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First we’ve launched the first volume of The IRA Bank Book , a review of the operating and credit performance of the US banking industry written for institutional investors. US banks have the best financial disclosure in the world, down to the portfolio level, a fact that allows analysts to dig deep if they care to spend the time. They don't. We’ve done the digging for you and present a macro level view of key industry trends. And best of all, you get to pay us for our work. Watching the continuing trials of HNA Group, we are reminded that the side effect of years of central bank largess will be an arithmetic reckoning when it comes to credit. The massive liabilities accumulated by the likes of HNA, Anbang Insurance and even Softbank will eventually come back to haunt these ambitious Asian debtors. And behind them stands the world’s most indebted state, namely China, governed by the paramount leader Xi Jinping. “And so castles made of sand, fall in the sea, eventually.” So wrote Jimi Hendrix in 1967, but he was talking about love not global investing, right? Our friends at Grant’s Interest Rate Observer recently cataloged China’s debt overhang in a comment appropriately titled for the Easter season: “Xi Jinping’s poisoned chalice.” They noted with typical understatement: “The whole world lives at the end of the whip of China’s credit growth.” Ditto. Especially when that growth is driven by an authoritarian state and makes no sense in economic terms. And yes the size of China’s financial pyramid is extraordinary, as befits a system where political concerns trump all other questions. The Chinese communists have taken the progressive model of money creation from the US and doubled down several times over! Everyone expressed surprise when the Trump Administration announced the imposition of tariffs on China. But readers of The Institutional Risk Analyst know that last November Leland Miller of China Beige Book pretty much called the start of the trade war down to the day . We asked author and intelligence analyst Jim Rickards what he thought of the timing and substance of the trade actions by Washington. "Many observers are shocked by the new trade wars. They shouldn’t be,” Rickards notes. “Trump has been talking about unfair trade and lost jobs for decades; long before he launched his political career. Unfair trade was a pillar of his speech announcing his presidential candidacy in June 2015 along with immigration and 'The Wall.' “Trump continued hitting the unfair trade issue hard throughout the campaign in 2016, and during the transition after he won the presidential election on November 8, 2016. He intended to make trade his first order of business upon being sworn in as president on January 20, 2017. But then the trade agenda was put on hold. Trump refrained from imposing tariffs in 2017, his first year in office, based on the advice of his national security team including National Security Advisor General H. R. McMaster, Secretary of State Rex Tillerson, and Secretary of Defense James Mattis.” “The national security team urged President Trump not to start a trade war because the U.S. needed Chinese help to avoid a war in North Korea. However, China did not do all it could to apply pressure on North Korea. Once China’s lack of cooperation on North Korea became clear by late 2017, Trump saw no harm in confronting China on trade. Now the gloves are off.” But even with the astounding numbers on China’s bad debt pile assembled by Grant’s and the sage political judgment of Jim Rickards, we remain unsatisfied in our search for an explanation of the behavior of Chinese dictator Xi Jinping. Sure, the country’s debt (aka the entire banking system) is enormous, the biggest of any industrial nation on earth. And yes, the political stars seem aligned for a trade war with the Trump Administration. But that still does no explain the level of disarray and haste seemingly driving the consolidation of political power in China. Uncle Xi is a man in a hurry. His moves to eliminate rivals in the Chinese Communist Party have come swiftly, as have belated moves to seize insurer Anbang and extend credit to the apparently insolvent HNA. But more to the point, the CCP’s tolerance for and even encouragement of the debt fueled spending spree of the past decade is unseemly. It evidences a degree of sloppiness and financial naiveté on the part of the CCP party leadership that raises questions about their chances of survival. Viewed in this light, Xi’s moves to consolidate power may be seen as defensive and reactionary. The thing western analysts have trouble accepting is that the Chinese economy is actually far weaker that the state-approved statistics suggest. Unemployment and massive bad debts are just part of an increasingly unstable situation in some Chinese provinces. China’s "One Belt, One Road" plan, for example, is a bad copy of the New Deal that is doomed to fail in terms of generating real, sustainable growth. But it will certainly add to China's debt. A trade war with the US will only exacerbate an already bad situation, where the CCP tries to manufacture internal economic demand via subsidies for dead companies and infrastructure projects that produce little or no return. The failure of Xi and the CCP to build a stable, sustainable economic system is the root of the political fear evidenced by Xi and his cronies. James Palmer wrote in Foreign Affairs in February ’18: “[T]he most recent change signals something far deeper than the party’s primacy over the law; it spotlights the essential instability of the entire political system… During Lunar New Year this month, traditional fireworks were banned from Beijing — even down to the firecrackers thrown joyfully by small children. By itself, that could be passed off as a legitimate health and safety measure. But such was the worry about public gatherings that there were not even any organized displays of fireworks. For the first time in decades, the sky over China’s capital as spring arrived was dead, black, and silent.” Thus the trade war moves by the Trump Administration, to position for the 2018 and 2020 elections by focusing outward in the daily search for new antagonists, comes at a bad time for China and the financial markets. With Mike Pompeo at the State Department, John Bolton as National Security chief and Peter Navarro as trade czar, you have an almost Reagan era formulation that may try to use trade disputes to provoke a political crisis in China. Yes, the Trump White house may even think regime change in Beijing is possible given sufficient pressure. Ponder the effect of a 21st Century version of the Taiping Rebellion with nuclear weapons in the mix. China's version of the US Civil War lasted for some 14 years (1850–64), decimated 17 provinces, took an estimated 20 million lives. And this type of unrest is precisely what Xi and China's communist rulers fear. Financial markets need to anticipate that the tariffs announced by the White House are only the first steps in a much broader retaliation against China for decades of theft and deceptive trade practices. Again, Rickards: “What the market is missing is that all of the tariffs on steel, aluminum, solar panels and the rest are small beer compared to the mother of all trade sanctions coming soon in the form of a “Section 301” report that will land on the President’s desk any day. Section 301 of the Trade Act of 1974 is the “nuclear option” when it comes to trade wars. It does not involve tariffs and subsidies by trading partners. It involves the theft of intellectual property. The damages from Chinese theft of U.S. intellectual property will add up to trillions of dollars.” He continues: “The remedies available to President Trump are much broader than those permitted by other provisions of the trade act. Trump does not have to retaliate against a specific good or industry. He can impose penalties on any part of the Chinese economy that arguably benefited from the theft of intellectual property. When it comes to electronics, computer code, and the 'internet of things,' that can be almost anything. When the Section 301 report reaches Trump’s desk he has 90 days to make decisions on penalties on Chinese goods. But, those decisions have already been made. Trump is just waiting for the report. When he gets it, he won’t wait 90 days to respond. He’ll respond almost immediately. So, these opening salvos are just the beginning. There's a lot more trade war damage to come." As the markets react to the moves by Xi Jinping and Donald Trump, it is important to remember that there is a wonderful co-dependence between the governments in Beijing and Washington. Both leaders need a new enemy to distract their restive populations from other issues. In the case of President Donald Trump, he needs enemies to distract attention from the increasingly erratic and scandal prone nature of his government . We note, in this regard, that our colleagues at Kroll Bond Rating Agency just assigned a "AAA" rating to the United States even as we stare at $1 trillion plus annual fiscal deficits. Really? For Uncle Xi, he seeks to focus attention away from the growing tyranny and insecurity evidenced by China’s return to 1950s style authoritarianism. With growing concerns about the political stability of China, including unflattering comparisons of Xi with Romanian dictator Nicolae Ceaușescu (1918-1989), it will be increasingly difficult for corporate cheerleaders in the West to sell the China growth story. In the case of both Uncle Xi and President Trump, we should remember the words of George Orwell in his 1944 classic, “Animal Farm: A fairy story.” “Twelve voices were shouting in anger, and they were all alike. No question now, what had happened to the faces of the pigs. The creatures outside looked from pig to man, and from man to pig, and from pig to man again; but already it was impossible to say which was which.” Happy Easter. #NicolaeCeaușescu #XiJinping #DonaldTrump #JamesRickards #LelandMiller #ChinaBeigeBook #JimiHendrix

