, threatened to sell, forcing Durant to personally support the stock. By June 1920, Durant had been buying GM stock through intermediaries for more than a month, but to no avail. The stock broke to $20 in public trading when a 100,000 share block was offered, Sparling reports. GM reached $12 per share by the end of the month. The value of GM continued to fall along with his fortune. Durant spent his entire cash reserve -- $90 million – to allow some of his personal friends and associates to exit the stock. By the end of 1920, JPMorgan stepped in once again and along with the du Ponts took charge of GM for the second time in two decades. They paid Durant $40 million for his stake, of note. More important, Du Pont controlled GM until the Administration of President Dwight D. Eisenhower forced the divestiture. It seems to us that Elon Musk has a choice. He can either magically cut the cash burn rate of TSLA down to nothing and start delivering cars on time or he can look for an exit strategy. Musk has created an awful lot of value in TSLA, but the better part of valor may be for this American icon to partner with a global automaker and move on to personal aircraft, for example. Otherwise TSLA will continue to burn cash and, eventually, must go back to the markets for more. And if TSLA is unsuccessful in raising new cash, then like GM in 1920 the great endeavor will be finished – unless Musk is prepared to fund the venture out of his own pocket. The bond holders and other creditors are, of course, ultimately the true owners of TSLA. Thus a sale may be the best outcome for this valuable brand, but how to get Musk to accept such an outcome? Trouble is, Musk may not be able to fund his project until it becomes at least as competitive as the rest of the industry. And between today and that operational goal, TSLA will be valued more and more as a car company as opposed to a technology play. Ponder Audi AG valued at $34 billion vs TSLA at $49 billion. The markets will resolve the question soon enough. One might apply the judgment of Sparling on the persistent Durant to the personality of Musk: “[I]t isn’t money nor even power that this man has striven for all his years, but achievement, a role in the play of life that might turn that comedy and farce into the kind of drama it would be had a surer playwright written it.” #ElonMusk #Tesla #Ford #GM #Audi #CNBC

New York | In this issue of The Institutional Risk Analyst , we talk with Dennis Santiago, co-founder of Institutional Risk Analytics and the author of the Bank Monitor safety and rating system. The Bank Monitor was acquired by Total Financial Solutions of Hackensack, NJ in 2014. Dennis is a rare analyst who combines a high-level understanding of operations analysis and business process with an equally sophisticated understanding of technology. He is an involved public citizen and political commentator published on platforms such as the Huffington Post and America Out Loud . His personal blog at www.pickingnits.com focuses on global risk and national policy. We spoke to Dennis at his office in Los Angeles. The IRA: Dennis thanks for taking the time to catch up. Let’s start off by talking a little about how you are using the Bank Monitor ratings engine and specifically the use case developed for the State of Ohio at TBS. How are they using the Bank Monitor to screen the risk of the banks that are participating in their state-level deposit insurance program for banks? Dennis: The Ohio case is a fascinating study in action and reaction dynamics of federal regulation. As the market has gone beyond the 2008 crisis, new business cases for safety and soundness testing have emerged. This one stems from how the increased capital requirements at the federal level have constrained capital flexibility for local markets, reducing the amount of credit available to these communities. As a result of capital and liquidity requirements imposed at the federal level, banks are compelled to over-collateralize loans. The driving rule behind public depositor overcollateralization was the implementation of the US version of Basel III’s Liquidity Coverage Rule (LCR). It was structured such that a bank gained no operational liquidity for taking municipal deposits. Roughly, every muni deposit dollar had to be collateralized with a low yield high quality liquid asset. The net net interest margin (NIM) for the silo is zero. The IRA: That’s very interesting and something we’ve never heard about in the financial industry media. What approach did Ohio take ultimately? Santiago: The regulatory answer was to allow the pooling of collateral by a guarantor so as to generate headroom to engage in higher yielding assets. This created conditions for generating economical NIM’s off these exposures. Ohio enacted a law that created a way for the state to pool the collateral. They created a vehicle to guarantee a portion of the collateralization requirement at the federal level for in-state banks are deemed to be safe and sound using acceptance criteria more strenuous than federal requirements. The collateral relief is significant thus enabling banking services to Ohio municipalities. To enable this, what Ohio did was use a customized version of the Bank Monitor safety and soundness monitoring solution that not only looked beyond FDIC insured deposits regime analysis but went further and assessed the overall quality of depository institutions at the uninsured deposits layer. Municipal deposits tend to be well above FDIC insurance limits. The IRA: We had no idea the State of Ohio was doing this. To be clear, the state is using public funds guarantee mechanisms to provide collateral cover for uninsured deposits of municipalities at prime banks? And this is being done to give capital relief to banks in Ohio? Santiago: That is correct. Banks that operate within state lines can follow state law and are able to take advantage of this facility. The bank must have a physical branch in the state of Ohio. It’s a very innovative solution. More importantly from a fiscal policy perspective, it illustrates agency theory in action between federal and state actors. The IRA: Talk about this dynamic between state and federal regulation. How have the new capital and liquidity rules constrained credit? Santiago: The constraint is because of the need to put up additional capital and reserves against different types of risk exposures. The higher capital levels and the new risk weighting for different assets penalizes banks for selecting higher yielding asset types. We are essentially removing capital that the bank would use to lend from the business operating equation. The IRA: And less effective leverage? Santiago: Yes, yes. The banks look great and have lots of capital, but the business volumes are flat and down vs 2015-2016. The banks don’t have any capital allocation left to lend. Volume is constrained by the Dodd-Frank capital rules; that’s why investors are skittish about bank valuations today. The IRA: Agreed. In the great continuum of risk and public policy, where are we now? Are we too restrictive on banks? Santiago: We may have gone a