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New York | The Federal Open Market Committee cut the target for short-term funds another quarter point last night, raising the question as to whether the central bank can actually defend the 1.75% upper bound of the new policy range. Fact is, demand for short-term funding is pulling rates higher as the year draws to a close. Ray's Camp, The Flowage, Princeton, Maine We got to dine with the risk committee this week, revealing new aspects of the recent repo kerfuffle that deserve mention. Chief among them was the idea of competition and, indeed, even conflict between the retail bank side of the house and the capital markets component inside the Fed’s primary dealers. It seems that when the Federal Reserve Board was caught napping in mid-September, the bank treasury side of one of the largest US banks basically took a line from the 1990 Martin Scorsese film “Goodfellas” and told the bank’s capital markets side: “ Fuck you, pay me. ” Under Regulation W, which implements what we traditionalists know as Section 23A of the Federal Reserve Act, transactions inside the bank holding co do not count against the bank’s statutory allocation for transactions with affiliates. But when market rates spiked, the retail treasury representing a very large insured depository, essentially told the traders to pound sand when it came to price. Reg W requires transactions with affiliates to be at market on an arm’s length basis, even with risk-free collateral supporting the trade. The lesson here is that regulators do not want the cash-rich retail bank to give carte blanche to the traders, either with respect to the amount of liquidity or the price. The regulatory system worked – but also caused a new problem. A rush of fully motivated capital markets banksters suddenly turned outward and sought funding in the broader market for federal funds. A squeeze ensued on or around September 16th, needless to say. Risk free collateral went begging for funding. Effective rates to finance Treasury and GNMA collateral spiked to double digits. So then, ask not whether one aspect of federal prudential regulations or another caused the liquidity squeeze seen last December and in June and later in September. Ask instead why the Fed and other regulators cannot cooperate to tweak the system and fix da plumbing. December is just a month away. The reality, as F.A. Hayek described in his classic 1988 essay “Fatal Conceit: The Errors of Socialism” (H/T Michael Lewitt ) is that fine tuning the markets is an impossibility. The Fed suffers from the “fatal conceit” that "man is able to shape the world around him according to his wishes." Happy Halloween Softbank Denies WeWork Control?? Meanwhile in the world of finance, a couple of notable events and comments occurred that deserve comment. PIMCO announced that it is reducing allocations to corporate debt, another data point on our worry beads regarding corporate credit in 2020. Our favorite was the blasé Street reaction to the announcement by Softbank that its 80% stake in the insolvent WeWork did not mean control. Hello?? Further, Masayoshi Son indicated that therefore the company would not be consolidated onto Softbank’s balance sheet. Really? If this transparent evasion of leverage disclosure does not qualify for securities fraud in the US, then we need to buy some new textbooks. Several managers, ratings firms and former shareholders complained about a “lack of controls” at Softbank in a Wall Street Journal article by Phred Dvorak and Justin Baer , but when one man is in charge is this even up for debate? We have always viewed Softbank as an investor driven Ponzi scheme, but we suspect our readers already knew that. Of note, we also were reminded over dinner that no less than Deutsche Bank AG (DB) has been the advisor and lender for much of Softbank’s issuance of securities. Would be funny were it not so very sad, especially for the credulous sovereign investors in Softbank. The whole vision thing strikes us as a grotesque speculation verging on outright fraud. On Wednesday, DB reported a third-quarter loss of $955.1 million or about 10% of total revenue, after reporting a profit in the same period a year earlier. The Softbank strategy goes like this: Give me and lend me enough capital and I will corner the market for innovation or some such version of that theme. We recall that Jim Fisk and Jay Gould attempted a similar operation in the late 1860s. Their machinations resulted in Black Friday September 24, 1869, the first modern financial crisis. Their scheme to corner the gold market – and ensnare President Ulysses Grant in the operation -- collapsed in spectacular fashion, leading the US into a credit crisis. Gold, after all, was money in those days. DOJ/HUD Accord Reached Hannah Lang of National Mortgage News reports that Department of Housing and Urban Development Secretary Ben Carson announced that HUD and the Department of Justice released a joint a memorandum of understanding, stating that HUD will deal with False Claims Act violations — involving Federal Housing Administration (FHA) lenders — mainly through administrative proceedings. This is a big deal for HUD and the mortgage industry, which has been brutally raped since 2008 to the tune of tens of billions of dollars by a succession of ambitious politicians. One of the main reasons why Senator Kamala Harris (D-CA) , who served as the state’s AG during the 2012 National Mortgage Settlement, won higher office was the billions she extracted from the shareholders of JPMorgan (JPM) , Bank America (BAC) et al. And this is why a very angry Jamie Dimon publicly took Chase out of the FHA loan market immediately after, followed by hundreds of other banks. Today only Wells Fargo & Co (WFC) and Flagstar Bank (FBC) remain as significant bank issuers and servicers of GNMA securities in the FHA/VA/USDA loan market. As former GNMA President Ted Tozer told us last week, without the bond market execution of GNMA-guaranteed securities the FHA/VA/USDA programs are moribund. We salute Secretary Carson and FHA chief Brian Montgomery for getting this interagency understanding done, but the banks won’t come back to the FHA/VA loan market until 1) the cost of servicing GNMA securities is brought into line with the GSEs Fannie Mae and Freddie Mac and 2) profitability on origination of FHA/VA loans improves a lot more. GNMA MSRs should trade even yield to conventional mortgage servicing assets. Perhaps the bigger challenge for HUD is convincing the Fed, OCC, FDIC and other prudential regulators to allow large banks to return to the FHA market. So long as the federal regulatory community sees small, low FICO, high LTV loans as being “unsafe and unsound,” the banks are unlikely to return fully to the GNMA market. Small loans are loss leaders. Would you rather service a $280,000 FHA loan for 32bs per year gross or a $3 million prime jumbo loan at 25bps per year? Further Reading The American Conservative https://www.theamericanconservative.com/author/christopherwhalen/ National Mortgage News https://www.nationalmortgagenews.com/author/christopher-whalen #MartinScorsese #Goodfellas #JPM #WFC #Softbank #WeWork #MasaSon #Ponzi #americatalyst

New York | In the last issue of The Institutional Risk Analyst , " Elizabeth Warren Wants to Crash the Global Financial Markets ," we talked with Ralph Delguidice about why the spread differential between the dollar markets and other liquid offshore markets is thwarting efforts by the Federal Open Market Committee to restore liquidity in domestic money markets. When the New York Fed provides liquidity to the primary dealers, that cash does not necessarily “trickle down” to the rest of the money markets. Indeed, a good bit of it goes offshore seeking to maximize yield. One example from our discussion last week is the vast offshore market in dollar lending by non-US banks and governments, lending that is largely unreported. Horn , Reinhart and Trebesch note in their must-read paper for NBER, “China's Overseas Lending” (2019) : “[T]he government of China holds more than five trillion USD of debt towards the rest of the world (6% of world GDP), up from less than 500 billion in the early 2000s (1% of world GDP)… China’s total financial claims abroad amount to more than 8% of world GDP in 2017. This dramatic increase in Chinese official lending and investment is almost unprecedented in peacetime history, being only comparable to the rise of US lending in the wake of WWI and WWII (Horn et al. forthcoming). Indeed, the rapid growth of claims have transformed the Chinese government into the world’s largest official creditor (the largest overall creditor remains the United States). Despite these developments, however, we know strikingly little about China’s capital exports and their global implications.” The chart below shows LIBOR interest rates for dollars, yen and euros. The rest of the interest rate complex denominated in the three largest global currencies rests upon these basic short-term rates. It does not take much time to see that a Chinese bank able to borrow at a negative yield in euros or yen and swap the debt payments into dollars has enormous arbitrage opportunities. The fact that the members of the FOMC actually believed they could raise short-term interest rates anywhere close to 3% is entirely ridiculous in view of the spread differentials shown above. More than half a century since Bretton Woods, the community of economists in the US, including the members of the FOMC and the Fed’s staff, still tend to think about monetary policy in purely domestic terms. Most economists ignore the impact of interest rate differentials and how these spread relationships can impact the demand for dollars and short-term interest rates. The funny part is that American economists can prattle endlessly about the “special” attributes of the dollar as a reserve currency, yet somehow miss the impact of this fact on the interest rates that prevail in domestic US markets. The fact of low or even negative rates in Japan and the EU is driving demand for dollars, which non-US banks and governments use to make loans. Even at just 1.7% this AM for overnight forward Treasury repo transactions, zero risk dollar assets are extremely attractive for offshore investors. The short-dollar overhang in the offshore Eurodollar market is a key factor behind the dollar’s strength -- and has been for 75 years. Many US economists take comfort in the special relationship of the dollar as a “reserve currency,” but totally miss the other side of the coin – namely that the end of that special status implies disaster for the US economy. As the former Chairman of the Joint Chiefs of Staff Michael Mullen warned in 2011: “I believe the single, biggest threat to our national security is debt.” Growing debt is certainly a threat to the role of the dollar as a reserve currency, but the debt also provides the liquidity that makes the dollar market function as the world's prefered means of exchange. The greenback accounts for something like three quarters of global commercial and financial transactions, especially when you factor in currency swaps and hidden debt described by Reinhart et al and the Bank for International Settlements we discussed last week. For the US central bank, offshore demand for dollars makes calibrating policy to achieve the entirely domestic mandate in the Humphrey-Hawkins law increasingly difficult. Since the end of WWII, nations around the globe have used dollars as both a means of exchange in trade and as a store of value for central bank reserves. Even large nations such as the EU today remain chronically short dollars, an important fact that is often ignored by US policy makers. Without a steady supply of fiat paper dollars, the global economy would essentially come to a halt. But the flip side of that coin is that short-term interest rates in the US must be measured against the interest rates prevailing in other major nations if US monetary policy is to be effective. How do we shake the FOMC and the wider economics profession from their domestically focused lethargy when it comes to understanding (or better, remembering) the global dimension of the dollar system? Richard Gardener in his classic book "Sterling Dollar Diplomacy" (1956) described the creation of the dollar system after WWII. He ends the work with these lines from John Maynard Keynes classic essay on "National Self-Sufficiency" (1935): "Words ought to be a little wild, for they are an assault of thought upon the unthinking. But when the seats of power and authority have been attained, there should be no more poetic license.... When a doctrinaire proceeds to action, he must, so to speak, forget his doctrine. For those who in action remember the letter will probably lose what they are seeking." Further Reading The American Conservative https://www.theamericanconservative.com/author/christopherwhalen/ National Mortgage News https://www.nationalmortgagenews.com/author/christopher-whalen