New York | Next week we launch the first paid product for The Institutional Risk Analyst , "The IRA Bank Book," which will feature our concise thoughts on the US banking industry and credit markets, along with some pretty charts to illuminate the discussion. More on this soon. This week the markets await the first press conference of Federal Reserve Board Chairman Jerome Powell, a tribal ritual that brings together the media, investors and policy makers in a shared experience of confusion, accidental misstatement and deliberate obfuscation. The question we all ask is whether the Federal Open Market Committee will raise targets for short-term interest rates a quarter of a percentage point? Or More? How soon? But the question that we ought to ask is this: How long will it take for the narcotic effect of central bank market intervention to wear off? And what happens to market volatility as the end of official suppression of rates and credit spreads slowly plays out. Will there be lumps in the proverbial gravy train on Wall Street? Yeah… "We make linear forecasts but in reality, interest rates, corporate profits and exchange rates—all crucial measures of return in their markets—are actually nonlinear series,” writes our friend John Silvia, Chief Economist of Wells Fargo & Co (NYSE:WFC). “This is an important challenge to how we think.” Indeed, the biggest challenge facing market analysts is to ignore the linear data that overwhelms our senses and focus on the random nature of markets. Consider the idea of record bank profitability, a theme repeated over and over again by the financial media. But is this true? One of the things we focus on in the inaugural issue of "The IRA Bank Book" is whether the US banking industry is really profitable given the huge disparity between the rising interest earnings of banks and the still tiny, heavily subsidized cost of funds for the industry. One of the costs for consumers of central bank intervention has been the transfer of trillions of dollars in income from savers to debtors such as banks over the past decade. In Q4 2017, the total interest expense of all US banks was just $21 billion, but banks made $150 billion on total earning assets at the end of 2017. A decade ago, the interest expense of a smaller US banking industry was $100 billion vs $180 billion in income. Today adjusted for the 33% growth in total bank assets, US banks should be paying well more than $100 billion on various sources of funding, from deposits to short-term borrowing from other banks to bond investors. With the net interest income of banks at $107 billion last quarter, how much of bank earnings disappears in a rising rate environment? (Q: Do you think investors or journalists can get their minds around the idea of shrinking NIM in a rising interest rate world?) If we simply return to the net interest income spreads of a decade ago, that implies a shrinkage of $25 billion in net interest income for US banks as rates rise. Much depends on how fast deposit rates rise. Just saying. Source: FDIC Meanwhile, away from the relatively blissful world of banks, bonds and borrowed money, the world of global equities and perceived volatility is starting to evidence increased stress. After years of a 100% correlation between stocks and bonds, rate movements are beginning to impact the direction and magnitude of stock price moves. How this process of “normalization” proceeds and at what pace are the imponderable questions. But to John Silvia’s earlier observation, neither equity markets nor bonds follow a linear pattern. Instead, global markets tend to follow a change pattern closer to entropy , where the inefficiency of market understanding and reaction in terms of asset allocation tends to make investors lag events as a matter of course. Even with massive amounts of data, the gap to understanding and then action is considerable and largely random. And this random quality is present both for policy makers and investors, raising interesting questions as to systemic risk events. “The main problem with entropy uncertainty models is that they are used to justify the notion that there’s room to push agendas to the limit line of the outer edge of the envelope that supports the policy maker’s cognitive bias,” opines Dennis Santiago, Senior Managing Director for Compliance and Analytics at Total Bank Solutions. “It’s a rubber band. It’ll snap.” Even with the sharp rise in equity market volatility in early February, many market participants are still groggy after years on maintenance medication c/o the FOMC. An important indicator of changing market perception is corporate credit spreads, which are starting to widen as uncertainty regarding interest rates and the economy grow, as shown in the chart below. The smarter money is already rolling out of equities into the safety of short duration credit, but the broad market still underestimates the possible rate of acceleration in volatility. “Active equities investors were slower to react to last week’s ‘signal’ in momentum ‘reversals’ and defensive / ‘duration-sensitive’ leadership—as such, much more ‘deer in headlights’ yesterday than rest with Long-Short Beta to Nasdaq at the 86th percentile,” writes Charlie McElliott at Nomura. Note to readers: You don’t want to be the deer in the headlights. There are some analysts who believe that Chairman Powell and his colleagues on the FOMC may try to get ahead of the curve and increase rates by more than 25 basis points when the Fed next moves. Powell is in the difficult position of having to remedy the slow pace of FOMC decision making under his predecessor. Although a rise of 50bp is certainly justified by the available employment and inflation indicators, not to mention toppy stock and real estate prices, accelerating the normalization process via Fed action may have a very unpleasant impact on investor perceptions, volatility and most important, credit spreads. Our biggest worry heading into the end of Q1 2018 is that the artificial stability engineered by the Fed is going to snap again, but on a larger scale and more lasting basis than we saw in February. In the event, credit spreads will widen, loss rates on loans and credit products will accelerate, and the US economy may slowly slip into a stall. Fed Chairmen tend to start their terms with a financial crisis and the migration back to normal may be very rough indeed. #volatility #federalreserveboard #entropy

San Diego | Reports last week that Goldman Sachs (NYSE:GS) CEO Lloyd Blankfein was planning to retire by the end of 2018 caused a bit of a fuss. We spoke about the prospect of a change on CNBC’s Closing Bell on Friday. And yes, we do hope Mr. Blankfein goes to Washington, a city where adult supervision is badly needed. As Blankfein prepares to declare victory and hand the leader’s baton to another GS banker, it is worth considering how the investment bank has changed under his tenure and its competitive prospects going forward. While Blankfein did an admirable job stewarding GS through the financial crisis, the bank’s future has never been less certain. When GS was founded by German immigrants in 1869 , the tiny non-bank made its way in a marketplace dominated by large commercial banks. Marcus Goldman built his firm by providing credit to small businesses in New York, what is today known as commercial paper. By the turn of the century, GS was venturing into the world of equity underwriting, leading offering for businesses like General Cigar and Sears Roebuck. You can divide the history of GS into two major periods: the first half, which includes the firm’s early years and the 40-year tenure of Sidney Weinberg; and the second half, which begins with the ascension of Gus Levy as senior partner in 1969. Levy grew the trading business which became the primary source of revenue for GS by the 1970s. Weinberg, who was known as “Mr. Wall Street,” focused on building the firm’s corporate finance business after the 1930s. Under his direction, GS recovered from the Great Depression and became a leader on Wall Street in such areas as real estate and mergers & acquisitions. And yet despite the success of GS, the firm still operated in the shadow of the large Wall Street commercial banks and investment houses. Sidney James Weinberg For example, when the Ford clan wanted to save their business from the Internal Revenue Service after the death of Henry Ford in 1947, the family of Edsel Ford consulted Sidney Weinberg. The result of those efforts was the novel creation of the Ford Foundation, as described in “ Ford Men: From Inspiration to Enterprise . ” But when Ford Motor Co (NYSE:F) went public in 1956, Blyth, Eastman Dillon & Co. got the mandate. GS was the number four underwriter in the deal. Even with Weinberg’s relationship with the Ford family, another firm got the underwriting business. Going back 12 years to when Blankfein took over as CEO, GS was in some respect little changed from the firm created by Gus Levy. It was a large broker dealer with no bank deposit base and a business that rested on two legs, investment banking and trading. A third leg could be added to include the internal funds managed by GS for its partners and clients, a dimension that made the bank part advisor and part private equity investor. With the 2008 financial crisis, however, GS was forced to become a bank – in name, at least – in order to gain access to liquidity and support from the Federal Reserve. While other firms such as Lehman Brothers and Bear, Stearns & Co. were annihilated during the 2008 financial crisis, GS survived, albeit in a different form. With the passage of Dodd Frank in 2010, the major banks were forced to shed their internal funds and principal activities because of the Volcker Rule, which rightly identified the principal activities of banks as a fundamental conflict of interest with the bank’s clients. So today the house build by Marcus Goldman really rests upon just two legs, leaving GS vulnerable to changes in the trading environment. By becoming a bank, GS reassured its clients and came under the regulation (and protection) of the Federal Reserve Board. But in one of the many ironies of this period, the Fed’s purchase of securities