bit too far in terms of restrictive policy on banks, thus causing new forms of behavior to emerge. You’re seeing regulations that are effectively encouraging the growth of non-bank companies, which are the customers of banks. The banks lend the marginal dollars out to non-bank firms at relatively high spreads compared to real estate lending, for example. If banks have to keep more funds sequestered in capital and reserves, then the growth in non-bank lending is a way to boost NIM. What you have is higher capital balanced by riskier operations to get to the same returns. It begs the question, is this really the center lane path we want to see our financial system following? The IRA: Probably not. The banks do look better, but the pre-tax asset and equity returns are clearly lower than prior to 2008. The after-tax results look better thanks to the tax legislation last year. Santiago: We have lots of money in the piggy bank and lots of risky stuff, creating a barbell of risk at most banks. It’s like the barbell on the cover of Nassim Taleb’s new book “Skin in the Game,” with one tiny end and one grotesquely large end. The banks look under-risked because of the huge reserves they are required to hold. And it causes problems and costs. What we are seeing years after Dodd-Frank is a reaction by proactive states like OH to adjust their own bank regulation to maintain economic activity in the face of restrictive federal regulations. States like OH eventually adapted and passed laws leading to new filtering methodologies for tracking the performance of prime banks. This was a reaction to the negative impact on the OH economy as a consequence and effect of federal regulation. The IRA: We have a banking system that is under-levered and over-reserved. But we also have a system where the Fed has manipulated credit spreads and risk pricing. How much risk is hidden under the comfortable blanket of Fed open market operations? Santiago: Loss rates are clearly headed higher. In order to achieve the returns that investors expect, banks have taken on increasingly more risk in terms of asset participations. NIM is not a forgiving number. You make it or you don’t. The IRA: And NIM is extremely unforgiving when the cost of funds for banks is rising 3x the rate of asset returns. In the most recent earnings cycle, Goldman Sachs (GS) was the only large bank that actually grew interest income faster than interest expense. The great rubber band has clearly snapped. But you won’t hear anybody in the economics profession talking about this on CNBC. The narrative still says higher rates are good for banks. Santiago: Correct. And in the world of bank balance sheets, we have a capital squeeze in addition to a NIM squeeze. The rate of adjustment in terms of NIM is going to depend upon the inflation rate and how fast the Fed adjusts. Banks are already being forced to stretch in terms of asset returns and credit risk. Basically the Fed has flooded the room with liquidity for the past eight years. Banks have to keep their head above water in terms of earning positive returns. But the abundance of liquidity makes finding acceptable returns very challenging. In order to survive, the banks move their asset allocation decisions to less safe, especially when volumes are constrained by capital rules. The IRA: Bankers want bonuses. Where is your big worry bead for the future of the US banking industry? Santiago: Clearly the big transition in the banking industry in terms of asset-liability management (ALM) is going to be managing the shift from liability sensitive strategies to asset focused strategies. One of the big aspects of the 2008 crisis and the recovery was liability management by banks… The IRA: And by the Federal Open Market Committee, which protected bank NIM from 2009 onward by killing depositors and bond holders. Santiago: Now the focus is going to shift over the managing asset returns and related risks. How do you manage yield? In an environment where prices are constrained by the Fed and volumes are constrained by capital regulation, how do you placate the Goddess of NIM? I repeat, NIM is a unforgiving goddess. She does not care how. So if you are short on price and volumes, you turn up the risk on credit participations. All NIM wants to know is that you made your nut last quarter. The IRA: Speaking of assorted nuts, you’ve had some prescient things to say about bitcoin and the so-called blockchain tech that enables it. Haven’t we seen this movie before?? Santiago: Crypto is a really interesting phenomenon. It’s not the tech, it’s how the tech affects the landscape of money. It has grayed the line between people who live on the network and people who don’t. The blending of the two worlds of barter and above board enterprises is like oil and water. As a rule, they do not mix. The way a barter community exchanges value is totally antithetical to the tax paying world. The world of “Hawala” with two sets of books allows for the transfer of value without money actually changing hands. We note the exchanges in a “cross-ledger.” This stuff has been going on for hundred of years in parallel with other forms of finance. The IRA: So crypto has enabled the ancient barter system and outside of the established network. The barter participants don’t pay taxes. OK, we get it. Is that all there is, to paraphrase Peggy Lee? Santiago: We have not really thought through the implications of enabling barter via electronic multiple ledger bookkeeping on a global scale. The IRA: The true participants in the barter world would never trade bitcoin via an exchange. They exchange the numbers and report the transaction to the collective. Our friends in places like Russia and Lebanon use crypto to live, pay bills, outside of the formal system. It is a binary choice. Santiago: Exactly. Trading cryptos via electronic means defeats the point of trust in the barter world. The compact in the barter world is that your net value trade is zero. There’s no taxes or excise or fees. It’s currency-free economics. Crypto imposes itself upon this barter market. The thing about this is that taxes, excise and fees attempting to extract their due won’t be far behind. That’s just the way of things. The IRA: Fair enough on cryptos, but how about blockchain? This is definitely a movie we’ve seen before. It was an electric KoolAid XML taxonomy building party hosted by Chairman Chris Cox at the Securities and Exchange Commission. Eventually led to public companies filing their financials in a dialect of XML. Is there anything here with blockchain? Santiago: As a technologist, I have to admit that there are moments when blockchain bemuses me. If you listen to the pundits, about half say it is a solution in search of a problem and the other half says it’s the greatest thing since sliced bread. I’m a bit more pragmatic about tech having been around since before people started calling it FinTech. To me, the shared ledger technology that seems to get everybody exited is just the latest version of SOAP XML, which is also the basis of a ledgering system. This technology was designed about 30 years ago and eventually