Ft. Myers | Sisyphus is a figure from Greek mythology. For sins in mortal life, he was punished by Zeus to forever roll a boulder up a hill in the depths of Hades, only to see it to roll down again. The Federal Open Market Committee is essentially trapped in the torment of Sisyphus. They keep trying to add liquidity to the domestic US money markets, only to see it leak out into the vast offshore market for dollar funding. This week the FOMC announced that the minimum size of its overnight repurchase-agreement operations will rise to $120 billion , from what had been at least $75 billion. Long-term repo operations will rise from a minimum daily offering size of $35 billion and go up to $45 billion in interventions scheduled for Thursday and Oct. 29. The longer-term repo operations are scheduled to carry over into November, but you can expect the operations to be extended into next year. Trouble is that these larger operations are unlikely to be effective. Why? Because the US and foreign banks that hold liquidity have no incentive to make this liquidity available to domestic borrowers in the US. Indeed, the entire intellectual construct that allowed the FOMC to think in 2018 that they could actually raise interest rates is shown to be a complete fallacy. “Everyone in the markets focused on repo problem as technical, given the competition for funding from T-bills/reserves,” notes Ralph Delguidice at Pavilion Global Markets . “The Fed asset swap, which is ‘not QE’ you understand, is designed to force cash out of T-bills into general collateral (GC), but is now failing as sellers of those bills (foreign official mostly) park cash in reverse repurchase (RRPs) instead. But problem isn’t cash not flowing UP to repo, it is cash not flowing DOWN to repo.” A number of analysts such as George Selgin at Cato Institute have rightly focused on the “leakage” in the Fed’s “floor” system for fed funds , but the offshore dimension may be a more significant factor thwarting the efficacy of Fed policy. It's about the spread everybody. Duh. The fact that regulatory policies such as Dodd-Frank and Basel III are blocking the movement of funding is easily understood by the markets (but not Massachusetts Senator Elizabeth Warren, it seems). Most of the TBTF/G-SIB banks must shrink going into year end to avoid a G-SIB capital surcharge penalty. Last December’s liquidity crisis was a function of JPMorgan (JPM) and other large banks backing away from the short-term markets. Thanks Elizabeth! With the level of bank reserves now lower than a year ago, the rocks in the proverbial stream are starting to appear. The Fed is trying to address their error by dumping more reserves back into the system via QE and repo, but the “liquidity” is running out of a hole in the bucket thanks to the spread between what a cash provider earns on repo – say +75bps over LIBOR in Treasury and agency repo – and the higher yields available in the $10 trillion market for currency swaps. Call the hypothetical offshore spread 2% over funding. Delguidice believes that as US interest rates have risen, demand in the $10 trillion market for currency swaps (aka “Eurodollars”) has soared, proving an impossible situation for the Fed as it tries to manage the 1.75-2.0% target range for Fed funds. “FX-swaps are a ten trillion-dollar market and are functionally equivalent to a repo to lenders of USD (most of the time), only with higher rates reflected by the basis,” says Delguidice. “They also receive derivative treatment on balance sheets, unlike repo, so dealers would MUCH rather do them. You only have count MTMs in the capital charge, but unlike repo they MUST be physically settled when they mature. They cannot just be rolled over.” Many sellers of T-bills are non-US banks. Many of these then take the cash and go into the RRP market away from the Fed. These banks get Treasury collateral that they can hypothecate to, you guessed it, access dollar liquidity. Many of these non-US banks in China and other Asian nations are profoundly short-dollars and hold trillions in dollar loan assets. Important, you cannot hypothecate the RRPs at the Fed. See BIS paper below on the "missing debt" parked offshore for your happy reading this weekend. https://www.bis.org/publ/qtrpdf/r_qt1709e.pdf Bottom line is that the rate paid and earned for RPs and RRPs is important, but the actual flow of cash vs "excess reserves" measured by our friends at the Fed is another matter. The Fed is uniquely ill-equipped to deal with such tactical issues. The Fed's balance sheet may grow, but the supply of cash liquidity in the broad market may not. The liquidity that the Fed is adding may not "trickle down" to the GCF and fed funds markets outside the primary dealers. Indeed, each day there is a 20-30 basis point differential between what the Fed charges primary dealers (~1.85% today and the rest of the market (~2.05%). This effective rate differential is likely to widen as the year comes to a close. Truth is, not only has the FOMC lost control of the Fed’s balance sheet to the financial markets, but the offshore Eurodollar market may force the FOMC to collapse US rates to eliminate the rate differential or "spread" between domestic fed funds and repo and the effective negative cost of funds offshore. The Fed and prudential regulators could take a lot of pressure off the money markets by adjusting the G-SIB capital surcharge and a couple of other relatively minor tweaks to the bank regulatory environment, but Senator Warren is having none of it. So now the worst single thing that can possibly happen has happened. Elizabeth Warren wants to complicate what could have been a simple and straightforward hostage negotiation with JPM’s Jamie Dimon over regulatory relief and the eventual Fed acquisition of the UST he is having increasing difficulty funding in the GC markets on his balance sheet. Remember, the TBTF/G-SIBs will again be shrinking their balance sheets going into year-end thanks to Basel III/IV and Dodd-Frank. Now you understand why the Fed just doubled down on adding repo liquidity to the markets, but it may not work. And a socialist presidential candidate named Elizabeth Warren is perfectly willing to crash the US financial markets to advance her never ending quest for celebrity and fame. Fed Chairman Jay Powell is Sisyphus. Elizabeth Warren thinks she is Zeus. This will not end well. Good weekend. #PavilionGlobal #GSIB #Sisyphus #ElizabethWarren

New York | This week in The Institutional Risk Analyst, we feature a discussion with Ted Tozer, former President of Ginnie Mae (2010-2017) and veteran mortgage banker. He is a Senior Fellow with the Milken Institute. The IRA: Thanks for talking the time to catch up Ted. First, let’s start by talking about what it was like to take over GNMA in 2010, which was a very tough year in the mortgage industry and for financials generally. Can you give us a sense for your priorities when you took that job a decade ago? Tozer: I was somewhat prepared for the task because of running capital markets for National City Mortgage, which was a top ten originator at that time. We saw the shift from Fannie Mae and Freddie Mac product to FHA product that occurred after 2008 as the credit climate changed. I knew the shift to FHA was going to occur, but I also recognized the potential that GNMA had to serve as a backstop for the industry and the US economy. We needed to leverage and improve our technology and the effectiveness of our people to really make a difference for consumers, so I made customer service for our issuers and our investors the priority. The IRA: That’s a radical concept for Washington, especially when aspiring politicians like to portray mortgage lenders as the enemy. How did you reorient the culture at GNMA to focus more on being customer centric? Tozer: When I got to GNMA, we had good people, but they were like all government employees, focused on the job instead of the customer. We had to change from merely offering a product to being concerned about making the GNMA market attractive to lenders and investors. We needed to focus on service to all of our constituencies if GNMA was going to position itself to help the industry recover. GNMA provides the liquidity that makes the FHA, VA and USDA programs possible. We had to focus on improving the capital markets execution of GNMA. A lot of veterans at FHA saw their loan guarantee program as the only concern, but I made the argument that the combination with GNMA was powerful and really essential to our being able to serve the industry’s needs. The IRA: How was the reception to that message? Tozer: It was very positive. National City was the largest GNMA issuer in the US in 2007 and 2008, so I knew the GNMA staff well. We had worked together for years so that set me up to help the organization get through some tough years after the financial crisis. I really focused on conveying to my colleagues at GNMA, FHA and HUD how important we were to supporting the industry in those years. I also tried to educate people about the VA program and why that program was also crucially important. We had all of these veterans coming back from Afghanistan and Iraq that had an important benefit in the VA loan program, but many did not use it. Promoting the VA program was another way to support the mortgage industry and the US economy. The IRA: People forget that in 2010 many investors, especially offshore sovereigns like the Bank of Japan and Norinchukin Bank, had backed away from the GSE debt market, leaving GNMA as the only mortgage asset class they would buy. The market for smaller, low-FICO loans had essentially disappeared when the banks and even GSEs backed away. Did you and your colleagues at GNMA feel like you were catching the falling knife in the housing sector in those dark years before