as part of “Quantitative Easing” badly diminished the trading business of GS and the other major Wall Street banks. As we described earlier (“ Banks and the Fed’s Duration Trap ”), by taking $4 trillion worth of securities out of the private marketplace, the Federal Open Market Committee not only distorted credit spreads and juiced asset prices, but also suppressed volatility and trading in the secondary markets. Today at just shy of $1 trillion in total assets, GS is one of the smallest of the global universal banks. Compared to other large US banks, GS has among the lowest asset returns and net operating income as a percentage of total assets, but boasts non-interest income as a percentage of its balance sheet that is three times that of larger peers. At year-end 2017, net loans and leases at Goldman’s single subsidiary bank were just 12% of the firm’s consolidated assets vs 70% for most large banks. These metrics illustrate how the GS business model is very different from that of JPMorgan (NYSE:JPM) and Citigroup (NYSE:C) and remains dependent upon transactional income and volatile sources of funding. Let’s compare GS with Morgan Stanley (NYSE:MS), a slightly smaller bank holding company with two subsidiary banks that generates significantly more net interest income as a percentage of its balance sheet. The MS bank units have total assets of nearly $200 billion while the Goldman Sachs Bank USA had total assets of $160 billion at year end. Net loans and leases at MS were almost one fifth of the group’s total assets at the end of 2017 vs about 15% for the GS bank unit. Significantly, Goldman’s dependence upon non-core funding is twice that of JPM and C and roughly four times that of MS. The double leverage of GS (equity investment in subs / equity capital) was 116% at year end vs 101% for larger banks and just 85% for MS. Of note, the double leverage of GS was just 102% at the end of 2014. Credit rating agencies tend to get nervous when double leverage in a bank holding company is above 115%. One of the key measures of financial strength for a universal bank in the post-Dodd Frank world is assets under management (AUM), in part because so many universal banks have de-emphasized trading and focused instead on the regular cash flows of wealth management. At MS, assets under management were $438 billion at the end of 2017 generating an average of 46bp of fee income of $2.1 billion in 2017. Total fee based client assets at MS were $1 trillion at year-end earning 76bp on average or over $13 billion in pretax income. Of the $37 billion in net revenues for MS at year end 2017, 50% came from sales and trading, 44% came from wealth management and the remainder from investment management. By comparison, GS had $32 billion in net revenues at December 31, 2017, with less than a third coming from wealth and investment management and the largest portion from traditional trading and investment banking activities. GS has $1 trillion plus in assets under supervision, plus another $300 billion in liquidity products, yet the Investment Management segment generated half the net revenues of the comparable business at MS. In the half century since Gus Levy became the leader of GS, investment bank and trading remain the two largest segments at the firm. As and when new leadership takes over GS from Lloyd Blankfein, the key issue that confronts the firm is how to grow its current business model into a more balanced and less volatile franchise. Each time that GS has stumbled in terms of earnings from trading, for example, the firm has spent a great deal of time talking about growing the Goldman Sachs Bank into consumer deposit taking and lending. But these are low return businesses that offer more risk than reward. Trading cryptocurrencies was another suggestion advanced by Mr. Blankfein after a disappointing earnings report, a decidedly bad idea whose time hopefully has come and gone. As we discussed on CNBC last week, the opportunity for GS is to go where the larger banks are not. GS, for example, went into real estate finance, M&A and risk arbitrage long before the larger bulge bracket firms. In the wake of the 2008 financial crisis, many of the larger US banks have backed away from consumer finance and instead focused on lower risk wealth management and business lending. If GS chooses to remain a commercial bank, then it might consider acquiring another depository with a real retail deposit base and an established lending operation, hopefully one focused on business lending where spreads are higher and risks considerable lower. Construction lending, for example, is a short duration asset business that many commercial banks have fled, but it can be a very lucrative and low-risk business if managed properly. It also leads to other types of lending and asset securitization opportunities in real estate that GS knows very well. But if GS is to survive and prosper in the 21st Century, it needs to rely upon its legendary ability to see and execute on new opportunities before the larger players. Trading and investment banking are the heart of GS, but trying to grow consumer banking as the third leg of the stool seems like a bad trade, even if it helps to grow the wealth management business. Also, fighting with other banks and non-banks for the honor of earning 70bp on AUM is a tough way to get to double digit equity returns. If Lloyd Blankfein and his colleagues want a real world model for an innovative way to grow his bank we respectfully suggest two examples from the world of “fintech” (both of which we own): Square (NYSE:SQ) and PayPal (NASDAQ:PYPL). These are pioneers, “disruptors” in a sense, but also represent incremental additions to the existing monopoly of big banks in the world of payments processing. In each case, SQ and PYPL saw an opportunity to extend and reprice an existing business controlled by the largest banks and did so in partnership with the banks! SQ, for example, completely disrupted the sleepy world of bank merchant processing for credit cards and thereby created a new market segment and a new revenue stream. The entry of Starbucks (NASDAQ: SBUX) into the banal world of coffee is another example of creating a new, higher margin segment atop an established marketplace. The challenge for GS is how to leverage the fact of being a commercial bank into new, emerging markets where the big banks are not yet established. The trap that GS wants to avoid is doing what the larger universal banks are doing, but on a smaller scale. This is the unfortunate pattern that ultimately led to the demise of Lehman Brothers and Bear Stearns, which lacked the size, client base and liquidity to survive when the financial tide went out. When Sidney Weinberg and Gus Levy ran GS, they had not yet achieved the wealth and public acclaim that the firm has today. GS was still a tiny non-bank brokerage firm compared to the giant behemoths of Wall Street, which financed the Goldman business and still do today. GS is too small as a bank and too large as a securities firm to be a non-bank. GS has the financial wherewithal and reputation to make a bold move that allows them to break out of the established Wall Street model, but the question is whether they have the imagination, hunger and courage to take that risk. Fortunately, Weinberg and Levy provide pretty good role models for leading change.

In this issue of The Institutional Risk Analyst, we feature a comment by John Mouseau, Executive Vice President & Director of Fixed Income at Cumberland Advisors. You can read more of Cumberland's always timely comments on the financial markets at www.cumber.com . Sarasota | The Wall Street Journal had a story on the front page of the “B” section Wednesday morning about banks getting some relief with regard to counting municipal bonds among their “liquid assets.” On Tuesday the Senate voted to formally debate a bill containing that provision, and it should have enough Democratic support to pass. The debate over this issue has been going on for some time, and we wrote about it in 2015 ( http://www.cumber.com/hqla-and-lcr/ ). We always thought it was a mistake on a number of fronts that munis were left off the list of high-quality liquid assets (HQLA). First and foremost is the importance of banks in the marketplace. Because of the tax exemption, banks have been buyers of tax-free municipal bonds for years. The level of taxation on municipal bonds clearly has an effect on banks’ decisions to own tax-free or taxable debt. So changes in the tax structure are one input into the buying decision. The banks’ book (purchase) yields are another input, and the designation of bonds as either “available for sale” or “hold to maturity” is another input. (Without getting overly complicated, the distinction is that realized gains or losses from “available for sale” bonds flow into the income statement, while bonds in the second category are generally held to maturity and recorded at cost.) However, one of the most important purchase considerations is the generally high credit quality of the overall municipal bond market. Moody’s publishes a study that is updated approximately every two years in which it compares municipal bond and corporate bond default rates by rating categories over a ten-year period. In the last report, for 2016, in the broadest category, “A”-rated municipal bonds had a cumulative default rate over ten years of .07%, while that of corporates (globally) was 2.22%. While both numbers are low, the corporate default rate is 31x that of municipals in the “A” category. If you look at the numbers cumulatively, including AAA to A, the default rate for munis is .09% in total and 3.38% for corporates. In this case the corporate default rate is 37x that of municipal debt, which implies that there is higher event risk in corporates (e.g., in high-quality bonds subject to the stress of takeovers). The fact that high-quality corporates were included in the 2014 bill as high-quality liquid assets but municipal bonds were not has always stuck in our craw. General Electric was rated AAA by Standard & Poor’s up to 2009, when it lost its gilt-edged credit status and is now rated A, yet the State of Maryland has been a AAA credit before, during, and since the financial crisis. Our point is that on a credit quality basis municipals have outshined corporates for many years and in most cases have provided better taxable-equivalent, risk-adjusted yields for banks. Why would regulators be prejudiced against the muni credit? Our thought is that lobbying by state and local governments was lacking four years ago when these regulations were first promulgated. And there tends to be inertia among banks to modify rules once regulations are in place. But make no mistake; this new bill is a winner for banks and a winner for the muni bond market. Banks may have a lower tax rate but that will not necessarily disturb higher purchase yields. And the fact that munis should be able to be counted as high-quality liquid assets will further cement their part in banks’ portfolios. Indeed, this bill will help Congress put the “quality” into the “high-quality” designation. #munis #HQLA #Congress #Mouseau #CumberlandAdvisors