trickled down into areas like financial reporting at the SEC as you noted. The FDIC CALL Report data warehouse is another massive implementation of XML based technology to gather, screen and publish bank financial statement data. The transfer of data between banks and other financial institutions is based upon APIs that sit atop XML constructs that are ancient in technology terms. The growth of global trade, manufacturing and logistics is a massive and universal example of XML-based ledgering technology. The IRA: So there is nothing really new here in terms of basic functionality? Santiago: Blockchain is an alternative ledgering system architecture. It is replacing something that is working well. More non-ICO solutions are presently deployed than blockchain ones. Don’t get me wrong. For some use cases, it’s the perfect fit. As with all tools, knowing when and where it’s the best option, and when it’s not, is the key. But people also confuse blockchain as a ledgering system with blockchain as a cyber security system, which it is not. The cases of theft of bitcoin and derivative cryptos have shown the technology still has vulnerability as manifested by incidents of cyber theft poking holes in the tech. We have nerds stealing money from the other nerds in scenarios lifted right out of movies and novels, which is pretty funny. The IRA: Ha. How does this end up? Santiago: What I think is going to happen with blockchain is that people will eventually realize that it is first a foremost a ledgering system that competes with existing systems, some of which are technical, others structural. The question becomes, why is a blockchain-based solution the more efficient solution? When is cost and latency attractive because it provides improved trust or transparency? In a flat internet where everyone is a stranger and are trying to hack you all the time the answer may go one way. In closed universes of known senders where per message mechanistic send/receive confirmation is mitigated, the most efficient transmission and ledgering systems will win out. The pragmatic odds probably favor innovative hybrids still hatching in laboratories. In the end, once we are done with falling in love with the toys, then we will wake up. And people are already starting to wake up to the reality that there’s more than one use-case and implementation design solution in this phenomenon. It’s not a one size fits all discovery. These are savvy folks. They are asking the obvious questions. Stay tuned. The IRA: Thanks Dennis #dennissantiago #blockchain #banks #TotalBankSolutions

New York | Sometimes simple images are the most powerful. The chart below from FRED shows US real GDP change vs. the effective rate for Federal funds over the past five years. Just imagine around Election Day in the US this November, if the Fed funds rate is above the last print in real GDP and the gap between two year Treasury notes and ten year T-bonds is just about nada. Bad for stocks, yeah. But then maybe we see a bond market bull rally because the Street remains so painfully short quality duration. As major central banks turn off the Electric Kool Aid drip, we’ll find out soon enough whether the promise of growth is real in a world with equally real interest rates. This question of just how fast the US economy can grow without near-zero short term rates is really the first order of business when assessing macro market risk. If you believe the dot-plots from the Federal Open Market Committee, we are almost assured to see the convergence of GDP growth rates and Fed funds. Question to Chairman Powell: Are you prepared to start explicit sales of securities from the System portfolio? The chart below shows the painfully slow decline in the amount of Treasury bonds and mortgage backed securities behind the Fed’s $4 trillion in excess reserves. The consensus on the Street seems to be lower growth and higher inflation, but with little upward pressure on interest rates. The Mortgage Bankers Association, for example, has projected real GDP change slowly trending below 2 percent by 2020. If we do two more quarter point increases in Fed funds this year, then we get perfect stagnation with rising inflation, right? Fact is, global growth is not particularly strong, as witnessed by the slow attrition of Sell Side firms over the past decade. UBS, HSBC, BNP, Merrill Lynch, Morgan Stanley (MS) and other second tier transactional players fled to the safety of wealth management after the 2008 crisis, but folks like Deutsche Bank (DB) pretended that 2008 did not happen. This lack of response by management eventually crippled Deutsche financially and led to the current situation, where one of the biggest banks in Europe may require state aid. Last week, we saw Deutsche Bank retreat from the world of deal making and derivatives trading, and going back to an imaginary European commercial banking business. We saw former Goldman Sachs banker and now European Central Bank chief Mario “Whatever it Takes” Draghi make noises about possibly continuing with the ECBs disastrous experiment in “quantitative easing.” Then we ended the week with German Chancellor Angela Merkel holding hands with Donald Trump at the White House. One observer commented to The IRA last week that perhaps Merkel was at the White House to discuss “Plan B” for Deutsche Bank, but this of course assumes that there was Plan A. It seems pretty clear that there has never been a real design for dealing with Deutsche at the corporate level. Years of QE in Europe has decimated DB and other European universal banks. Just as in the US, the ECB’s bond purchases have suppressed bank earnings and loan pricing, and basically killed secondary market trading. Each day we hear further doubts raised about the prospects of synchronized global growth, if for no other reason than the level of indebtedness globally is growing faster than the underlying economy. Global debt is now at $164 trillion, or 225% of GDP, the International Monetary Fund warns. The world is now 12% of GDP deeper in debt than it was at a peak debt cycle during the financial crisis in 2009, hitting a whopping $164 trillion, according to the International Monetary Fund. Our friend David Rosenberg from Gluskin Sheff + Associates in Toronto likes to remind us that the growth of the past five years – both in terms of stock prices and GDP – has come to us c/o the Fed, ECB and Bank of Japan. Why this fact is not obvious to more people working in the equity markets is a source of wonderment to us. Our collective inner neo-Keynesian cheers for the impact of low rates on debtors, but forgets that banks and pensions and even individuals are savers as well. It is pretty clear that the much anticipated surge in cash from tax cuts has not caused an upward surge in corporate investment. The Street has been trimming GDP estimates since January, which in turn “trickle down” into earnings models. And the economic prognostication chorus has certainly turned bearish in the last few weeks. Indeed, Rosenberg told the gathered audience at the most recent Grant’s Interest Rate Observer conference that upcoming market adjustments would lead to a resurgence of religious faith. One place we can assure you there is no lack of tearful prayers is the world of financial institution treasury, where the prospect of a flat yield curve is seen as truly dreadful. Look at the US bank unit of DB, for example, and the gross spread on the half of the lending book deployed in real estate loans is a whole 311 basis points (bp). The same measure at JPMorgan (JPM) is 361 bp. Wells Fargo (WFC) real estate loans? 