residential assets truly recovered in 2012 and thereafter? Tozer: There was certainly a sense of mission, but fortunately both the FHA and GNMA were well-positioned to play a counter-cyclical role in the housing sector. We were in a unique situation because GNMA had gotten so small during the 2000s. Most of the GNMA servicing was being done by Bank of America (BAC) , Wells Fargo (WFC) , JPMorganChase (JPM) , and U.S. Bancorp (USB), strong financial institutions that minimized Ginnie Mae’s counterparty risk. This left us free to focus on the future and what we needed to accomplish to better support the industry. Unlike the GSEs, which as issuers of MBS with pre-crisis loans had to deal with the problems of legacy subprime mortgages, our servicing was being done by large banks. But we also put out the welcome mat to attract new non-bank issuers into the GNMA market. Had we merely focused on working with the large banks as before, would have dramatically slowed the housing recovery. The IRA: After BAC closed the Countrywide acquisition, they shut down their correspondent channel. Cost BAC shareholders billions in lost revenue. But good timing on your part to pivot back to the non-banks as the commercial banks were leaving the FHA market. We always laugh when researchers fret about the rise of the non-banks, when in fact it was the return of the non-banks going back to the S&Ls of the 1980s. In this cycle, much of that distressed FHA loan product was eventually transferred from BAC, JPM et al. to high touch non-bank servicers and at the insistence of prudential regulators and state AGs. Tozer: A lot of the correspondent people at Bank of America came to GNMA. And non-banks strengthened the agency and helped us build a business with new issuers like Quicken, Penny Mac (PMT) , Freedom and Caliber. There were also some significant new high touch distressed servicers like Mr. Cooper (COOP) , Ocwen (OCN) and Carrington, who processed huge volumes of troubled loans and made many thousands of FHA loan modifications. Carrington was a great example because they were set up to clean up the private label mortgage market, so they had the people and systems to handle distressed FHA loans very effectively. The IRA: What was the biggest challenge during your time at GNMA? Tozer: Throughout Washington, whether you are talking about HUD or Capitol Hill or other agencies outside the mortgage complex, there is little real awareness about how mortgage finance works in practical terms and GNMA specifically. The IRA: One of the more amusing things about housing reform is to see how few people understand that GNMA is a guarantor only, with bank and non-bank issuers handling the bond issuance and servicing, while the GSEs are issuers themselves, guarantors and the owners of servicing. How do we bridge the enormous chasm of understanding? Tozer: At the start of my tenure, very few people at Treasury or the other parts of government knew what GNMA did or what we accomplished by enabling the FHA and other programs. When I explained it to people at the White House, they were actually shocked. I am not being critical here, but housing finance is a specialized niche. There were a lot of very smart financial people and politicians I met over the years who did not understand GNMA’s role and our potential to drive recovery in the housing market. And this is the same challenge with housing finance reform, because so few people understand the complexity and nuances of housing finance. The IRA: Even with the growth in FHA lending and RMBS issuance at $2.1 trillion, today GNMA is less than 20% of the total residential housing market. The large banks are the top of the food chain with $2.5 trillion of mostly large, prime, non-FHA loans, the GSEs currently occupy the big middle of $5.5 trillion or so, and the non-agency private loan market makes up the rest. So when we read the Trump Administration proposal to downsize the FHA, we wonder if they understand that there is no other practical market for small, lower FICO loans? Tozer: Reading the Administration proposal, the first thing that jumps out at me is the huge growth in GNMA were it to provide the credit wrap for the existing GSE securities as part of the re-privatization of Fannie Mae and Freddie Mac. Under the proposal, GNMA would become a monster guarantor for three quarters of the mortgage bond market. Operationally Ginnie Mae could support the growth because of the hundreds of millions of dollars Ginnie Mae spent to modernize its infrastructure. FHA has actually been a very successful program in a sense that they capped market share by limiting the size of the loans, but they took such a broad swath of the market that the credit loss performance was fine. By undercutting private issuers and taking a broad cross section of the credit spectrum in smaller loans, you did not need risk-based pricing. The good loans balanced out the bad in terms of risk. When the subprime issuers that underpriced the credit risk arrived from Wall Street, however, that threw off the entire system through FHA being adversely selected. But the basic FHA model actually worked quite well. The IRA: During the period before 2007, the large banks were pushing the GSEs out of the way to acquire residential collateral for private label securitization deals. Investors clamored for more deals. How did that surge of demand affect FHA and GNMA? Tozer: The Wall Street banks cherry picked the better loans out of the market and left the FHA with the poorest quality subprime product. Now that we have restored the balance in the FHA and other programs, however, we don’t really need risk-based pricing to do a good job for our issuers and investors, and thereby protect the taxpayer. If we coordinate the demarcation between GSE execution and FHA, the program is quite stable and could return to the type of operating performance we saw before 2008. In the early 2000s, the FHA was so well capitalized that it actually waived premiums for some low-income borrowers. I’d like to get back to that situation. The IRA: So will banks come back to the FHA market? Prudential regulators have told banks to avoid smaller loans due to reputational risk. Tozer When the DOJ and FHA took the pound of flesh from banks large and small after the 2008 financial crisis, they ensured that banks would exit FHA lending and not return. The big public banks don’t want the reputational risk and the smaller banks don’t want to put capital at risk with the DOJ. You can’t force people to make FHA loans. If you have a limited number of people that want to make FHA loans, then the program will be offered on a limited basis. This capacity issue should become apparent in the next economic cycle. The punitive aspect of the DOJ and FHA approach, where they went back years to penalize technical deficiencies in loans, defects that will not affect the loan’s performance, burned the bridge with the depositories. This has important effects because it essentially makes the FHA a procyclical program. That scares me. When we had the large bank issuers, they could lean into a receding market as a countercyclical resource and help to support lending during a recession as in 2010 onward. But not anymore. The IRA: The smaller non-banks in the GNMA market clearly face a funding challenge in a moderate to severe loss cycle. Yet in retrospect, the FHA and GNMA were fortunate that the non-banks came into the government market, cleaned up the subprime mess and then replaced the banks in the role of GNMA issuers. Clearly a depository is a superior model for the GNMA market because of the large escrow balances. But speaking of non-bank issuers, what would you say about the White House proposal prohibiting refinance of FHA loans? We discussed same in National Mortgage News ( "Trump's housing plan attacks the FHA mortgage market" ). Tozer: Many borrowers in the FHA market would not be able to refinance out of the FHA market because of needing to get private mortgage insurance on the GSE loan. I do agree that a GSE loan should not be refinance by the FHA, because that suggests that the FHA is again going to be getting the problem loans. I don’t see the issue of an FHA refinance into another FHA loan. FHA already owns the risk, so lowering the payment for a borrower is good for the FHA and the consumer both. The IRA: Precisely. Most of the product being written in 2019 is rate product, not cash out loans as in 2018. Responsible FHA and VA lenders will lower the cost to the borrower and keep the loan amount stable. Speaking about risk-based pricing, if we take Fannie and Freddie out of conservatorship without a legislative fix that provides for GNMA guaranteeing the existing securities, what happens? Do Washington folks understand that the GSEs are issuers, and also need to fund bond payments and have the liquidity to fund advances? Tozer: Fannie and Freddie are like CapitalOne (COF) before they bought Chevy Chase and MBNA before they got bought by Bank of America. These monoline non-bank credit card issuers had a very tough time funding their businesses without access to government guaranteed debt (bank deposits). None of them were really able to make it because of the cost of financing. I think the cost of financing for Fannie and Freddie will become prohibitive to them if their debt is no longer guaranteed by the Treasury. The IRA: The discussions about GSE reform make us recall the warnings from Dave Stephens when he was head of the Mortgage Bankers Association. He said that when Mel Watt left the Federal Housing Finance Administration, things would change. And they certainly have. Mark Calabria seems to think that private capital is enough to support the GSEs, but most of our colleagues inside the enterprises suggest otherwise. Even a change in funding costs of as little as 20% to reflect the difference between GNMA at zero risk weight and Fannie/Freddie at 20% for Basel III would be intolerable. Warren Kornfeld of Moody’s wrote that: “Reducing Freddie and Fannie’s footprint would be credit negative for GSEs,” but increased funding costs are even more problematic. What would happen to FHA flows if the GSEs were really privatized without a federal guarantee for the bonds or the issuers? Say the GSEs ended up as “A” credits c/o Moody’s. Tozer: Well, first off, the UMBS would become next to impossible to administer. The GSE MBS would become the obligations of the issuers that were no longer obligations guaranteed by the United States. MBS investors would have limits on how much exposure they would have to each GSE. The GSEs would be joint and severally liable for the other GSE MBS that were included in their mega or giant pools. For example, the only reason they are allowing other issuers to sell production into mega pools is that there is a government guarantee. If they are guaranteeing the other agencies securities, then they have the counterparty risk as well. I don’t think that people in Washington understand all of the moving parts involved with the GSEs operationally. You miss one moving part and the whole operation falls apart. You can tinker on the edges, but you cannot make wholesale changes without destabilizing the conventional market. That is why unless Congress acts to guarantee the securities issued by the GSEs, I do not see how they will be able to leave conservatorship. The IRA: Thanks Ted. See you in Dallas next year at Americatalyst 2020 .