New York | Count the numbers of markets and economic indicators currently at extreme valuations and positive correlations. Financial markets showed a glimmer of normality last week when stock prices fell and bonds rose. The surprise expressed by market participants is an illustration of just how long investors have been dealing with a market where all manner of assets are correlated and at multi-year highs. We talked about this last week with our friends at BNN in Toronto in a TV hit from Bloomberg TV in New York. To our readers: We are ending our weekly email notifications via our third-party listserve. If you’d like a reminder from Wix when new items are posted, please register again at www.theinstitutionalriskanalyst.com and you can manage your subscription directly. As before, new items will be posted on Twitter , Google and other social media . Apologies for any inconvenience. – The IRA Markets were abuzz last week over the prospect of a trade war, but we see President Donald Trump’s latest outburst over tarrifs as the opening salvo in the 2020 election cycle. Yet a number of observers are openly wondering if the latest upward move in interest rates is essentially finished and if the next leg for the 10-year Treasury is a bull rally back down to the low 2% range in yield. As the chart below illustrates, the 10-year popped to 2.8% yield following the November 2016 election, then re-traced back down just shy of 2% yield on September 8th of last year. Despite the latest upward move in rates, we remain in the bond bull, flattening yield curve camp for the simple reason that there is still far too much liquidity – call them dead presidents -- chasing scarce assets. Even with credit problems emerging around the world following eight years of irrational easing by the Federal Reserve and other central banks, the markets and particularly credit spreads remain remarkably calm – almost too tranquil. It’s as though that last big dose of monetary thorazine from former Fed Chair Janet Yellen still has not quite worn off. Should long-term interest rates continue to rise, however, we think it is fair to ask whether the period of low credit costs and artificially boosted economic activity in the US also is ending. It is clear that the proverbial party is over in autos, with rising credit standards and falling sales incentives more than tapping the brakes on industry volumes. The particularly nasty chart below shows monthly light vehicle sales in the US through January 2018. Default rates on prime auto loans held by banks have essentially doubled since 2015 and now stand at 1%, which is really not a big deal compared with unsecured loans. But the rate of change is notable. The Wall Street Journal reported last week that residual values for cars coming off lease are falling, one reason why dealers and the automakers have pulled back on costly sales incentives. By no coincidence, loss given default (LGD) for auto loans, which is calculated as charge-offs less recoveries divided by charge-offs, has risen 10 points over the past three years to just under 70% of the original loan amount. LGDs are essentially the inverse of asset prices in a given loan category, thus rising LGDs for auto loans is another way of saying that prices for used cars are weakening. Our pals at the Federal Deposit Insurance Corp reported last week that provisions for future credit losses for all loans and leases have increased nine quarters in a row, albeit from very low levels seen in the trough of 2015. But the key question facing investors is whether the end of the period of extraordinary ease by global central banks will now see a decline in economic activity and an increase in credit costs for US banks and bond investors. The secular increase in asset prices for stocks, bonds and particularly real estate is exhibit number one in this analysis. As we’ve noted in past issues of The Institutional Risk Analyst , the credit metrics coming from US banks in asset classes such as 1-4 family home loans and multi-family real estate are anything but normal and suggest an adjustment down the road. Will home sales and even prices follow the bearish example of autos? It is interesting to see, for example, that past-due 1-4s owned by banks actually rose to 2.7% in Q4 ’17 after falling steadily for the past five years. More thought-provoking, however, is that fact that record low LGDs for bank owned 1-4s have stabilized at just 24% of the original loan balance vs the 25-year average of 65%, as shown below. Is the next leg up? Source: FDIC Like the chart for auto sales above, the LGDs of 1-4 family loans exhibit a large degree of skew from historical norms, something you’d expect to see after years of experimentation by Chair Yellen and her colleagues on the Federal Open Market Committee. The researchers at the San Francisco Fed (hat tip to Rosie) put it very nicely in a January 8th comment: “Current valuation ratios for U.S. equities and household net worth are high relative to historical benchmarks. The cyclically adjusted price-to-earnings ratio reached its third highest level on record recently, and the ratio of household net worth to disposable income, which includes a broad set of household assets, stands at a record high. Such extreme values of these ratios have historically been followed by reversions toward their long-run averages. However, other current factors, such as low interest rates, caution against bearish forecasts.” So if Yellen and company have front loaded a decade of growth into the past five years, what does that say about prices for stocks, bonds and particularly real estate? While the price increases illustrated in the world of 1-4 family loans suggest a considerable deviation from long-term averages, the degree of skew in the world of multifamily real estate is even more pronounced and suggests a proportionately great degree of asset price distortion. The chart below show LGDs for the $400 billion in bank owned loans backed by multifamily residential properties. Like 1-4s, the default rates on this asset class are extremely low – in large part because distressed debtors are often taken out of these exposures short of a formal default. Last quarter, LGDs for bank multifamily exposures fell to minus 109%, meaning in cash terms that recoveries exceeded charge-offs 2:1. Source: FDIC This chart describing relative change in collateral valuations in the multifamily sector suggests that these assets are overvalued and must, eventually, revert to the LT mean. Also, if the weakness in autos suggests a more general slowing of economic activity, particularly among consumers, how much should banks and bond investors expect loss rates – and LGDs – to rise in coming months and years in related asset classes? The good news is that both 1-4s and multifamily assets are quite solid historically, with the 2007-2010 period of extreme losses standing out. Losses on bank owned 1-4s peaked at the end of 2009 at a whole 2.47% for $2.5 trillion in loans. Multifamily loans held by banks saw net charge-offs peak at just 1.77% at the end of 2009. The chart below shows loss and past due rates for both 1-4 family and multifamily loans. Source: FDIC Compared with unsecured consumer loans, the real estate exposures of US banks have performed quite well over the past 25 years. For example, the charge off rate on the $850 billion in credit card receivables held by all US banks at year end was 3.77%. Of course, credit cards are a much more profitable product for banks than making loans on real estate. But the unusual behavior of the credit loss experience of these asset classes today suggest that prices are very toppy indeed. Both the low loss rates and LGDs displayed by real estate portfolios illustrate the high value of the collateral behind these bank credit exposures. The key question for investors and risk mavens is when or even if these valuations actually adjust downward. When you price credit at zero and compress spreads via brute force methods like quantitative easing, it is easy to conceal a lot of sins in credit terms. For example, the dearth of assets engineered by the Fed has also led to a deterioration in credit covenants and other investor protections. Yet even today, few economists inside the Fed system have publicly stated that QE was overdone, that is distorted markets, and has perhaps created the circumstances for the next financial crunch. Fed Chairman Jerome Powell brushed aside a new paper by two Wall Street economists and two academics questioning the effectiveness of QE, but the next couple of years may reveal some significant real world costs of this ultimately speculative policy. The bad news is that the enormous skew in asset prices engineered by the FOMC may hold significant credit risk in the future. The twin shocks of rising interest rates and widening credit spreads could significantly increase loss rates across the board in US and global banks. Looking at the body language of US regulators, it is hard to avoid the conclusion that the supervisory community is bracing for a repricing of risk.