391 bp. Bank of America (BAC)? 364 bp. Do you want to even hear Citigroup? A whole 263 bp gross spread on real estate loans according to the FDIC. With inflation currently at 2 percent, less funding costs, these banks are giving money away for nothing. If you look at the real estate loan book at US Bancorp (USB), suddenly we are near 5 percent gross yield. How about Bank of the Ozarks (OZRK) at 554 bp? BBT Corporation at 432 bp? Get the idea ? The smaller banks have more pricing power for originating assets, but net loan yields overall are still constrained and barely positive in inflation-adjusted terms. So here’s the big question we face: Has the FOMC effectively capped financial asset returns for the foreseeable future? That is, do all savers face years ahead where yields on securities are better than say the lows of 2012-2015, but not much higher than today? And do banks now face competition from the bond market even as pricing for loans and securities show little real upward pressure? Our best guess is that the attempt by the Fed, ECB and BOJ to stoke inflation by stealing duration from the markets via QE has had the reverse impact, namely constrained asset returns and income – that is, carry – from the global investment book. We’ve discussed the impact of curve flattening on net-interest margins previously in The IRA (" Bank Earnings and Financial Repression "). If GDP slows as the FOMC continues to literally force short-term rates higher, market sentiment toward the weaker financials such as DB could become very dicey indeed. But the more important concern is how global equity investors react to the idea that inflation may be higher than GDP in the years ahead -- the classic definition of stagflation. #deflation #FRED #GDP #duration #DeutscheBank #AngelaMerkel #DonaldTrump

New York | Watching the related financial dramas of China’s HNA Group and Germany’s Deutsche Bank AG (DB), we are reminded of Timothy Dickinson, who reminded us that the image of purposeful design and order imposed from above by experts and regulators is largely an illusion. The world is filled with ill-considered people and strategies, and no realm more than the intersection of public policy and corporate governance. The Federal Open Market Committee is raising short-term interest rates as though it matters, yet in fact Fed policy remains relatively easy in terms of the cost of credit -- the duration . The problem comes because of the scarcity of assets, one reason why high-yield credit spreads have been tightening even as short term funding rates have risen. And the fat part of the Fed’s passive portfolio runoff is in the mid-2020s and thereafter. The chart below shows "AAA," "BBB" and high yield bond spreads. Of course, everybody is so excited by the move of the 10 year Treasury bond to a three percent yield. The move of the short end has been even more pronounced, however, one reason why so many banks are reporting shrinkage in net margins even as shareholder payouts of capital surge. The FRED chart below shows Federal funds, Treasury 2s and 10s. Imagine Fed funds at 2% and Treasury 10s still shy of 3.5 percent yields. The alarm bells in Washington will be ringing. As we note in an upcoming conversation with Dennis Santiago, banks are constrained by the dual impact of restrictions on lending due to regulation and a dearth of duration due to the Fed, ECB, BOJ and “quantitative easing.” In an already difficult market environment, the less well managed institutions get into trouble more readily. We’ve already described the comic behavior of HNA in previous comments, but needless to say there is always more grist for the mill. Most recently, Lucy Hornby in Beijing and Hudson Lockett of the Financial Times described some of the structural aspects of the HNA investment in DB , including a suggestion of a rather complex leverage structure above the investment in the bank. “The sharp fall in the bank’s share price has forced HNA either to sell part of its stake, or pay cash to cover a derivatives arrangement that was used to acquire the shares,” they report. Although it is very common for financial investors to apply leverage high up the capital stack, bank regulators tend to frown on double leverage – especially when it is not adequately disclosed. Double digit ownership of voting shares certainly is a threshold most competent regulators set as requiring active assent for any bank investment. Ultimately, diligent bank regulators generally need to know who is investing in a bank in a significant way. And a key requirement in that approval process is the ability to be a stable investor and potentially a source of strength to the bank should more capital be required. Readers of The IRA will recall that DB searched for years and in vain for a new shareholder prior to the arrival of HNA. When the shadowy Chinese group started to accumulate DB shares in February 2017, the situation at the bank was grave – and had been for years. The board and management of DB has been unable to articulate a strategy for the business going back a decade. While much attention has been focused on the procession of CEOs that have moved through the DB CSUITE, the blame ultimately rests with the board and chairman Paul Achleitner. Like most supervisory bodies in Europe, the board of DB has proven remarkably inert in recent years, basically a reflection of the lax governance of banks more generally in the EU. For example, the FT reported on April 19, 2018, “ Deutsche Bank, HNA, and the GAR chase ” that their investigation into the provenance of the HNA investment in DB suggests the possibility “of an additional undisclosed shareholder behind one of the HNA entities.” This is a remarkable revelation (kudos to Cynthia O'Murchu and Robert Smith at FT ), yet note that prudential regulators on both sides of the Atlantic have taken no action – at least in public – for fear or toppling over the sagging Deutsche Bank. Normally when you hide the identity of the beneficial owner of a US bank, the primary regulator begins an enforcement action and sends out cheery referrals to the US Attorney and other law enforcement agencies. The parties involved start thinking about jail time. Yet in the strange case of DB and HNA, exactly nothing is happening. The regulatory community has been caught completely off base over the past year and more, but can do nothing for fear of ragin contagion. Indeed, the festering mess at DB shows that “took big to fail” is alive and well and global regulators are powerless. The key issue for investors is to understand that precisely no one is in charge when it comes to the twin systemic risks