New York | This week in The Institutional Risk Analyst , we look at Q3 earnings for financials from 10,000 feet. We do this through four perspectives on four large US banks. If you want a closer look, purchase a copy of The IRA Bank Book for Q3 2019 in our online store. The Street has continued to retreat from previous estimates of bank earnings made just a few months ago. Some analysts have even figured out that bank earnings will fall for a few quarters. A number of banks have guided down on revenue and Q3 ’19 earnings, but some are actually looking for up volumes in a decidely downbeat market. All that said, the financials are fully invested by Buy Side managers and quite fully valued, but the issue of liquidity still adds a damper to the market narrative. The liquidity problems which we have discussed over the past several weeks have served as a distraction to investors. Greg Hertrich at Nomura (NMR) put the tactical situation facing banks for the balance of the year into perspective as we head into earnings this week: “The most recent short-term funding dislocations have been broadly discussed, but the market is still grappling with the overall response by banks to stay ‘on the sidelines’ while markets offered a short-lived earning opportunity… The need for liquidity around mid-September timeframe was amply clear but a number of market participants were caught off-guard by the speed at which the shortfall manifested and that contributed to the paucity of bank response. Banks, by nature, tend to be more methodical and rules-based when it comes to market reactivity. But that’s not the entire story and we think a deeper discussion of banks’ roles is worth the time. There is a lot to unpack here, but as month- and quarter-end periods have the potential to expose weaknesses in the system, it seems rational to expect that spikes like we saw in mid-September are not lost to the sands of time and are likely to be revisited in coming periods.” Banks are not the only players backing away from big promises made in past days and weeks due to adverse market conditions. The accelerating demise of Libra, the sorta-crypto currency postulated by Facebook (FB) founder Mark Zuckerberg, illustrates the fact that the very smart folks who work outside the banking monopoly in the wonderful world of fintech just don’t get it. In the US and EU, the world of banking and payments is a carefully guarded market populated by government sponsored entities or GSEs. Recall that Feinberg's First Law states that no private entity can compete with a GSE. Regulators refer to the large money center depositories as "global systemically important banks," but they are all GSEs. We call them zombie dance queens because they are destroyers of shareholder value. As Mr. Wonderful said on CNBC this summer: "Dead money." To have a hard IP address on the global payments system (like a master account at a Federal Reserve Bank, for example), you must be a regulated depository institution. No amount of pretentious talk about "disruption" in the world of payments or "fintech" changes this reality. Governments have a monopoly on money & banking, period. This is not to say that FB or Lending Club (LC) or SoFi or Quicken can’t enter the world of banking and payments. They can given the right legal and financial advice. But you need to understand the rules of the game. And you need to do the hard work quietly, up front, before putting out the optimistic press release. Count the number of fintechs in the past five years that have talked about a banking strategy of some sort, issued press releases, but then failed miserably. Whether you looking for a full bank charter a la Warburg Pincus portfolio company Varo Bank , an industrial loan company or even a limited purpose federally-insured trust company, it’s all possible given planning, management focus and purpose. FB, for example, could have approached US and offshore authorities to create a Libra-like token with a full-blown payments solution as part of the offer. FB might have backed the well-concieved proposal with a commitment to charter an FDIC insured, non-bank trust company to take deposits and make payments. The FB TrustCo would be a member of the Fed regulated by the FDIC. You join the GSE club. Somehow with all that money and all those smart people, nobody thought to suggest same to Mr. Zuckerberg. Lower Bank Earnings Over in the world of commercial banks, Q3 2019 earnings loom over a maket where analysts are generally backpedalling away from past prognostications. A number of analysts have actually raised estimates for JPMorgan (JPM), of note, but the bull contingent is thinning out as the number of analysts following the stock declines. Likewise, with U.S. Bancorp (USB ), three quarters of the analysts have a “hold” on the $85 billion market cap stock, which trades a little over 1.8x book value. We own USB but the stock is fully valued given the outlook for the industry. The chart below shows net income as a percentage of average assets for JPM, USB, Citigroup (C) , CapitalOne (COF) and Peer Group 1, which includes the 130 or so US banks with total assets about $10 billion. The first thing to notice is how the 2017 tax legislation increased net income for the industry as a whole, a one- time gift that is now in the rearview mirror so to speak. Source: FFIEC Notice too how USB and COF consistently make more net income per dollar of assets than their peers large and small. And C, by comparison, underperforms its peers, one reason why the bank consistently trades below book value in terms of market cap. The Street has Citi's revenue up small in Q3 but then up 6% in Q4, which never happens. Citi historically is light revenue in Q4 due to seasonal factors. The biggest negative factor hurting bank earnings in Q3 ’19 is interest expense, something we’ve been talking about since 2017. The good news is that the rate of increase in interest expense for all banks slowed in Q2’19 as the chart below suggests, but observe the huge change in funding costs that has occurred since 2016. Funding costs will continue to increase through the rest of 2019, albeit at a slower rate than the 60-70% annual increases we saw in 2018 and Q1 ’19. Source: FFIEC Credit metrics for the US banking industry remain quite strong, but note how much higher are the net credit losses of subprime lenders such as C and COF compared to average of Peer Group 1 or JPM. COF has some of the most aggressive analyst estimates among the top banks and relative high rates of revenue growth. But again, like C and other subprime lenders, COF tends to trade at a discount to book due to concerns about credit. In 2009, let us recall, COF peaked at almost 10% gross charge-offs vs ~ 2% for the industry as a whole. The chart below shows net loan losses as a percentage of average loans and leases. Source: FFIEC Finally, in the chart below we look at gross loan spreads for our sample group and Peer Group 1. As you would expect, the gross yield on loans and leases for subprime COF is 2x that of Peer Group 1. C is about 35% above the average spread for the peer group. It is interesting to note that loan yields for Peer Group 1 have been rising steadily since 2016, but not nearly as fast as funding costs have risen over the same period of time. Source: FFIEC Funding cost, at the end of the day, is the single most important headwind facing financials in 2019 and 2020. While the liquidity environment in Q2’19 was reasonably positive for financials, in Q3 the situation changed dramatically. The FOMC has been forced to add massive amounts of short-term liquidity to the money markets. Yet competition for funding has intensified for smaller and midsize institutions away from the largest banks and their captive primary dealer units. We expect to see funding costs continue to rise faster than gross spreads on loans and securities at US banks for the balance of 2019. The Institutional Risk Analyst publisher Chritopher Whalen is scheduled to discuss Q3'19 bank earnings with Brian Sullivan on CNBC's "WorldWide Exchange" on Tuesday, October 15th at 5:30 ET. #JPM #USB #COG #Citigroup #Nomura #CNBC

New York | We spent a good bit of time in Washington last week, listening to very smart people talk about housing reform. Little of what we heard makes sense in market terms, but that does not seem to bother anyone in Washington. To read our latest comment in National Mortgage News about the Trump Administration’s plans for reforming the Federal Housing Administration, click the image below. The strange thing about the Washington conversation regarding housing reform is that nobody seems to understand how the FHA and the GSEs actually function in the secondary mortgage market. For example, the Trump Administration actually thinks they can gut the FHA program for low- and middle-income households with no knock of effect for the US economy or secondary market participants. Then there is the absurd discussion about privatizing the GSEs. Private capital is irrelevant to the future of Fannie Mae and Freddie Mac, but credit spreads are crucial. If the GSEs cannot offer execution that is attractive to private lenders seeking to sell loans to investors, then they will fail. If they cannot access unsecured funding near current yields, then the GSEs will die. No amount of private capital will change this reality. The spread of GSE debt over US Treasury yields determines whether Fannie Mae and Freddie Mac are competitive with the big banks and the FHA. That’s it. The GSEs fund their operations, including advances on defaulted loans and even the payments to bond holders, in the unsecured debt market. If after re-privatization the cost of funds for Fannie Mae and Freddie Mac goes up significantly, then the GSEs will die. The execution for the GSEs as issuers of debt in the bond market is all that matters. But nobody in Washington knows or cares about such details. Meanwhile in New York, the Federal Open Market Committee has now completely reversed its 2018 policy goals, ending increases in the target for fed funds (FF) and ceasing shrinkage of the Fed’s balance sheet – and indirectly bank deposits. The FOMC has dropped the target for FF and is now adding reserves back into the system in a short-term version of “quantitative easing.” Let’s call it by name: “QE4.” The short-term repo operations announced last week by the FOMC through early November likely will be made permanent a la TALF and other post crisis liquidity facilities. The entire narrative for monetary policy that existed a year ago has been abandoned, leaving some to wonder if the FOMC should continue to use FF as a policy tool. Question: If the FOMC cannot effectively defend the target range for FF, then what is the purpose of this policy approach? Since Q4 2018, the FOMC has faced a deteriorating market situation when it comes to liquidity, this as debt issuance by the US Treasury has risen significantly and once plentiful excess reserves were drained from the system via “quantitative tightening” or QT. The movement of FFs did not suggest any problem, however, until a combination of a shrinking Fed balance sheet, soaring Treasury borrowing and rules for large bank liquidity caused a funding squeeze last month. Looking at the GCF repo index compiled by the DTCC, the increase in interest rates prior to the end of 2018 and in September 2019 look strikingly similar. In each case, liquidity was suddenly lacking in the fed funds market and rates spiked across the repo market for Treasury and agency collateral. As the chart below shows, RMBS repo between dealers traded over 6% in September – twice the effective coupon on the underlying securities. It does not take a lot of volatility of this magnitude to convince investors to back away from Treasury and agency debt as an asset class. Is anyone on the FOMC listening? Here we though that the Federal Reserve Board wanted to protect Treasury's access to the debt markets! Maybe not. Suffice to say that if the FOMC cannot defend the upper bound of its FF target range, then year-end 2019 will be another mess. On Thursday of this week, we’ll be participating in a discussion sponsored by the Global Interdependence Center to review the liquidity situation in the market for fed funds. Join The IRA's Christopher Whalen, Robert Eisenbeis, Vice Chairman and Chief Monetary Economist at Cumberland Advisors and William Kennedy, Chief Investment Officer of Fieldpoint Private , for an important conversation. Click the image below to register for the virtual event.