New York | None other than Warren Buffett of investment fame started off the week complaining to Becky Quick of CNBC that there’s not enough big things to buy. Railroads? Airlines? Not even Wells Fargo & Co (NYSE:WFC) suffices to satiate Mr. Buffett's hunger for assets. With over $120 billion in cash burning its way through his trouser pocket, the best that the Sage of Omaha can come up with is buying one of the most overvalued stocks of all, namely the computer cult led by Apple Computer (NASDAQ: AAPL). Sure sounds like inflation to us. Too much cash chasing too few goods or at least good opportunities? Of note, we’re scheduled on CNBC WorldWide Exchange this Tuesday at 5:50 ET with Wilfred Frost to talk about the outlook for JPMorgan (NYSE:JPM) and other financials. In a year with rising volatility and slow loan growth, valuations for large banks are back to 52-week high but with virtually no change in the outlook for earnings save from changes in corporate taxes. In 2017, the only two loan categories at JPM that grew were real estate and agriculture, including some festering CRE multifamily exposures we can see out the office window here in Midtown Manhattan. As we’ve noted previously, the gross yield on JPM’s loan book was only 4.57% through the end of Q3 ’17 vs. 6.9% for Citigroup (NYSE:C) due to the subprime consumer and credit card book. But the gross yield on Citi’s commercial loan book is half JPM’s, illustrating the extreme competition for assets in the world of large commercial bank credits. Once you net out 100bps of SG&A, getting to the Street's 6% revenue growth rate for JPM obviously depends on the trading and advisory side of the bank. Indeed, Street analysts have JPM growing revenue 6% in Q1 and ~ 4% for all of '18. Positives are rising interest rates in terms of NIM and a positive mark on the bank's MSRs. Net interest income was up mid-teens for JPM in 2017. Negatives include slowing loan growth, still modest trading/FIG volumes, and a soft residential loan market. JPM, Wells Fargo & Co (NYSE:WFC), and Bank America (NYSE:BAC) are paying up big time for jumbo mortgages in major MSAs, a large but unprofitable business for years to come. Same goes for C&I loans and CRE, which really peaked in terms of volumes in '16 and have been slowing every since. Like WFC, big negative for JPM is size. The bank's yield on earning assets is in the bottom decile of large bank peer group. The bank’s overall results are boosted by trading/asset management, which is half of the bank, but precious little vigorish is coming from the loan book. The same shortage of assets that so vexes Warren Buffett is putting enormous downward pressure on bank loan yields and even relatively inaccessible assets such as GNMA MSRs, which are changing hands around a 9% unlevered yield according to our friends at Mountain View. This is half the yield seen for GNMA MSRs back in 2012, another indication of the tightness of asset markets. So on Tuesday as former Fed Chairs Janet Yellen and Ben Bernanke are celebrated at Brookings Institution in Washington, we will no doubt hear some cautious discussion about rising risks of inflation. But in fact Chair Yellen and her colleagues on the Federal Open Market Committee have already baked double digit inflation into asset prices. This type of thinking apparently prompted Goldman Sachs (NYSE:GS) to issue a report suggesting a stock market collapse if the 10-year Treasury bond reaches 4.5% yield. We take some comfort that bond spreads have not moved significantly even as the yield on the 10-year has backed up three quarters of a point from the 2016 lows (see chart below). But the latest CBRE report on cap rates for commercial real estate shows record tight spreads in multifamily. And we keep wondering if the systemic shortage of investable assets will cause another bond rally such as followed the 2016 election. Now the slow increase in interest rates and, dare we say, volatility will eventually boost the possibility of revenue growth on the trading side of banks like JPM and C. Our former colleague Mike Mayo has triple digit growth targets for earnings from JPM and Citi over the next three years. But to hit those generous levels of earnings growth, the FOMC needs to figure a way to lighten the system portfolio and increase trading volumes on the Street. With rates rising and the “economic cycle” showing signs of maturity, it is hard to see where we can grow volumes in the large banks to fulfill those sort of bullish earnings estimates. Indeed, the biggest risk to the overheated equity markets is the Fed. If Fed Chairman Jerome Powell is true to form during his two congressional appearances this week, look for him to continue speaking forthrightly about things like inflation and deficits. Powell also may surprise everyone and scold Congress for again raiding the Fed's capital to "pay" for the most recent spending bill. The Federal Reserve Chairman is the nation’s banker. He has a duty to speak up when Congress and the Executive Branch are so badly wrong on so many issues. He can start by explaining to members of Congress why the Fed and Treasury are alter egos and why remittances from or the assets of the Fed are not valid sources of new public revenue. None of this is particularly good for the markets. Powell is the most intelligent, forthright and decisive Fed Chair we've seen in many years -- and he is not an economist. We think Chairman Powell is likely to break the golden rule of Washington, which is to never tell the truth in public. #JeromePowell #JanetYellen #JPMorganChase #WellsFargo #Citigroup #C #JPM #WFC #GS #GoldmanSachs

"Al", retired Wells Fargo stagecoach pony New York | Wall Street more than bounced last week as the secular shortage of stocks quickly snapped investors out of their collective funk. But one once stellar performer in the large cap financials, Wells Fargo & Co (NYSE:WFC), hung back from the surging crowd. In years gone by, Wells was the quiet exemplar of operating efficiency among large banks, but no more. Today WFC is the bank that everyone loves to hate. But while WFC may be the object of scorn, its operations continue pretty much as before. As we told SquawkBox a week ago, having WFC trading at a discount to JPMorgan (NYSE:JPM) is not a normal state of affairs. The former has better nominal as well as risk adjusted returns than JPM on most days, but of late WFC senior management has been slicing off figurative fingers and toes in a stunning display of reputational self-destruction. With WFC up just single digits for the year following the perfunctory sanctions from Chair Janet Yellen and the Federal Reserve Board, and its large bank peers up 3x this amount, the question many investors ask naturally is whether Warren Buffett’s favorite bank is good value compared with JPM and other peers. The short answer is “Yes” – but only if you believe that WFC, sans problemas , ought to be trading at 2x book value. With JPM at 1.7x book, WFC in normal times should be trading at a 20-25% premium to the House of Morgan. But these are hardly normal times. It seems more than ironic that at a time when financials are trading at all time highs, one of the more dependable large banks has managed to put itself into the penalty box with progressive politicians and federal regulators. Ron Lieber of The New York Times last week listed the long bill of particulars against WFC: “Any one of the sins that Wells Fargo committed against consumers would have been bad enough. There was the unnecessary auto insurance it forced auto loan borrowers to buy. And the data breach where scores of the bank’s wealthiest clients woke up to the news that a lawyer for the company had handed over their personal information to an adversary. Plus accusations of unauthorized changes to people’s mortgages. And those fake accounts — numbering in seven figures — that employees created in customers’ names.” Lieber then goes on to bemoan the fact that he cannot pull all of his business from WFC, including the operationally challenged world of loan servicing. WFC has $1.7 trillion in loans it manages as a loan servicer. In the consumer centric world of financial journalism, it may seem entirely appropriate for borrowers to have the option – nay, the right – to decide who services their mortgage. But in fact it is the investor in the mortgage note, frequently Uncle Sam, who ultimately makes that decision. For the past two decades, WFC has built a huge business originating and servicing residential and commercial mortgages. By default, when investors purchase a mortgage backed security (MBS) issued by a large universal bank such as Wells, they also select the loan servicer. WFC originates or buys the billions of dollars per year in residential mortgage loans, packages them into securities, and then issues MBS while retaining the right to service the loans, what is known as mortgage servicing rights or “MSRs.” Servicing rights such as MSRs are naturally occuring negative duration assets, the opposite in technical terms to a loan portfolio or a Treasury bond. This invaluable quality makes MSRs perform well in a rising interest rate environment as we see today. But most Sell Side analysts neither know nor care about such details when it comes to following mortgage focused banks and non-banks such as WFC. And only a few members of the mainstream financial press such as John Dizard at the FT dare to write about MSRs. The total carrying value of WFC’s residential and commercial MSRs was $14.7 billion at September 30, 2017, and $14.4 billion at December 31, 2016, or a bit less than one percent of the $1.7 trillion in total outstanding principal balance of mortgage paper that Wells services. The nation’s largest loan servicing portfolio (WFC owns about one third of all bank owned MSRs) generates significant income for the bank, but is also perhaps the most problematic business for WFC due to the consumer facing risks that arise in the mortgage world every single day. You can argue that the large financials are overvalued, as we did on CNBC's Halftime Report the other day, but don’t fight the Fed, ECB and Bank of Japan all at once. The path to “normal” as defined in the Gospel according to St Janet will take years longer than the Federal Open Market Committee admits publicly. Note, for