posed by DB and HNA. If as seems likely HNA is forced to unwind its leveraged investment in DB, then the German bank will be worse off than before. DB will have wasted more than a year engaged with a surreal investor who has disappeared into the mist like a character in a bad Chinese martial arts film. Who then will step forward to rescue DB? After a $50 billion deal spree, much of it fueled with leverage, HNA has cut a wide swath of value destruction through the world of banking, aviation, lodging, real estate and other sectors. Just how did HNA get the approval of EU regulators for this investment? Nobody knows and nobody is talking. But the aftermath of this celebration of global incompetence could create significant dangers for the financial markets. When the government of New Zealand shot-down an HNA Group investment in a bank, this provided an indication of big problems. The Overseas Investment Office (OIO) blocked an attempt by China’s HNA Group to buy a vehicle finance firm in part due to doubts about the debt-saddled conglomerate’s financial stability, Reuters reports. The OIO apparently disliked the HNA practice of pledging equity investments in group companies as collateral on loans. “The information provided about ownership and control interests was not sufficient or adequate for the OIO to determine who the relevant overseas persons are for [HNA’s] application to acquire UDC,” said Lisa Barrett, the office’s deputy chief executive for policy and overseas investment. “We were therefore not satisfied that the investor test in section 18 of the Overseas Investment Act 2005 was met.” Were US regulators consulted or even aware of the HNA share purchases in DB last year? DB operates a mostly securities business in the US, but the German bank does have a $55 billion trust company in New York. Deutsche Bank Trust Corporation is regulated by the Fed and the State of New York, and is a significant player in the market for commercial mortgage backed securities (CMBS). Of note, one possible permutation of the DB saga back in Germany is the sale of the US banking business. JP Morgan weighed in on the DB debate several weeks back with the publication of a research report for clients that said Deutsche should shrink its U.S. business “to create shareholder value.” But since German Chancellor Angela Merkel threw the German bank under the bus several years ago, the remaining value of DB is questionable. Reports that former Merrill Lynch CEO John Thain is being nominated to the supervisory board of DB is certainly good news. Thain is a veteran operator, but sadly he is not CEO. More than anything else, DB needs to tell investors and regulators why this bank should continue to exist. If in fact DB moves forward with the sale of its US unit, then the entire business could be in play. But should the bank stumble in a way that surprises Europe’s distracted politicians, look for a very hastily planned merger. Our candidate for the first zombie merger of the 21st Century: DB plus Citigroup (C). Neither bank has a particularly strong domestic banking business or funding base, but there are some interesting asymmetries. Financially it would be a disaster for shareholders, but politically it makes all the sense in the world -- especially if you are Angela Merkel or Donald Trump. #HNA #DeutscheBank #Citigroup

New York | There are a number of factors that have led to the historic gains seen in equity markets since the election of Donald Trump and the subsequent tax cuts, especially when it comes to financials. Some of these assumptions were never realized, others no longer pertain. Number one was the idea that tax cuts would drive an increase in economic growth, and thus add more borrowing volumes for banks. Overall, the promise of tax cuts has yet to arrive for the banking industry when it comes to credit volumes. JPMorgan Chase (JPM) did manage to turn in some impressive lending growth, mostly in credit cards. But the overall financial performance of JPM came due to some one-time events, benefits on the legal expense line and a big pop in principal transactions. Lending fees and loan volumes overall rose a whole 2% year-over-year (YOY). The Trump tax cuts added four hundred basis points to bank equity returns this quarter, but the top line remains constrained. With EPS of $2.38, JPM’s basic earnings per share rose 40% YOY. Return on equity rose to 15% according to the JPM IR supplement. Notable for readers of The IRA Bank Book , JPM’s interest expense rose 47% in Q1 2018 vs the same period a year before. Meanwhile, interest income increased just 18% year-over-year, resulting in a substantial reduction in net interest margin (NIM). In many parts of the financial media, you still hear happy talk from economists about expanding net interest margins for banks as the Federal Open Market Committee takes the Treasury yield curve negative. But that clearly is not the case. Economists are often wrong, especially when they wander into the world of finance. Pay attention to this relationship between interest income and expense as 2018 continues and the yield curve flattens, as shown in the FRED chart below. At Citigroup (C), which like JPM is more market sensitive in terms of liabilities than the industry norm, interest expense rose 44% YOY in Q1 2018. Interest income was up a mere 12% YOY. Other than shrinking NIM, what this suggests, at least for JPM and C – some $4 trillion in assets and the two biggest OTC derivatives shops on the planet – is less return from float going forward. Interest earnings, lest we forget, account for the lion’s share of equity returns in both cases. But we digress. Aside from the lack of a demand-pull surge from the Trump tax cuts, banks have not seen the increase in corporate investment predicted by so many economists as a result of cash repatriation. In fact, most companies have paid their tax bill w/o moving the cash concerned. As we noted in January of this year (" Tax Cuts, Offshore Cash & Jobs "), this is known as “deemed repatriation” at the Internal Revenue Service. Another, third, big factor that helped drive the maniac bull rush in financials during 2017 and into February of 2018 was the prospect of deregulation. There have been a number of meaningful changes made since 2016 under administrative rules, in particular the appointment of OMB head Mick Mulvaney to run the Consumer Financial Protection Bureau. But the Trump Administration has been slow to fill regulatory positions, like Fed governors and FDIC directors. The much awaited financial reform “reform” legislation started with the Choice Act (Versions 1&2) sponsored by House Financial Services Committee Chairman Jeb Hensarling (R-TX) but was quickly narrowed down to what could garner a majority in the Senate. The original Choice Act had a broad reform of the CFPB, which is now totally gone. Senate Banking Committee Chair Mike Crapo knew that Hensarling’s Choice Act was a non-starter in the Senate. He got together with members of both parties and focused on reform for small banks, which has bipartisan support. The regulatory reform legislation that has