In this issue of The Institutional Risk Analyst, we feature a comment by Robert Eisenbeis , Vice Chairman & Chief Monetary Economist at Cumberland Advisors in Sarasota .Dr. Eisenbeis was formerly Executive Vice-President and Director of Research at the Federal Reserve Bank of Atlanta. As you read his analysis, ponder the enormous importance of the decision by then FRBNY President E. Gerald Corrigan to shut down the bank's dealer surveillance function in the wake of the 1991 Solomon Brothers scandal. He later crossed the street to Goldman Sachs & Co. Corrigan retired in 2016, but the FRBNY is still struggling to rebuild its market surveillance capabilities. See also " Gone Fishing " (1993) and "Nightmare on Wall Street: Salomon Brothers and the Corruption of the Marketplace" by Martin Mayer (1993). Repos And Reverse Repos Robert Eisenbeis The week of September 16 saw the Federal Reserve Bank of New York inject funds into the repo market in response to an unusual spike in rates that was above the initial target range for the federal funds rate of 2.0–2.25%. (The target rate was lowered to 1.75–2.00% after the close of the FOMC’s meeting on Wednesday, September 18.) The repo rate, which is usually closely linked to the federal funds rate, spiked to levels close to 10% on Monday that week, causing a squeeze on broker-dealers that finance their portfolios of Treasury and agency securities in the repo market. On Tuesday, September 17, the Fed provided about $52 billion in funds to primary dealers (broker-dealers who regularly act as counterparties to the Fed in its open-market transactions), followed by $75 billion or more each subsequent day through September 25 and declining to $71 billion on September 27.[2] In each case, the Fed offered to buy Treasuries and MBS overnight from primary dealers in return for funds. It remains somewhat of a mystery as to why the sudden pressures have arisen in this market. Some observers point to the need for about $70 billion in corporate tax payments that had to be made, which drew down funds to some extent from money market mutual funds, and to the issuance by the Treasury that same day of about $50 billion in securities that had to be financed.[3] Both of these transactions ran through the primary dealers and arguably may explain some of the rate spike, or at least its timing. But to get a better understanding of what was going on and why the repo market was hit requires us to get into the weeds a bit in terms of the background and structure of that market and to understand who the main participants are before further exploring the possible causes of the problem. The current repo transactions entered into by the Fed can be thought of as an extension of what was the Primary Dealer Credit Facility, which the Fed established in March 2008 in response to the financial crisis and problems in the tri-party repo market. The Facility was closed at the beginning of February 2010.[4] As its name implies, the Primary Dealer Credit Facility was designed to support some of the important primary dealers, that is, specially designated counterparties who were authorized by the Federal Reserve Bank of New York to buy and sell securities with the Fed in connection with issuance and distribution of Treasury securities and the conduct of Federal Reserve daily open-market operations.[5] Later in October 2008, the Federal Reserve also created the Money Market Investor Funding Facility, designed to provide emergency liquidity to money market funds that were experiencing withdrawals and liquidity problems. That program was terminated on October 30, 2009.[6] The repo transactions last week put the Fed once again in the position of being a significant lender to primary dealers. One way to think of the Facility is that it is similar to the discount window for banks, but is provided not to banks but to broker-dealers. At its December 16, 2015 meeting, the FOMC authorized the New York Fed to supplement its normal open-market desk operations by initiating what it called Over Night Reserve Repos as a supplemental (but supposedly temporary) tool to control overnight money market rates.[7] Authorized counterparties included certain banks with assets of more than $30 billion, GSEs, primary dealers, and money market mutual funds. This facility has been heavily used, until recently almost exclusively by money market funds, as the chart shows. This history brings us to the last piece of institutional detail relevant to the current problems in the RRP market. First, in the normal operation of the Fed in the repo market, it sells securities overnight, and it calls that sale a reverse repo.[8] The Fed contracts with the buyer (i.e. counterparty) to buy back the securities the next day, as is the case with an overnight repo.[9] The Fed keeps the securities on its books, and on the liability side of its balance sheet it draws down the reserve account of the counterparty’s bank and increases an account that it calls “reverse repurchase” agreements. There is no impact on the size of either the Fed’s assets or its liabilities, just a change in liability composition. The same is not true when, as was the case last week, the Fed purchased securities from the primary dealers to address their funding problem. In that case, the Fed bought securities overnight and recorded the transaction as an increase in “repurchase agreements” on the asset side of its balance sheet, and it also increased bank reserves of the primary dealers’ banks by the same amount on the liability side of its balance sheet. In this case, the transactions did increase the size of the Fed’s balance sheet. Another element of the transaction needs to be clarified. Of the four categories of approved participants in the Fed’s repurchase program, only banks are permitted to hold deposits at the Fed and to receive interest on those funds. GSEs are permitted to hold deposits at the Fed, but they cannot receive interest on those deposits. Neither the primary dealers nor money market funds can hold deposits at the Fed, so if they need funds or are experiencing liquidity problems, they turn to the Fed through the repurchase market and transact through primary dealers. Most of the primary dealers are broker-dealers and are affiliated with a bank or bank holding company. US law limits bank lending to subsidiaries or affiliates, essentially precluding a bank from borrowing funds at the discount window and lending those funds to its securities affiliate in times of stress. It also seems that banks are often reluctant to lend to the securities affiliates of other banks or bank holding companies. This may be one possible source of the recent stress in the market, especially if money market funds were liquidating securities holdings through the primary dealers. Against this background, what do we now know about what might have happened to cause the spike in the repo rate? Simple supply and demand theory implies that when a rate such as the repo rate spikes, there can be three possible explanations: The demand for funds has suddenly increased; the supply of available funds has suddenly dried up; or a combination of both. Some of the most insightful thinking about developments in the repo market over the past few months has been provided by Credit Suisse’s Zoltan Pozsar. He has been dissecting the evolution of the repo market for more than a year and was prescient in anticipating the kinds of problems that led to the Fed’s recent injection of funds. His analysis is detailed and nuanced, so that it is not possible to cover all that he details here.[10] What follows is a distillation of some of his key points and insights. His analysis suggests that supply and demand factors for both Treasuries and for short-term funding have been important in laying the groundwork, across numerous domestic and international short-term funding markets, for current pressures in the repo market. In August, Pozsar noted that by the end of this year, the Treasury was on pace to issue more than $800 billion in new debt and to increase its deposits at the Fed by $200 billion, while at the same time, he suggested, primary dealers had a limited supply of funds to accommodate such an influx before being impacted by required leverage ratios.[11] Furthermore, Pozsar detailed a number of factors, all tending to reduce market demand for securities, that help explain what has been a steady rise in primary dealers’ inventories of securities from an estimated $75 billion in 2018 to almost $300 billion as of the second quarter of 2019.[12] He argues that non-dealer demand for Treasuries has been dampened due to several factors, including shrinkage of off-shore corporate holdings of Treasuries and the inversion of the yield curve, making Treasuries less desirable investments. Finally, it is also the case that foreign central bank usage of the Fed’s reverse repo facility has added to the volume of securities in the overnight market. Foreign central banks have been buying securities overnight from the Fed in return for a cash balance that shows up on the Fed’s balance sheet as a reverse repurchase agreement. Remember that such transactions reduce bank reserves (since foreign entities must transact through a bank with a reserve account) and increase recorded reverse repurchase agreements, thus acting to sterilize about $290 billion of reserves that might otherwise be available in the market. All told, it is estimated that total demand for US Treasuries has shrunk by about $800 billion since 2018, which has bloated dealer inventories and increased the demand for overnight funding by the primary dealers. At the same time, collateral supply is up by about $1 trillion that also needs to be financed.[13] Against this background, Pozsar also argues that there is in fact a hierarchy of both providers and users of both cash and securities in the repo market, depending upon whether or not they are members of the Fixed Income Clearing Corporation (FICC), who ultimately transact through the primary dealers.[14] Cash lenders would include money market mutual funds and hedge funds that are not members of the FICC and that transact in the repo market at slightly different rates than do FICC member institutions such as banks, some GSEs, and branches of foreign banks. Like the cash providers, there are also providers of collateral, some of which are members of the FICC and some not, and which consist of essentially the same types of institutions as the cash providers; and they too face different interest rates. The important point is that this hierarchy means that there is not one clearing rate in the repo market, but a sequence of rates depending upon whether FICC institutions and non-FICC members are trading with like member institutions or with non-member institutions. Shortages and surpluses of both cash and securities can exist in any of these markets, which can result in rate spikes and liquidity problems. One last point. It is being reported that the Fed is considering increasing the size of its balance sheet so as to inject more reserves into the banking system as a way to deal with the problem in the ON RRP market. Presumably, this would endow banks with additional excess reserves, possibly making them more willing to lend to the primary dealers. Indeed, if the problems are in institutions that are not permitted to hold reserves at the Fed, then the private market must rely on banks’ willingness to lend reserves to address the needs for funds by either the primary dealers or money market funds. The problem with proposals to increase the size of the balance sheet is that there is no guarantee that an increased amount of bank reserves would find their way into the various segments of the repo market where needed. Just increasing bank reserves does not guarantee that lending will take place. Moreover, there is little to guide the Fed on how much of an expansion of its balance sheet would be needed to ensure that the problem would not arise again. One possible reform that would clearly address the problem would be to grant the primary dealers access to a permanent discount-window repo facility.[15] A downside is that this would put the Fed in the position of lending to many subsidiaries of foreign institutions; plus, it doesn’t address the issue that the Fed’s foreign RP facility is uncapped and acts to reduce bank reserves as the facility expands. Another option would be to modify both its regular open market operations and the ON RRP facility so as to engage in continuous transactions during the day. This move would eliminate the need to try to guess at the beginning of the day what market funding needs might be by day’s end and ensure that rates were within the target range.[16] [1] The following discussion relies heavily upon institutional details and insights provided by James McAndrews, who was formerly head of the Open Market Desk at the Federal Reserve Bank of New York. [2] Some of the transactions were overnight and some were term transactions. For details see: https://apps.newyorkfed.org/markets/autorates/tomo-results-display?SHOWMORE=TRUE&startDate=01/01/2000&enddate=01/01/2000 [3] See https://www.marketwatch.com/story/wall-street-raises-questions-about-feds-late-action-on-funding-squeeze-2019-09-17. [4] See https://www.newyorkfed.org/markets/pdcf.html. [5] Primary dealers were also obligated to participate in Treasury auctions, whether they wanted to or not. [6] See https://www.federalreserve.gov/regreform/reform-mmiff.htm. [7] See FOMC transcript https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20151216.pdf. [8] The Fed’s terminology is a bit skewed, since the sale of a security for repurchase is technically a repo; but the Fed describes the transaction from the perspective of the counterparty, who technically is engaging in a reverse repurchase agreement. [9] Term repos are also done from time to time. [10] Indeed, to get the full picture, the reader is urged to look at Pozsar’s work. [11] See Zoltan Pozsar, “The Revenge of the Plumbing,” Credit Suisse Economics, Global Money Notes #23, August 12, 2019. [12] Pozsar goes on to provide a lot of detailed analysis of how these factors have impacted spreads and trading. [13] See Zoltan Pozsar, “Sagittarius A*,” Credit Suisse Economics, Global Money Notes #24, August 21, 2019. [14] See Zoltan Pozsar, “Design Options for an o/n Repo Facility,” Credit Suisse Economics, Global Money Notes #25, September 9, 2019. [15] See Zoltan Pozsar, “Design Options for an o/n Repo Facility,” Credit Suisse Economics, Global Money Notes #25, September 9, 2019. [16] This commentary may be reproduced or distributed without requiring permission. #Eisenbeis #Corrigan #repo #SOMA #MartinMayer