example, that the estimated timing of prepayments on the Fed’s portfolio of RMBS is clustered in the mid-2020s, at least for now. Like Sell Side bank earnings estimates, the FOMC numbers on monthly portfolio runoff rates will change over the course of 2018. The beauty of MSRs is sadly called “extension risk.” Rates rise, bond prices fall, prepayments decrease, duration and IRR increase, and the fair value of your MSR magically grows. Kidder Peabody (1986)? Long Term Capital Management (1998)? Citigroup (2008)? All of these firms died due to extension risk on various types of pass through securities, one reason why the SEC effectively banned non-banks from issuing their own MBS in 1998. By amending Rule 2a-7, the SEC not only may have killed LTCM, but it made it impossible for nonbanks to issue their own paper. The SEC under Chairman Arthur Levitt handed the largest banks a monopoly in making and servicing home mortgages. It is hard to ignore the superior performance of WFC vs other large banks, even if you assume no balance sheet growth due to the Fed sanctions and the risk of its many consumer facing businesses. WFC has equity returns that are two points better than its assets peers and with similar risk adjusted returns on capital (RAROC). The only name in the top five banks with even close to WFCs’ equity returns is USB, which deliberately manages its size at below half a trillion in total assets. Source: TBS Bank Monitor Q3 2017 Could smaller mean higher ROEs at WFC?? An intriguing possibility. The travails of WFC are a blissful situation, however, compared to the life and death situation that confronts many non-bank mortgage firms as the first quarter of 2018 heads to a close. Indeed, market pressures are seemingly driving a renewed focus on M&A. Nationstar Mortgage (NYSE: NSM) last Tuesday announced a nearly $4 billion merger with WMIH Corp. (NASDAQ: WMIH), the successor company to mortgage originator Washington Mutual. After 2008, WFC and other large banks sold problematic mortgages to non-banks such as NSM. Firms such as Countrywide and Washington Mutual, though technically commercial banks, operated as non-banks in the secondary market for home loans and funded themselves mostly with short-term money. Let’s walk down memory lane. In September 2008, readers of The IRA will doubtless recall, JPMorgan Chase acquired the banking operations of Washington Mutual Bank in a transaction facilitated by the Federal Deposit Insurance Corporation. JPMorgan Chase acquired the assets, assumed the qualified financial contracts and made a payment of $1.9 billion to the FDIC. Claims by equity, subordinated and senior debt holders of WMIH were not acquired and ended up in bankruptcy in Delaware. "For all depositors and other customers of Washington Mutual Bank, this is simply a combination of two banks," FDIC Chairman Sheila C. Bair said that fateful day. "WaMu's balance sheet and the payment paid by JPMorgan Chase allowed a transaction in which neither the uninsured depositors nor the insurance fund absorbed any losses," Bair added significantly. Of course, when the FDIC seized the bank and sold it to JPM, it left the controlling financial investor, Texas Pacific Group, high and dry. From bankruptcy, the predecessors of WMIH commenced nearly a decade of litigation with the FDIC and other parties over disputed assets of the failed bank. When WMIH won a $2 billion judgment against FDIC, the bank insurance agency then turned around and sued the officers and directors of WaMu for the now $2 billion deficiency in the FDIC fund. God does have a sense of humor. WMIH’s merger with NSM marks a new page in the firm’s corporate history. With a decade of litigation behind it, WMIH now boasts a couple hundred million in capital and $6 billion in usable net operating loss (NOL) carryforwards. WMIH also has a new private equity sponsor, KKR, who is joined by Texas Teacher Retirement Fund and Greywolf Capital. The NSM transaction also may mark the start of a consolidation in the world of mortgage finance and servicing, where over-capacity is hurting profitability as loan volumes and servicing assets steadily fall. But don’t look for any large banks to be buyers of large non-bank mortgage firms. WFC is one of the few large banks that remain in the market for government-guaranteed FHA loans and Ginnie Mae securities. As non-bank seller servicers exit the GNMA market, banks such as WFC and Flagstar (NYSE:FBC) will be under pressure from regulators to pick up the slack or even acquire insolvent non-banks, but likely that door is closed for the largest banks. Thanks to Dodd-Frank and the CFPB, federal bank regulators consider consumer facing businesses toxic for the large banks. They have effectively told WFC et al to avoid reputation risk at all costs. Even if WFC is not allowed to grow its assets for the next several years, we expect the bank to eventually return to a slight premium to JPM. We see two possibilities. Either a) WFC is going to slowly rise to 2x book value vs JPM’s 1.7x multiple or b) JPM and the other larger banks will slowly adjust downward as the full weight of securities issuance descends upon the major banks in the post-QE world. Just for the record, we are betting on the latter scenario as Wall Street desperately seeks a reasonable explanation for current market valuations. Just remember that reaching “normal” and adjusting asset prices accordingly will take years thanks to the over-generosity of Chair Yellen and the FOMC. #WellFargo #JanetYellen #FOMC #WFC #JPM #NSM #WMIH #FBC

New York | In this issue of The Institutional Risk Analyst , we turn our attention to the auto sector. Kevin Tynan is the Senior Automotive Analyst at Bloomberg Intelligence and has been covering the industry for decades. We first met Kevin during the research for " Ford Men: From Inspiration to Enterprise " and value his insights on the automakers and the macro trends that impact this particularly American industry sector. We spoke to Kevin last week at his office in Princeton. The IRA: Ford just reported lackluster earnings, making more money per unit on lower sales. How do you assess the situation facing the US automakers? Is this a case of the industry shrinking or is there a more nuanced explanation for the competitive situation is facing the US automakers? Tynan: Those issues are really Ford specific. They are caught between this smallish product portfolio that is very dependent upon one nameplate, namely the F-series pickup truck, and the lack of other products. Lincoln only did sales of about 100,000 units last year. The market in the US is just about to touch 70 percent trucks overall and Ford is about 76%. But Fiat-Chrysler was 90 percent trucks in January or nine out of ten units sold were some form of truck. GM was about 80% trucks and SUVs in January, but they have a much broader portfolio. They have GMC which is only trucks and Silverado under the Chevrolet brand and all the trucks in Buick and even Escalade in Cadillac. The IRA: Wow. It gives us a feeling of déjà vu when you describe the industry. Nothing has really changed, has it? For much of the 20th Century Ford was only ever compared to Chevrolet because it was so much smaller that the colossus of General Motors built by Alfred Sloan. Ford never had a move-up offering for its customers from the basic Ford models and now is dependent upon a premium truck line. Tynan: Just looking at the statistics it may seem so, but under the surface it is really different. If you go back to pre-bankruptcy days for GM and Chrysler, one thing that is different is the definition of a truck. When gas was $4.50 per gallon you really saw the consumer shop on the car side of the dealership. You don’t see that today. A decade ago most SUVs were being built on a truck platform, but that is not the case at all today. These were full frame vehicles. Today there are very few SUVs that are built on the same platform as the pickups. The IRA: What we call trucks in the data are really passenger cars, is that the point? Tynan: Yes. Fuel efficiency has improved so dramatically compared with 2008 that the price of gasoline is no longer an issue for consumers. Even if there was a spike in gasoline prices, consumers would be buying smaller trucks not go back to the car side. The IRA: So is it really fair to say that the industry is 80% trucks or has the definition of a truck now become blended with a passenger car into the now ubiquitous crossover? Tynan: It is just a different type of truck. Look at the Ford Explorer, which was really the first mass produced SUV and was built on a truck chassis. Now the Explorer is built on the same platform as the Taurus. Nissan Pathfinder shares a platform with the Altima. There are a lot of crossovers out there that look like trucks but are built on passenger car platforms. They have the driving dynamics and efficiency of cars. There are a couple of automakers who are really too car heavy and they are scrambling to move to trucks. VW, BMW and Tesla are all upside down in terms of the focus on cars. Tesla is valued as a tech company, but as a car maker they are in precisely the wrong place in terms of consumer who want a higher ride and other attributes of a truck or crossover. The IRA: Don’t get us started on Tesla. It’s a toy. Tesla is a beautiful model slot car built by a guy who thinks he’s Tony Stark. Elon Musk is clearly a genius, but he should stick to building rockets. He just spent a couple of billion dollars to put a Tesla into orbit on the Falcon Heavy rocket. Maybe Tesla could build a flying car to cut the commute to JFK? Tynan: Well, Tesla could at least build a car that consumers want. The IRA: We spent a couple of weeks in Uruguay over the holiday and there were a number of brand new Maserati SUVs in Punta del Este. With the taxes that is a very expensive car, but the ladies love them. My spouse has a passion for the Porsche Cayenne – not a 911. She wants the SUV, but then again, she also thinks the new F-250 Super Duty is pretty cool. Tynan: What you are seeing with the premium brands – Jaguar, Lamborghini, Porsche and BMW – are lower, wider SUV crossovers. I was joking with somebody the other day that we may eventually see the return of wagons for people who don’t want that high, floating feeling and want to sit low but want