passed the Senate is very modest indeed. The Crapo Senate bill is not a strong, broad reform proposal, but it was supported by 16 Democrats. The result is a very narrow bill which is now pending in the House but has so far not moved from the House Financial Services Committee. The IRA hears from several well-placed sources that any attempt to modify S. 2155 will doom any chances of regulatory reform this year. For example, the legislation passed by the House to streamline the Volcker Rule is the top priority of the large banks. It may be added to S. 2155 by Chairman Hensarling, but this will likely kill the legislation. So far Hensarling is not "backing down," whatever that means. Just what constituency Hensarling is serving by taking an intransigent position on S. 2155 is debatable, but the fact is that he is one of the least productive House FSC Chairs in recent memory. Hensarling could be noble and get something done as his tenure ends, but few are betting on that outcome. There are a number of Democratic Senators who signed onto S. 2155 who took a good amount of heat from Senator Elizabeth Warren (D-MA) and other far-left Democrats. And keep in mind that this is really not a Dodd-Frank reform bill as much as relief for small banks and mortgage companies. There is very little if any lift contained in the Senate legislation to help large banks. And changes to the Volcker Rule are DOA in the Senate. Bottom line: S. 2155 must get passed as is or it will die when it comes back to the Senate with amendments. The bill would get no Democratic support. We do not expect S. 2155 to get out of committee in the House. Even if Dodd-Frank reform is dead this year, that does not mean that there is no deregulation in Washington. The tenure of Mick Mulvaney as acting director of the CFPB is perhaps the most significant. Mulvaney put a stake in the heart of regulation by enforcement, a key issue for the mortgage industry. Mulvaney says he is not going to use Section 5 of the Federal Trade Commission Act (FTC Act), 15 USC 45(a)(1) (a/k/a “UDAP”), which prohibits "unfair or deceptive acts or practices in or affecting commerce." The impending $1 billion fine against Wells Fargo (WFC) by the CFPB and the OCC is an example of how Mulvaney will use the power of the CFPB when actual harm is done to consumers. But it needs to be said that the past regime of regulation via enforcement, with no due process or public guidelines for compliance, was outrageous, even by the usually irrational standards used by most progressives. Most people in the mortgage or consumer finance business, if they make a mistake and a consumer is harmed, they will make good. They don’t need to be sued. By bringing the CFPB into alignment with the FTC and other agencies when it comes to UDAP, Mulvaney has restored some modicum of fairness and balance to an agency that was run more like the Spanish Inquisition, with Richard Cordray as Torquemada. While having Mick Mulvaney at CFPB is certainly not a bad thing for banks, it is far from the wave of deregulation that was one of the original drivers of the bull market in financials. Indeed, as time slowly runs off the legislative clock, it is increasingly clear that there may be no significant financial reform legislation passed this year. This represents yet another failed promise for financials at a time when sources of support for current market valuations are dwindling.

New York | This week The Institutional Risk Analyst is travelling to San Francisco for the Executive Roundtable, a conclave of mortgage professionals that meets twice a year to discuss issues facing the housing finance industry. We’ll be reporting to the group on the progress – or lack thereof – in adopting the technology known as “blockchain.” Some of our findings follow below. A “block-chain” is the transaction validation technology behind bitcoin and other crypto currencies. It has a very high price in terms of per unit transaction cost, but has some promising qualitative possibilities. The technology combines industrial strength encryption with a public ledger that allows market participants to validate transactions collectively. Blockchain by design is extremely inefficient in order to achieve its primary purpose, namely security, but has the advantage of a public transaction record In a survey of the mortgage industry and other domains, to date we are not able to find any commercially successful adoptions of the blockchain technology. Despite an enormous amount of hype and billions of dollars in funds invested, the combination of 1) encryption and 2) public ledgers has yet to find a viable use case – other than crypto currencies such as bitcoin. Ironically, the strong cryptography of blockchain has failed to protect the network from hacking and fraud, raising basic issues about the cost-benefit tradeoff of this type of approach. And the high cost and other operational considerations has so far thwarted efforts to drive adoption. Consider some recent developments: “Decisions by Depository Trust & Clearing Corp., BNP Paribas and SIX Group to stop working on blockchain projects reflect Wall Street's concerns about industry readiness and cost” – Rob Chrisman “Wall Street has been much more excited about the system underpinning bitcoin than the cryptocurrency itself, but the global financial industry has not yet been able to do much with the technology known as blockchain” Reuters "Basically, [blockchain has become] a solution in search of a problem" – Murray Pozmanter, MD, DTCC As initial enthusiasm for the blockchain technology ebbs, party due to the hype and chicanery surrounding the multiplying crypto currencies, some observers are starting to argue in favor of using a distributed ledger technology (DLT) without the costly encryption component of crypto currency schemes. One possible use case for the mortgage industry is the documentation of title transfers for residential mortgages, an area that is rife with fraud and inaccuracy. “Since the financial crisis of 2008, there has been a certain level of distrust with respect to residential mortgages. This distrust is rooted in the secondary mortgage market, in which thousands of residential mortgage loans were originated and then sold and assigned to successor lenders and/or trustees, sometimes multiple times,” notes Michael Reyen, writing in American Banker . But hope springs eternal. Last week, Ranieri Solutions, a financial services technology investment firm founded by Lewis S. Ranieri, father of the securitized mortgage market, announced a partnership with Symbiont , to explore opportunities to use Symbiont’s blockchain platform to improve all aspects of the mortgage industry. “The mortgage market, despite significant efforts, continues to lag behind from a technological standpoint creating inefficiencies that impact mortgage loans throughout their life cycle,” say Ranieri. “By partnering with Symbiont, a proven blockchain pioneer, Ranieri Solutions believes that together we can implement this transformative technology to bring necessary efficiencies, transparency, and security to the mortgage markets.” While