New York | Last week's volatility in the market for fed funds gave a lot of equity managers an opportunity to brush up on their understanding of the workings of the short-term money markets. The Fed of New York was forced to offer cash to the Street in the form of forward repurchase agreements all week. These activities are likely to continue. Nathan Tankus posted a good discussion of the mechanics of adjusting bank reserves on Twitter last week . He particularly highlights not only the Liquidity Coverage Ratio or LCR, but also the additional liquidity stash meant to fund a resolution of an insolvent money center bank. Given that we would never actually resolve a bank over $100 billion assets, we wonder why this rule exists: What is the point of the “resolution liquidity” for a G-SIB if we’re likely to just put the bank into an FDIC conservatorship a la Indy Mac and then sell it after a bad asset cleanup? We appreciate the kudos on our call this past July on CNBC regarding liquidity problems in the markets, but we erred in thinking that merely ending the runoff of the Fed’s portfolio was sufficient. When our colleagues who trade TBA, and agency and whole loan repo, saw cash tightening up in the middle of August , that was a sign that problems lay ahead. Even with the Fed’s operations, the repo market is still displaying a lack of liquidity. A lot of people asked: what is going on? The best primer we can suggest is the 2018 book “Floored” by Dr. George Selgin of Cato Institute , who has been producing excellent research focused on the mechanics of monetary policy for years. Selgin describes “How a Misguided Fed Experiment Deepened and Prolonged the Great Recession.” By deciding to target the Fed Funds rate after Congress amended the central bank’s mandate in 1977, the Federal Open Market Committee essentially nationalized what had been a free market rate. Since then, whenever the FOMC wanted to adopt a looser stance to achieve the inflation and/or employment mandates set by Congress, it would lower the target for Fed funds. Here’s the problem. Who gave the FOMC the authority to essentially intervene in or “target” the private market for fed funds on a permanent basis? As Selgin notes: “It is important to note that the federal funds rate, whose value the FOMC endeavors to control, is a private-market rate. Its level, like those of other market-determined, interest rates, depends on the interaction of supply and demand – specifically the supply and demand for the reserve balances at the Fed, a.k.a. ‘federal funds.’” Tankus notes in his 20-part discussion of reserve mechanics that “Basel 3 has imposed liquidity requirements that encourage hoarding and discourage buying treasuries. The Federal Reserve is still behind the curve at becoming Dealer of Last Resort.” Ditto. And Selgin argues that paying interest on excess reserves held at the Fed has created some decidedly unanticipated consequences. To understand why the Fed's cash adding operations seen last week are likely to continue, read David Andolfatto of the Federal Reserve Bank of St. Louis and Jane Ihrig of the Federal Reserve Board of Governors: “ Why the Fed Should Create a Standing Repo Facility. ” They focus on how the FOMC’s use of increased or “excess” reserves that banks deposit at the Fed have distorted the money markets. They write: “Even though balance sheet normalization is well underway, we think it is never too late to introduce a repo facility. The FOMC would learn over time whether the facility is working to reduce the demand for reserves. The FOMC could do so, for example, by permitting reserves to run off organically with the growth of currency in circulation while remaining confident that interest rate control would be maintained through the repo facility.” The authors essentially argue that by making a market in Treasury and agency securities (at least GNMA and Federal Home Loan Bank issues) via a standing repo facility, the FOMC can encourage banks to meet their reserve requirements by holding securities instead of reserves. They also suggests that a permanent repo facility would allow the FOMC to continue to shrink the system open market account portfolio. And they suggest another not insignificant benefit of encouraging banks to treat Treasury securities as equivalent to reserves: “Finally, apart from being consistent with the 2014 Policy Normalization Principles and Plans, a repo facility would minimize the politically bad optics of the Fed paying interest on reserves (of which a large share goes to foreign banks). It seems both wise and proper to let the Treasury directly bear the interest expense associated with the regulatory demand for [high quality liquid assets] HQLA.” Indeed. The question of how much monetary policy intrudes into private markets, including the fiscal operations of the Treasury, was raised in an exchange on Twitter last week. Nathan Tankus retorted to a question about the lack of discussion of fiscal operations in monetary policy: As we learned long ago from Robert Eisenbeis , former head of research at The Federal Reserve Bank of Atlanta , the Treasury and Fed are alter-egos. The Fed is a creature of the Treasury and as such is merely a new layer of leverage added to the US political economy a century ago on the eve of WWI. Since then we’ve added the GSEs and various other government sponsored schemes to lever up the US economy even more. But the key point to us is that when the actions of the Treasury affect the federal funds rate or inflation or employment, how can the FOMC possibly know how to respond? Well, they don’t. Former Fed Chairman Alan Greenspan told CNBC in 2015 that if all countries don’t tackle fiscal problems, monetary policy will be “become utterly irrelevant.” “The real problem has got nothing to do with monetary policy—although I grant you it’s a crucial issue short term—it’s fiscal policy,” he said. “If we [had] matched up to Simpson-Bowles basic recommendations of a few years ago, we’d be in a much better place now. And we could have a legitimate discussion about monetary policy ... which is a minor consideration relatively speaking.” Here are some other responses we got on the question we posed: Is fiscal policy “irrelevant” to monetary policy? David Kotok, Chairman of Cumberland Advisors: “Yes. Yes. And yes it is. "Old days. Central bank supplied required bank reserves and currency. That was liability side of central bank balance sheet. Asset side of US treasury holdings were determined by the liability side. "New days. Fed is an arm of fiscal finance, remits spread to the Treasury. Asset side permanently larger and liability side multidimensional use." Michael Pento , President of Pento Portfolio Strategies: “This is an easy question to answer; profligate fiscal policies tend towards promoting loose monetary policies in order to augment demand for government bonds and ensure state borrowing costs remain tractable.” Mike Fratantoni , Chief Economist at the Mortgage Bankers Association: “It is certainly not irrelevant. The Fed is charged with keeping the economy at full employment while maintaining price stability and financial stability. They need to be aware of how different fiscal actions could impact the economy and their ability to reach these goals. The difficult balance is knowing when to speak out about their views on the consequences of fiscal policy actions with respect to their goals, without getting entangled in the necessarily political choices that many fiscal policy actions entail.” Robert Brusca , Chief Economist FAO Economics NYC: "No fiscal policy is never irrelevant. But no one is trying to make them work together either. So it is easy to see how some might think fiscal policy is irrelevant. In the 1980s Volcker held up a rate cut telling Congress it had to pass a bill to contain the deficit before he would cut rates. "Janet Yellen and her Fed went ahead with a program of rate hikes in part because it saw the Trump tax cuts and fiscal policy as too expansive at a time the economy had 'few idle resources' that did not turn out well as the Fed over tightened and is currently in the process of rescinding its excessive rate hikes. "The main 'problems' with fiscal policy is that it is too tempting. Keynes' Idea was to use it as a counter-cyclical tool- on then off. But once governments start using fiscal policy for economic expansion they just can't control themselves - fiscal policy is the opiate of.the elected." We think the key point is that the changes in the mechanisms used by the Fed that Selgin describes so nicely in “Floored” have, in turn, had a profound impact on the dealer community and their willingness to take risk. The volatility introduced into the market for reserve assets is not helpful either. More, the HQLA and “resolution liquidity” that the largest banks are required to hold has also had the effect of tightening liquidity in the short-term markets. Banks, after all, are the largest cash providers to the repo market, that is typically populated by smaller dealers. These same dealers make markets in Treasury and agency securities, and provide financing to the non-bank sector. So now we fix the problem largely caused by the Bernanke and Yellen FOMCs, Dodd-Frank and Basel III, by increasing the government’s control over the once private market for federal funds. The report by Andolfatto and Ihrig provides a road map for how the FOMC is likely to deal with the liquidity crisis in the short-term money markets, both immediately and in terms of addressing some of the structural flaws in Fed policy illustrated by Selgin in his book. The once private market for fed funds will now be truly "federal" going forward. #GeorgeSelgin #DavidKotok #RobertBrusca #MichaelPento #MikeFratantoni #NathanTankus #HQLA