the utility of a truck. The wave of the future may be a return to wagons in the guise of a crossover. The IRA: I drove a Lexus LX 300 for many years. That was the first round, stylish SUV that really appealed to women. It was dependable and great on gas. But most men seem to prefer sedans. Look at the Audi A-3 mini wagon, which unfortunately became a sedan. Tynan: Have a look at the Volvo V-90, absolutely gorgeous wagon. It is beautifully designed and they just came out with the Cross Country version which is a legitimate wagon you can take off road. All wheel drive, all you need. The IRA: Let’s talk about mobility. Has the panic over mobility subsided or are all of the automakers still chasing this threat/opportunity? Tynan: There is a lot of capital being wasted on mobility. It feels strange. Automakers are trying to reinvent themselves by getting into things they have never done before. The automakers are chasing relevance. There is a lot of money being spent with no ROI attached to it, but what is interesting is that this is what is driving valuations in the market right now. The IRA: Yes, it's called the Amazon model. Go out and spend as much as possible and grab market share and pretend that you are Jeff Bezos. Or look at Uber, a car service with Internet enablement that has no comparative advantage long term. Uber is burning capital to subsidize a car service for urban millennials who may never own a car. There seems to be a massive misallocation of capital in the mobility space on an almost Chinese scale. Is this too harsh? Tynan: The fascinating thing about Uber is the idea of level five self-driving. If you take the cost of the driver out of the equation, let’s say its mid-five figures, that becomes interesting. You can amortize the cost over five years for a car that runs 24x7. Can we ever get to level five? Will the government ever support the investment required? I don’t know. Robo taxis everywhere. If the current model does not make money, then you take out the most expensive part of the model which is the driver, then maybe you have a shot at profitability. The IRA: Well, we see it in the movies so it must be true. The 1973 Woody Allen film “Sleeper” is the first self-driving car we can recall. That is going to take some time. New highways with the guidance systems embedded in the pavement. But more to the point, who is going to insure the operation of these passenger vehicles? Tynan: Correct. We are legitimately at level two now and some manufacturers with large corporate parents will maybe get to level three in a few years, but nobody ever talks about the cost. It is challenging today to put $1,800 options in passenger vehicles. The cost of a driverless car is going to be enormous compared with the price of today’s vehicles. Frankly, the auto industry is not going to get to level five for consumers anytime soon. The IRA: To that point, doesn’t it make more sense for the first autonomous vehicles to be trucks or busses? Issues like safety and liability almost force the first roll-out of driverless vehicles to come in use cases other than passenger cars. Tynan: Think about congestion. There are valid applications for cars to operate autonomously and, say, drop you off at work and then carry other passengers while you are at work. But I am not sure that this really addresses congestion in urban areas. The IRA: More to the point, think about the current trends in housing. Less affluent populations are being forced out of the center cities into the suburbs. These people are going to need transportation to get to work, to school, to shop, etc. The demographics are compelling. Tynan: I’d be happy if we could fix the potholes. I have an eight mile commute on Route 206 towards Princeton in the morning and the roads are a mess. We don’t invest enough in infrastructure. The idea that we are going to wire the entire country or wireless the entire country so that autonomous vehicles can drive at 80 mph eight inches from each other seems a bit of a stretch. The IRA: Sounds like the sales pitch for Blockchain. So talk about the auto sector going forward. The auto sector went from death and destruction in 2010 to an amazing rebound through 2016. What should we expect over the next decade in terms of auto sales? Tynan: We hear a lot of analysts talking about “peak auto.” In 2016 we saw a record at 17.5 million units and then sales fell a bit in 2017. In fact, 2014 was “peak car” but on the truck side of the business demand is still increasing. Hard as it may be to believe, approaching 70% trucks for the industry as a whole is still not yet a peak. Those two categories – compact car and midsize car – really dwindled as crossovers and compact crossovers specifically surged. Compact crossover is the largest segment in the industry now. But as sales volumes for smaller car segments fell, trucks and SUVs simply could not grow fast enough to meet demand. Investors look at US auto sales and say “they’ve peaked, they’re plateauing.” But in fact car sales have fallen so fast that truck sales are struggling to keep up – but making a valiant effort at it. The IRA: So what should investors be focused on with the automakers? Tynan: The profits from truck sales are so much better than cars - automakers are actively deemphasizing their car offerings or at least the smart manufacturers are doing so. The IRA: Tastes have clearly changed. Going back to the Model T Ford, the car was essentially a wagon with a gasoline engine. Then we evolved large, enclosed passenger cars and trucks were really meant for commercial use. It took years for engineers at Ford to convince Henry Ford to make a Model T truck. And even then, you had to buy most of the parts for your Model T from the Sears catalog. But now consumers seem to embrace the crossover as the ideal design. Based on your comments, it sounds like the crossover is the design archetype for the future. Tynan: The higher ride height is clearly in favor, especially as more and more people buy SUVs. The fact that you can seat six people is also a big attraction. The utility of a truck and the ride dynamics and gas mileage of a car is a very compelling combination. There is no way back to the pre-2008 days, even if gas prices spike. On the luxury side of the business, big sedans are no longer the sweet spot for consumers. The IRA: What percentage of F-150 owners are women? Do you have any idea? Tynan: I’m not sure about that, but the percentage of people who drive a truck and never use it for work is soaring. The new pickups are very nicely appointed and can compete in terms of features and comfort with any passenger car. The mid-size trucks are nice too, Ford is getting back into smaller trucks with the new Ranger. The IRA: What in the world happened with Ford? How did they ever decide that people did not want a small truck? They left the entire mid-size segment in the US to the Japanese. Bill Ford is all twisted in a knot over mobility, but then Ford abandoned an important product segment in a category they should dominate. Tynan: They were printing money with the F-150. I’ve spoke to Ford a number of times about this decision. They’re feeling was that the smaller truck would have to be 25 percent more fuel efficient and be 25 percent cheaper to not cannibalize F-150 sales. When GM got back into the segment with Canyon and Colorado, they took market share but not from Toyota Tacoma or other manufacturers. The whole segment just grew. That small truck segment that was 300,000 units a few years ago was almost half a million units last year, but growth has also slowed. Ford and Fiat-Chrysler with the Jeep pickup missed the opportunity. I think that horse has left the barn. Today the Toyota Tacoma is half the segment, while GM is about a third. And the thing is that Ford sells Ranger all over the world. They just weren’t bringing it here. The IRA: As you said Kevin, trucks have not peaked. The Toyota Tacoma is a beautiful vehicle. Tynan: While the US automakers dominate the large truck segment, until GM got back into smaller trucks Toyota owned that segment almost entirely. So it's not about brand loyalty as much as it is about producing a product that consumer want to buy. Some people want to have a pickup that can fit into their garage. They don’t need a full size pickup. So there is roughly half a million buyers for that size vehicle. The IRA: So last question, let’s bring it back to Ford. What is your assessment of Bill Ford and the situation with “his” company in the wake of Alan Mulally and the departure of Mark Fields last year? Bill Ford periodically feels the need to demonstrate his “leadership” with new ideas, but had to retreat entirely a decade ago and was rescued by Mulally. Tynan: The message from Ford has been tough to decipher. Analysts are wondering if Ford is really about cars and trucks or is it about mobility and smart cities? They have been talking about things that have nothing to do with the basic business of making cars and trucks. The message coming from Ford is not as clear as say GM, which is all about making vehicles even while working on new technologies. Mark Fields had been with the company for 25 years, but then was let go after three years as CEO. It seemed a little bit strange to have Fields in the organization for that long and to be that wrong about his leadership ability. The IRA: Tales of Henry the Deuce. Thanks Kevin. #Ford #Tesla #GM #FiatChrysler #Nissan #ElonMusk