improving the system for conveying and documenting ownership of residential homes is clearly a valid goal, it is far from clear that blockchain is the right technology solution for the problem. Property records are the unique province of the various states. Although there is obviously a need to improve the property sale and title recordation process, the chief obstacles to change are political and bureaucratic. Amendments to the Uniform Commercial Code and the Blue Sky laws for the securities industry provide a political roadmap for such an adoption process, but blockchain may not be the right solution for this task. Coming out of the 2008 financial crisis, the states, Congress and the mortgage industry fashioned a national standard for the foreclosure process via legislation, litigation and enforcement actions. In the case of property records, there is no immediate political catalyst to bring the states together and have them voluntarily adopt a treaty mandating a consistent recordation and disclosure system for real property transfers. And, again, it is far from evident that a DLT type approach is the best way to address the need for better property records. “The Deloitte Center for Government Insights found last March that land registration was the second most popular area of focus for public-sector experiments being conducted with blockchain, behind digital payments and currency,” reports Rob Chrisman. And Bert Ely, writing in The Hill , starts to suggest a practical roadmap to make such an enhanced property recordation system a reality: “A real-world application of DLT will occur only if it makes economic sense. An application that minimizes the potential for fraud, is highly accurate and very fast in executing transactions will not be implemented if it is more costly to operate than an alternative, less sophisticated technology. The pursuit of accuracy strongly suggests a central authority or governing body must oversee a specific application of DLT in a ‘permissioned’ environment, with pre-agreed rules and procedures to ensure the accurate entry of transaction data into the DTL ledger, the prompt correction of data-entry errors and overall data integrity.” Of course anything is possible given enough time and expenditure, but we continue to believe that the blockchain is a solution in search of a use case. The qualitative benefits of a DLT, for example, impressive as they may be, do not offset the additional cost of using this technology. In that regard, blockchain seems to violate the Three Laws of Silicon Valley – cheaper, better, faster – for the adoption of a new technology. In the case of the mortgage industry, improving the way in which property records are updated and maintained is clearly a desirable objective. But we think that before such a system is considered, the various states need to agree on a consistent national data template for property records. This all sounds great in theory. The tough part is doing the heavy lifting to make it a reality. Until then, blockchain will remain a clunky, very expensive solution looking for a relevant problem. #blockchain #chrisman #RanieriSolutions

Sarasota | Why are financials selling off as earnings season starts next week? Large cap banks such as JPMorgan (NYSE:JPM) led the markets higher earlier in the year, but have since underperformed the markets. What gives? First and foremost, when the markets are looking for a reason to sell, large cap financial names usually catch more that their share of attention. Remember that Wall Street only ever cares about the top 10-names in financials by market cap. When the thundering herd sells, banks usually get a disproportionate share of the short volume. The sector accounts for about 15% of the S&P 500. When a broad selloff is underway, look for financials to participate and then some, both in terms of cash and the highly liquid derivatives. Second, financials are overvalued – still. When JPM peaked at just shy of $120 per share on February 26th of this year, the market leader was trading just shy of 2x book value. The stock is still up 15% over the past six months vs single digits for the S&P 500. JPM has single digit equity returns and no real growth in terms of revenue. Hit the bid. Third and most important is the question of net interest margins and financial repression. In the inaugural edition of The IRA Bank Book , we discuss why the banking industry is facing a squeeze on margins thanks to the Federal Open Market Committee. Few analysts on the Street know or care about this looming threat to bank profits. At present, the US banking industry is earning about $130 billion per quarter in net interest income from loans and investments, but is paying depositors and bond holders a mere $20 billion per quarter for funding. This skew in favor of bank equity holders has been extreme since 2008, but the issue of financial repression goes back to the 1990s. Ponder the chart below. Source: FDIC In Q4 2007, when US banks grossed $180 billion from loans and other earning assets, they paid depositors and bond investors almost $100 billion. In 2015, the total cost of funds for the US banking industry was just $11 billion per quarter, but the industry booked $110 billion in net interest income. Get the joke?? Bank depositors and bond holders should be earning more like $40-50 billion per quarter. Today yields on deposits and fixed income securities are rising faster than the yields on bank loans. Just as the FOMC suppressed the cost of credit for banks after 2008, now the financial engineering of former Fed Chair Janet Yellen has created an interest rate trap for banks a la the 1980s. For those of you who missed that party, in the 1980s funding costs for S&Ls rose faster than asset earnings, gutting the capital of the entire housing finance sector. The unfortunate demise of the S&Ls also created the opportunity for banks to get into mortgage lending a decade later with similarly disastrous results. We look for the cost of bank funding to rise faster than the yield on earning assets over the next two years, a situation that is likely to put an effective cap on bank earnings and public market valuations. The kicker in the analysis is that credit costs are also likely to rise faster than either revenue or pre-tax earnings, adding an additional headwind to financials as 2018 unfolds. See you on CNBC Squawk Box tomorrow ~ 8:00 ET. Further Reading Whalen, Richard Christopher, The Financial Repression Index: U.S Banking System Since 1984 (April 3, 2018). Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3155370