In this issue of The Institutional Risk Analyst, we republish a commentary by Brian Wesbury, Chief Economist at First Trust Advisors , regarding the role of bank regulations in causing the liquidity squeeze in short term markets earlier this week. When Fed Chairman Jerome Powell says there is no connection between market tightness and monetary policy, he is right. The culprit is bank regulations that restrict the ability of banks to provide liquidity to the markets, as we wrote yesterday in Zero Hedge . In the past few days, stresses in the financial system have shown up. These stresses have pushed the federal funds rate above the Federal Reserve's desired target range of between 2.00% and 2.25% (as of Tuesday), and some reports have funds trading as high as 9%. The Fed has responded by using repos - re-purchase agreements - to put cash into the system and bring down short term interest rates. The question is, does this signal a systemic problem in the banking system. Our answer: an emphatic NO. We believe the stresses are caused by overzealous banking regulation put into place after the crisis of 2008. The most likely culprit being LCR, or the liquidity coverage ratio. Below is a quote from Jamie Dimon, CEO of JP Morgan, during a panel discussion at a Barclays financial services conference on September 10th, 2019. "And I just want to mention. One way to look at the LCR thing and this, I'm talking about monetary transmission policy, you see recently China changed the reserve requirement. And when they do that, it frees up $100 billion of lending. You can't do that here because of LCR. Because – it's got nothing to do with monetary policies, it's a conflicting regulatory policy. And LCR also means that I can't finance a corporate bond and include it in liquidity anywhere. So when you all – if you all are selling corporate bonds one day, and you want JPMorgan to take on – finance $1 billion, I can't, because it'll just immediately affect these ratios. So we've taken liquidity out of certain products. And it won't hurt you very much in good times. Watch out when times get bad and people are getting stressed a little bit." The LCR is calculated by bank regulators, and determines the amount of cash a bank would need in the event of a severe financial crisis. In other words, banks are forced to hold enough liquid assets to meet cash flow needs under a made-up stress test. These regulator-created stress tests are extraordinary, as are their estimates of potential losses. So, how does this fit into today's financial market conditions and the management of monetary policy? With the advent of quantitative easing, the Federal Reserve has put a massive amount of excess reserves in the banking system. However, the Fed has also limited banks' ability to use those reserves through regulation, by putting rules, like LCR, in place. Stories about what that is going on with the repo market are filled with suggestions that the banking system does not have enough reserves. With $1.4 trillion of excess reserves in the US banking system, that's simply not true. Because of those excess reserves, trading in the federal funds market has become very thin. Back in the 1990s, daily trading in federal funds was on the order of $150 to $250 billion per day and it climbed much higher in the 2000s. On Monday, total trading in reserves was just $46 billion, and in the past year trading in federal funds run near a 40-year low. Why? Because banks are forced to hold more reserves than they actually need. QE flooded the system. A spike in the federal funds rate might have signaled a systemic (system wide) problem pre-2008, but not anymore. So, what has happened this week? While the Fed isn't talking, this is our belief. 1) Fed rate cuts and low long-term rates increased the demand for mortgages, which reduced cash in banks. 2) Many companies also took advantage of lower rates and issued corporate debt, which some banks likely bought. 3) Oil prices spiked after the drone attack in Saudi Arabia and may have squeezed financial entities who had written contracts protecting their oil clients from changes in oil prices. 4) Third quarter corporate tax payments reduced deposits at US banks. With such a small amount of federal funds trading, its highly likely that one or two (at most a small handful) US banks got caught offsides. We believe this is a short-term problem, not a long-term one. One way to deal with this temporary issue is to change the overly strict rules on LCR and avoid limiting liquidity. That's our preference. It could also just let the market run and teach a small group of banks a lesson. Using repos or adding more QE is micro-managing the situation, it's not in the long-term best interest of the economy. Excess liquidity and rewarding bad management creates problems down the road. But most important, these problems signal that the new path of monetary policy the Fed started in 2008 has grave issues. The Fed should not be as active in managing the economy as it has become. In the end we think the market, and market pundits, have over-reacted. There are no true liquidity issues in the US, other than those caused by misguided regulation. #wesbury #LCR #liquidity

New York | Updated -- Q: How much of a rate cut did Fed Chairman Jerome Powell deliver to the markets last month when he stopped the runoff of the Fed’s portfolio of securities? A: Half a point. Now why hasn’t President Donald Trump reciprocated with some flowers via Twitter for Chairman Powell? But hold that thought. We are filled with sadness watching members of the Sell Side trying to concoct a rationale for going long banks stocks in front of Q3 earnings. We own bank common (USB) and preferred (USB, BAC, C) primarily for income, definitely not for alpha. Financials have badly under performed the indices for the past year but are still expensive. Thus we feel little need to beat that particular dead horse. Yet so long as there are central bankers who are willing to keep interest rates negative, even the dead can walk among us. A case in point is provided by the office provider WeWork, which is apparently in the midst of a road show for an initial public offering of shares. Billed as an “American real estate company that provides shared workspaces for technology startups, and services for other enterprises,” WeWork has used a lot of borrowed money to acquire commercial real estate – this as global central banks were deliberately manipulating the price of real estate of all sorts ever higher. Readers of The Institutional Risk Analyst know that loss given default on most real estate classes in the US has been negative for years, this due to soaring prices for property and buildings. Reuters reports such that WeWork owner, called “The We Company,” may seek a valuation in its upcoming initial public offering of between $10 billion and $12 billion, a dramatic discount of the $47 billion valuation it achieved in January. Source: WGA LLC One of the remarkable accomplishments of central bankers such as Ben Bernanke, Janet Yellen and Mario Draghi over the past decade has been to enable financial fraud. By shifting the cosmic risk curve away from low risk quality assets and in favor of pure garbage, companies such as WeWork, Softbank and Tesla (NASDAQ:TSLA) were able to raise funds from investors for highly speculative ventures with little chance of achieving profitability. If money has no or even a negative cost, then asset quality is irrelevant, right? While the central bankers were helping to promote and fund these financial swindles, they used negative interest rates to tax honest, hard-working retail investors. This dichotomy between the impact of negative interest rates on everyday people (bad) vs the effect on financial speculators and frauds (good) is significant both financially and politically. News reports suggest that the last meeting of the board of the European Central Bank featured nearly a third of the council members voting against more negative interest rate medicine recommended by Mr. Draghi. The outgoing ECB chief, let’s recall, formerly headed the Bank of Italy after a glorious banking career at Goldman Sachs (NYSE:GS). Thanks to Mr. Draghi, savers across Germany and other northern European nations are in a state of revolt, threatening a political backlash more severe than the tongue lashing given to Draghi by his German colleagues. The growing pressure on central bankers to end the use of negative interest rates is bad news for the markets overall and for a couple of reasons. The trouble is not so much in the leveraged loan markets or collateralized debt obligations (CLOs), where much of the media buzz has concentrated in recent months, but instead in global equities both public and private. The accumulation of unprofitable stocks in a global market populated by hundreds of unicorns suggests that the source of the next bout of raging contagion is not the mainstream bond markets, but rather global equities and related leverage. Just imagine the scene if and when WeWork prices this truly wretched IPO with a single digit valuation vs the $47 billion value of just nine months ago. What does this say about the Softbank investment portfolio, including its stake in WeWork? And just why were some of the largest US banks prepared to advance billions in new loans to this Ponzi scheme built atop overvalued commercial real estate? Reuters reports: “Eleven banks were initially asked to make commitments of US$750m-US$800m in early August. But as doubts grew about WeWork’s valuation and new banks were invited to join the credit, changes were made to make lenders more comfortable with the large tickets, sources said. A cash collateralization was added to a US$2bn letter of credit, after lenders demanded additional protection. In a cash collateralization, the banks require the borrower to deposit cash in an amount equivalent to the size of the loan (in this case the letter of credit) as collateral.” The days when investors will support fanciful scams such as Softbank and WeWork seem to be at and end. Meanwhile, all is just peaches and cream in the world of debt capital markets, at least since the Federal Open Market Committee ended the runoff for the systems open market account (SOMA). Since the end of July, rates for financing conventional RMBS have fallen by half a point, as shown in the chart below. Source: DTCC Notice how agency REPO rates on transactions cleared via DTCC basically fell off the edge of the proverbial table after the FOMC’s July decision on ending the reduction of the SOMA portfolio. Volumes have also fallen sharply, but are still within the range of the past year. Note as well the huge upward skew of rates and volumes in the agency REPO market last December, when Fed Chairman Jerome Powell and the other members of the FOMC almost wrecked the family car. Remember, these happy PhD economists actually thought that they could raise interest rates . Suffice to say that compared with May and June, when we told viewers on CNBC that the credit markets faced a potential train wreck due to "quantitative tightening" or QT, today the picture is sublime. Short terms rates have stabilized, spreads on agency loans have widened and mortgage lenders are actually making money. It appears that the Fed’s decision in July to end the balance sheet shrinkage was worth a half point cut to the money markets. Memo to Potus: Stop beating on Chair Powell. He’s doing exactly what you asked by resuming the QE drip. But as Zero Hedge notes this AM (9/17/19) , volatility has returned to the REPO markets with a vengeance as ST interest rates spiked to double digits intra-month. Meanwhile in the land of fantastic adventures (aka Washington), the Trump Administration has been making more noise about the privatization of the housing GSEs, Fannie Mae and Freddie Mac. We wrote in National Mortgage News last week: “Most executives who operate mortgage companies view the Washington conversation about GSE reform with a combination of bemusement and dread. On the one hand, the childlike naivete displayed by policy makers regarding the business implications to the GSEs of ending the conservatorship elicit chuckles and outright incredulity. But the prospect of Secretary Mnuchin and Director Calabria handing the residential mortgage market to the big banks on a silver platter as part of ‘leveling the playing field’ is a most unwelcome, even disastrous development.” We later in the week had a great discussion with Andrew McCreath from BNN in Toronto , who asked some very basic questions about the impending privatization of half of the US mortgage market. Remember, it’s not just about Fannie Mae and Freddie Mac as corporate entities, but also the $5.5 trillion in agency mortgage securities that they guarantee. The bottom line is that most of the risk facing the financial markets today is largely a function of dumb, at times childlike idiocy coming from our beloved policy makers at the Federal Reserve Board and other agencies in Washington. For example, nobody who works in the world of credit and mortgage finance thinks that negative interest rates are good for the economy, yet some economists persist in holding this view. When the working people of Europe finally revolt against the diktats of the ECB, problems like Brexit will fade by comparison. And nobody who works in the world of mortgage finance thinks that Fannie Mae and Freddie Mac can be truly privatized without legislation from Congress. Anything short of a new law fully covering the extant debt of the GSEs with a full "AAA" Treasury guarantee risks causing another market collapse a la Lehman Brothers. But in Washington, anything is possible. Special thanks to those who participated in last week’s sale of The IRA Bank Book for Q3 2019. Subscribers to The IRA also received a special coupon for the latest issue of our quarterly look at the US Banking industry + plus a look at the top US universal banks. Links Conflict of visions in GSE reform https://www.nationalmortgagenews.com/opinion/conflict-of-visions-in-gse-reform Normalized funding costs poised to squeeze U.S. banks https://www.bnnbloomberg.ca/video/normalized-funding-costs-poised-to-squeeze-u-s-banks~1779236 Boring is beautiful if you're eyeing the U.S. banks: Investor https://www.bnnbloomberg.ca/video/boring-is-beautiful-if-you-re-eyeing-the-u-s-banks-investor~1779237 Fannie Mae and Freddie Mac reform 'makes no sense: Investor https://www.bnnbloomberg.ca/video/fannie-mae-and-freddie-mac-reform-makes-no-sense-investor~1779123 #quantitativetightening #WeWork #Softbank #Tesla

New York | This week we posted the Q3 2019 edition of The IRA Bank Book , our quarterly review of the US banking industry. And to celebrate and say thank you to our readers, we’ve put the new edition on sale for 40% off the regular list price of $99 through close of business this Friday, September 13, 2019. In this issue of The Institutional Risk Analyst , we take a modest victory lap for our 2017 call predicting that net interest income (NII) for the US banking industry would peak and decline early in 2019. After feasting for years on the "extraordinary" policy of the Federal Open Market Committee (aka "Financial Repression)," the banks are now getting squeezed in a deflationary vice. We write: “In 2008, total quarterly funding costs for US banks was over $100 billion. We expect to see total funding costs for the industry close to $60 billion per quarter by Q1 2020, suggesting considerable additional pressure on bank profit margins in terms of the gross yield spread over funding costs. That said, we think it very unlikely that bank funding costs will return to the $80-100 billion per quarter run rate that prevailed pre-2008.” Ponder the fact that the US banking system has grown 30% since 2008, but the cost of funds for the industry is still less than half of pre-2008 levels. The great bailout of the US banking system by the Fed continues, but most analysts, media and policy mavens are too credulous to state the obvious. Just look at the data. Funding costs are rising, but yields are falling. In addition, we review the small but influential universal banks operating in the US. There are a number of non-US banks with large transaction arms that operate in the US via securities businesses -- Barclays, BNP, and Credit Suisse come to mind -- but we focus on the actual banks with a large transaction component, including: JPMorgan Chase (NYSE:JPM) Assets: $2.7 Trillion Citigroup (NYSE:C) Assets: $1.9 trillion Deutsche Bank AG (NYSE:DB) Assets: € 1.4 trillion Goldman Sachs Group (NYSE:GS) Assets: $925 billion Morgan Stanley (NYSE:MS) Assets: $876 billion We also take a close look at the various loan asset classes on the balance sheets of US banks, particularly the real estate sector. Default rates continue to fall, except at the FHA were rates of delinquency are almost touch double digits. Meanwhile, volatility is returning to net loss rates for bank owned mortgages after years of suppressed loss given default (LGD). The chart below shows LGDs for the $2.5 trillion in bank owned 1-4s through Q2 2019. Source: WGA LLC We note that most of the Street was guiding lower on investment banking and trading revenue coming out of the second quarter of 2019, but falling NII may be a bigger problem. The Financial Times reports that investment banking revenues for the largest universal banks plunged to a 13-year low in 1H 2019, according to the latest data from industry monitor Coalition. “The banks had individually reported poor second-quarter earnings for their markets and investment banking divisions, including an 18 per cent fall in fixed-income revenues at Morgan Stanley and a 32 per cent decline in equities revenues at Deutsche Bank, which is in the process of shutting its stock trading business,” the FT reports. As we go into Q3 2019 earnings for US financials, remember that pricing power for bank loans is non-existent and the cost of deposits may not actually be moving lower with medium term interest rates. Sandler O’Neill noted last month: “Right now, the central question facing community bank managers is whether lower short rates will translate into lower deposit costs. In our view, lower short rates might provide some modest relief, but they won’t be a panacea. We say this because deposit rates are more a function of market dynamics than absolute rates.” Of note, JPM Chairman and CEO Jamie Dimon apparently told an audience at the Barclays conference this week that he sees full-year 2019 net interest income as down $500 million from previous guidance, with full-year NII at about $57 billion. This is a full $2 billion below the $59 billion run rate implied by 1H 2019 results. If we spitball JPM’s NII for 2019 at $57.5 billion, here’s how the chart looks below. Source: FFIEC, WGA LLC Dimon told the conference that next year could be worse, reports SeekingAlpha , with a possible cut of several billion in NII vs 2019. The bank, Dimon says, is prepping for the possibility of 0% interest rates. The 2012-2018 boom time in financials finally seems to have ended and with it the steady ascension of bank earnings into the sky. Depending on the results from the transaction side of the house, the US banking industry could report significantly reduced earnings for the rest of 2019 and beyond. And the credit for this mess begins and ends with the FOMC. We recall the sage wisdom of George S. Moore in the wonderful 1987 book "The Banker's Life" as told by our friend Martin Mayer: "I've always agreed with Milton Friedman that the Federal Reserve was more responsible for the Depression than any collection of bankers or businessmen or politicians, but I don't think you can blame any individuals. In 1929, the Fed did not know what was happening. If they had known, they wouldn't have had any ideas of what to do about it, and if they'd known what to do there wasn't anybody around who could have done it." JPM CEO Jamie Dimon was smart enough to go long duration in Q3 2018, yet the leader of the largest universal bank in the world is now telling us that his carry on assets is falling. The carry on his $2 trillion portfolio of earning assets is falling. The logical endpoint of this situation is insolvency for the largest bank in the US. Meanwhile, those brave souls in the world of mortgage lending and servicing who are actually short-duration are about to get annihilated in the third quarter. Could we see a down mark of $10 billion in mortgage servicing rights (MSRs) in Q3 2019 for the owners of the $120 billion in mortgage servicing? To paraphrase Rocket in "Guardians of the Galaxy": "Oh yeah." If the guidance of JPM CEO Dimon does not adequately illustrate the insanity of negative interest rates, there is nothing else we can say. As a growing number of analysts are realizing, we must raise interest rates to save the global economy by restoring the carry on -- and thus the value of -- of financial assets . Any other course is collective suicide. Forget the Europeans and the Japanese. They are doomed. The US must lead the way out of the negative interest rate trap. But does Fed Chairman Jerome Powell have the courage to reject the past decade of Fed policy and lead the way? #financialrepression #JPM #JamieDimon #NII #GeorgeSMoore #MartinMayer

New York | In this issue of The Institutional Risk Analyst, we continue our discussion with a long-time reader and a corporate finance and risk officer who has decades of experience in New York, China and Korea. The IRA: When we last spoke you were explaining how China is ‘weaker’ than many in the West perceive, and that weakness in turn influences China’s actions. How does this play into what we are witnessing in the current trade war? Ricardo: China’s economy was facing challenges and had been slowing before the trade war with the US erupted, but the trade war certainly does not help. The GDP growth rate has been declining for years, but is now touching 27-year lows. China is structurally over-invested in manufacturing and real estate development capacity. Over-investment and unproductive investment leads to low and even negative productivity growth. And these ‘investments’, when uneconomically viable, lead to bad debts, which by many estimates have been increasing, separate and apart from the recent trade war impacts. China’s overall official debt levels continue to worsen. Unofficial estimates from International Institute of Finance and others place China’s debt at more than 300% of GDP. Truth is, given the government’s heavy involvement State Owned Industries and Town Village Enterprises, along with the government simultaneously owning banks, pension funds, and common corporations, and one branch of government lending to another, no one really knows China’s debt level. Worse yet, from a risk perspective, the cross-lending concentrates risk, rather than dispersing it. If the trade war was not happening, I suspect more discussions in financial circles would be focused on China’s debt problems. The IRA: The figures you cite seem to support the “China is weak narrative.” We've been fascinated by the absurd saga of heavily levered conglomerate HNA, which seemed to place unacceptable burdens on China's payments system. What action can Xi Jinping and the CCP do then in its spat with the US? Ricardo: The US just slapped billions of dollars on Chinese goods, and China retaliated with more tariffs on US goods. The impact is as would be expected, with the trade war hurting industries on both sides. But for Xi Jinping and the CCP to buckle under perceived foreign pressure would politically damaging in front of their domestic audience. Especially with the 70th anniversary of the founding of modern China approaching in October – China needs to project strength. One would hope and expect that quiet negotiations were going on behind the scenes and out of the limelight to reach an accord, but even here we face unique constraints. On the Chinese side, Xi Jinping has tightened ideological control in all aspects of life, demanding that the party line be strictly adhered to, which means information is getting filtered much more before it gets t o the top. This is partly why China misread Trump. And on the US side, Trump equally disdains expert opinions and old “China hands”, meaning back-door channels are fewer than at any other time in the last forty years. This leads to a higher risk of wrong decisions or mistakes. The IRA: That does not sound promising. Ricardo: What I am highlighting in possible “wrong decisions and mistakes” are tail risks. Most likely path involves cooler heads prevailing and a more modest path. The real question is when do US consumers, farmers and manufacturers feel the pinch and voice their concerns, such that political pressures start to sway Trump? The IRA: And Hong Kong? What are we to make of the events there? Certainly seems that the Trump trade measures have contributed to popular protests against Xi and the Chinese Communist Party. Ricardo: The protests in Hong Kong are not like the ones in Tienanmen thirty years ago, but there are important lessons to be learned. The protests in Tien-an-men thirty years ago posed an existential threat to Communist rule. There were visible fissures in the politburo leadership between Zhao Ziyang and Deng Xiao Peng; local military was not believed to be reliable towards putting down the movement, thus requiring 250,000 troops be brought in from the remote provinces; the protests were spreading to other cities; the protests were gaining legitimacy with ordinary workers outside of the student-led protests; the protests were happening in the heart of the nation’s capital - Beijing. The IRA: All true. But today social media is far more widespread, accelerating the potential for disruption inside China. Or is this a misreading of the situation? Ricardo: Fast forward to today. There are no visible fissures amongst CCP leadership; local HK forces are working to quell the disturbances; the protests are not spreading outside of HK; ordinary people in China view HK as already spoiled and coddled; and HK is far from Beijing. Basically, there is a very different situation between then and now. The (tail) risk again, however, is wrong decisions and miscalculations. Beijing will not hesitate to use force if it believes such is necessary, though they have and will try to avoid such as long as possible, with the hope that the protests dissipate similar to the Umbrella Movement of 2014. The IRA: So how does one trade this? Ricardo: In the short run, if I was running a quant shop I’d train my algos to watch internet traffic from HK. If that drops dramatically, i.e. China makes HK suddenly go dark, I’d brace for the worst. Unlikely, but a non-zero risk. Medium term, I’d look at how to play the renminbi. Given what we’ve discussed, would you want your life savings tied to their currency? The IRA: Thanks Ricardo