In this issue of The Institutional Risk Analyst, we feature a comment from our fellow fisherman David Kotok, Chairman & Chief Investment Officer of Cumberland Advisors (www.cumber.com), which was published earlier this week. A number of people have asked about the widening spread between LIBOR and the comparable rate in the US. The short answer is that, yes, it is a structural problem and may be a warning of future contagion ahead. Questions? Join us Thursday at the University of South Florida in Sarasota when we'll be talking about the state of the US banking industry and signing copies of " Ford Men: From Inspiration to Enterprise. " Today we look at the warning that the widening spread between the LIBOR rate and the OIS rate may be sounding about what lies ahead, given a two-pronged Fed tightening policy. Whether investors realize it or not, this spread (LOIS) impacts what strategies make for successful investing. This five-minute read will bring readers up to speed. We will start with Daniel Kurt's Investopedia post, " What is the OIS LIBOR Spread and What Is It For? ," from Feb. 21 of this year ( https://www.investopedia.com/articles/active-trading/061114/what-ois-libor-spread-and-what-it.asp ): "A decade ago, most traders didn't pay much attention to the difference between two important interest rates, the London Interbank Offered Rate (LIBOR) and the Overnight Indexed Swap (OIS) rate. That's because, until 2008, the gap, or 'spread,' between the two was minimal. But when LIBOR briefly skyrocketed in relation to OIS during the financial crisis beginning in 2007, the financial sector took note. Today, the LIBOR-OIS spread is considered a key measure of credit risk within the banking sector. (For a glimpse into the possible evolution of these two rates, read 'Will OIS Replace LIBOR?')" The LIBOR-OIS spread (or LOIS) has widened by twice the amount that the Federal Reserve has hiked rates. There are reasons for that, and we will discuss them below. But the impact of the LOIS's widening is at hand today. Think of it this way. The Fed sets the OIS as it determines the short-term policy rate. If the Fed wants to tighten policy by raising the short-term rate a quarter point, it has the complete power to do so. But the Fed cannot control those market forces that react to the Fed and to other factors. So if the Fed hikes a quarter point but market forces actually translate that hike into a half point, is the impact of the Fed's quarter point magnified and, in this case, doubled? We think the answer is yes. There are structural reasons why this magnification is occurring, and they are still in play. Hence the Fed is actually tighter than it would appear to be if we look only at the fed funds target rate and, by implication, at OIS. Three-month LOIS increased over a half point in the first quarter of 2018, while the Fed's policy target rate went up only a quarter point. And US Treasury debt management added to this mix. US Treasury bill yields are at their widest levels to OIS in fifteen years. They have widened in spread by a quarter point since the beginning of the year. At the end of the first quarter, three-month LIBOR was 2.30%. A year ago it was 1.15%. Thus the private sector has seen a 1.15% increase in this key interest rate. Note that about $200 trillion in global debt and derivatives prices daily from LIBOR. FRA (forward rates) used in foreign exchange derivatives are up 1% in the same period. So are US T-bill rates. And the new money market rules exacerbate these spreads. Meanwhile, the TED spread (eurodollar vs. T-bill) is wider than it was a year ago. I could go on, but the key point here is that the system is tighter by more than the Fed has tightened. There are at least six reasons: 1. Banks are reluctant to shift their liquidity pools out of the Fed (source: Joe Abate at Barclays). 2. Congress insists on perpetrating political shenanigans with the federal debt ceiling (BCA Research opinion). 3. Repatriation flows are adjusting cash balances worldwide, and the direct impact falls on the short-term money market end of the yield curve. 4. The Fed is shrinking its balance sheet at the same time it is raising the policy-setting, short-term target rate. (We think this approach is a potential double whammy for the markets. The Fed is playing with fire by trying to do two things at once.) 5. The new "base erosion and anti-abuse tax" (BEAT) was part of the 2017 tax code changes. It is causing dislocation in funding markets and driving some firms to use commercial paper (CP) as a way around the tax problem. But the CP traditional buyer was a money market fund that is now in the non-government group and can "break the buck." Using cross-currency swaps is an alternative, but banks "that used to be sources of structural demand for dollar funding (widening the basis swap) will require less dollar funding in the future. As a result, basis swap spreads tighten" (Deutsche Bank AG/London). 6. LIBOR is being phased out by 2021. The Alternative Reference Rate Committee (ARRC) wants to replace LIBOR with a new Secured Overnight Futures Rate (trading), or SOFR. Some banks are now leaving the LIBOR-setting pool in anticipation. There will be new SOFR futures contracts launched and trading. For the average investor this is a bewildering array of technical factors. We plod through all these factors ourselves in our daily work as we do the analysis on so many moving parts. Most investors have never heard of ARRC or SOFR, yet both impact their daily lives. Our issue concerns the businessmen and women who borrow using LIBOR as a reference rate. Their costs of funds are going up fast. And they are uncertain about future commitments since they know LIBOR is going away and they don't know what the market will do to replace it. And they are the ultimate target of Fed policy, for better or worse. For us there is a different question. We are puzzled by the Fed's silence on these impacts. The dot plots don't capture it. This issue is not about a GDP forecast. We are not talking about higher inflation expectations. No, this is about structural change and its impacts are broad. We worry that the Fed is setting things up for a slowing of the economy by being too doctrinaire and neglecting to acknowledge these structural changes. We worry that QT (quantitative tightening) is a dangerous force to combine with traditional interest rate normalization. We worry that the Fed has undertaken too much and is sailing the monetary policy boat into waters where the charts are incomplete. We think this policy error could be one of the reasons that the yield curve is flattening. At Cumberland our emphasis is on the higher-grade credits, whether muni or corporate or government. We are watching the distribution of credit and note Jim Bianco's observation that about half of the investment-grade debt is now Baa-rated. Jim points out that this percentage has nearly doubled from 25% in 1989. For Cumberland, that means about half the debt aggregate is off the table for our clients. We want to be sure our clients get paid. Bottom line: LOIS is screaming a message of warning. We know that members of the Fed are looking at this, but we wish there were more observations about it in their public statements. We don't expect the Fed to change its strategy. It is on a dual course of QT and rate hiking and will probably stay that course unless and until some shock occurs. So our professional stance is to worry. And we continue to search out and focus on high-grade credits. We think investors are poorly paid for chasing lower-grade or junk. #LIBOR #OIS #FOMC #KOTOK #CumberlandAdvisors #FederalReserveBoard #GIC