“Across the globe, investors have one thing in mind. How far will interest rates rise and is the great bull market in bonds finally over?” Lawrence MacDonald Henry Ford's missing punch bowl New York | The proverbial punch bowl has been spilled all over the floor. Not surprisingly, the departure of Janet Yellen as Chair of the Board of Governors of the Federal Reserve System is bad news in many quarters. The speculative policies that helped gun assets prices around the world are now ending – at least for now. An eight year bull market in bonds is also seemingly at a conclusion. Quantitative easing or “QE” went on for years longer than necessary, thus Yellen’s successor, Chairman Jerome Powell, must clean up a particularly large mess. Cleaning up other people’s messes is, of course, the key job requirement for being Fed Chairman and, particularly, President of the Federal Reserve Bank of New York. Names like Volcker and Corrigan return to front of mind, but the past three Fed chairs have not deigned to dirty their hands with mere banking . The mess cleaning task of the Fed is similar to the role played so wonderfully by Sally Hawkins and Octavia Spencer in The Shape of Water , our vote for the Oscar this year BTW. Besides conveying dying broker dealers and insurance companies into new hands, the merger of dying zombie banks with the living, and most important, preserving the Treasury’s access to the debt markets, the Fed is now tasked with cleaning up a mess in Washington. This last responsibility is about to become particularly difficult as we rocket into the future with a Republican Congress that refuses to raise revenue out of fear of losing the next election. Before Chair Yellen actually walked out the door, the Fed’s Supervision & Regulation function announced supposed sanctions against Wells Fargo & Co (WFC). The bank engaged in widespread acts of fraud against customers, apparently for years. The sanctions are an embarrassment and amount to a single gentle slap on the backside by the Fed. For starts, by telling a $2 trillion asset zombie bank and the largest loan servicer in the industry that they cannot get bigger, you are doing the CFO a favor. After all, it's about equity returns. The Fed has the power but not the will to act. For example, replace the CSUITE of WFC and force the bank to sell 50% of its assets. Then the Fed would be doing its job, as it would do without hesitation with a smaller institution. But by slamming dying zombies into healthy banks for fear of damaging confidence, the Fed created the governance problems at WFC. And the US central bank dares not challenge the bank monstrosities it has created over the years, in part because they are all primary dealers in US government bonds. None are more surprised about the market's turn of affairs than the inhabitants of Wall Street, both the perpetrators themselves and their loyal scribes in the world of financial journalism. The idea that markets for stocks, bonds and real estate might need to correct a bit after galloping along for five years at multiples of the official inflation statistics is a revelation to many -- but certainly not all. We still have “positive fundamentals,” you understand. Most of the senior pundits in the financial press have asked the right questions at one time or another, but as former Citigroup Chairman Chuck Prince lamented, on Wall Street you dance until the music stops. Or as they used to tell teary eyed fans at the end of his concerts, “Elvis has left the building.” No, Chair Yellen will not be playing an encore. And the timing of Chair Yellen’s departure is particularly unfortunate for the overbought and overheated financial markets. Washington has just done a reprise of sorts, repeating the market movements seen after the 2016 election. The yield on the 10-year bond is rising towards a five-year high, attracting cash from absurdly over-stretched equity markets. The chart below shows the 10-year Treasury bond and the S&P 500 Index. The arrow indicates the November election and subsequent discontinuity that included a surge in interest rates and stock prices. Was the post-election uptick in stock prices supported by “good fundamentals” or the proverbial animal spirits? Our friend and The IRA reader Dick Hardy down in Atlanta worries that the ratio of the 10-year Treasury bond and the SPX are nearing a worrying divergence. “Note the head and shoulders pattern developing, and note that if one draws a trend line off the 09 low and 14 low the trend has been broken. A break below 90 (the approximate head and shoulder neckline) would be an ominous sign. Might want to put this one on your watch list,” he writes. With most markets fully correlated, we may all be staring into the eye of a perfect storm in formation. First, Congress has just passed tax reductions that promise to greatly increase Treasury funding needs in the near term. Indeed, the position taken by Secretary Stephen Mnuchin and his predecessors about the US Treasury issuing primarily short-term debt seems to be evolving with each passing day. Look for those 10s and 30s to be reopened more frequently in coming months as the reality of Argentine style fiscal policy in Washington collides square on into a receding bond market and a weak dollar. Of particular interest is the decision by the Chinese government to reduce outflows of yuan and how this political shift will impact foreign asset prices. Press reports suggest that epitomes of leveraged growth such as HNA Group seem headed for default, although we still don’t know who actually owns the company! Speaking of AML violations, let's ponder the fact that global regulators and counterparties have no idea as to the overship of HNA, the largest shareholder of Deutsche Bank AG . Reports that HNA and other Chinese investors may be forced by Communist Party leader Xi Jinping Beijing to lighten up on foreign real estate certainly provides food for thought. Will the forced assets sales by some of the more egregious examples of excessive leverage in China cause a general liquidation of the Yellen bubbles in stocks and bonds? As one New York real estate publication The Real Deal warned, "Brace yourself for a yard sale." The unwind of large bubbles does not necessarily happen quickly. The Great Crash of 1929 was actually the final crescendo of a period of financial boom and bust that began to end with the collapse of the FL real estate market in the mid-1920s. John Kenneth Galbraith, writing in his classic 1954 book “The Great Crash, 1929,” describes how parcels of land in Florida were divided into building lots and sold for a mere 10% down payment. In effect, Americans of the early 1920s were trading fractional options on FL real estate. Charles Ponzi, the great American fraudster and namesake of the financial pyramid scheme, was actively involved in selling parcels of land in Florida in the 1920s. He leveraged a steadily growing flow of investors until 1927, when the tide of new investors peaked and the FL property market began to crack. Sound familiar? Bitcoin is merely the modern day extension of the alluring logic of Charles Ponzi, albeit enabled by the Internet. The Great Crash of the stock markets in 1929 was not the final act, however, and would lead to the catastrophe of the banking crisis of 1933. As recalled in Ford Men: From Inspiration to Enterprise , a decidedly selfish Henry Ford helped to crater the US banking system by threatening to withdraw his cash from Detroit's banks. From early 1933, financial institutions from Chicago to New York closed for months and even years -- all thanks to Henry Ford’s enmity for his former business partner, Senator James Couzens, and most people generally. Scores of private banks and businesses failed in the forced deflation from early 1933 onward. When President Franklin Delano Roosevelt made his famous March 1933 inauguration day utterance about Americans having “nothing to fear but fear itself,” every bank in New York was closed. Millions of Americans were quite literally standing in the streets of major US cities. The terrible year 1933 was quite a bit worse than the crisis of 2008. Out of the experiences of the Great Depression and World War II, the Fed and Washington generally have evolved a progressive attitude towards “pump priming” consumer demand that has led us to the current juncture of zero rates and infinite duration. Most of the industrialized world, including China, is drowning in bad debt, but this fact goes unremarked. Several years ago, the big idea coming from Chair Yellen and her comrades on the Federal Open Market Committee and other global central banks was to lever up the economy with even more debt. This increase in global leverage included the purchase of trillions of dollars in stock funded with record amounts of corporate debt. Just to add some spice, the Yellen Fed purchased two trillion dollars worth of mortgage paper -- bonds that will sit on the Fed’s books for many years to come. Indeed, should we start to see mortgage agency bond issuance with 4 and even 5 percent coupons not so far down the road, the duration of the Fed’s MBS position will explode -- even as the nominal principal amount very slowly runs off. But at least holders of mortgage servicing rights (MSRs) can look forward to big positive marks in Q1 2018. The pressing question facing investors is whether interest rates will follow the pattern seen a year ago, when Treasury yields feel as the market retraced the increase in yields seen after the election of Donald Trump. The key market benchmark flirted with 2% yields in September last year. With each uptick in interest rates, the massive amounts of investor cash sitting on the sidelines returns, acting to counterbalance the market’s bearish tendencies. The difference between last year and 2018, however, is that now the Treasury is seeking to fund trillions of dollars in red ink to fund a badly advised peacetime pump priming effort. Don’t get us wrong. Structural tax reform is great. But the US badly needs to raise some revenue pronto or will run the risk of looking ridiculous to the entire world. The danger here stems not from the colorful occupant of 1600 Pennsylvania Avenue but from the fact that the larger building down the street that sits atop Capitol Hill appears to be empty -- of courage or even practical perspective. Market prognostications aside, the lack of political will among America’s leaders when it comes to matters of money is the biggest risk facing the world in 2018. #Yellen #PunchBowl #HenryFord #FordMen #duration

Richard Cordray and Mick Mulvaney New York | It’s a strange time in the housing market. Home price increases have been running above the posted inflation rate for more than five years, yet lending volumes are expected to fall again in 2018 for the third year in a row. The end of the Progressive Inquisition at the Consumer Finance Protection Bureau is in sight, yet the housing industry continues to reel from the massive increase in the cost of regulation, which has seen productivity in the world of mortgage finance cut by two thirds since 2012. News reports suggest that thousands of jobs could be lost in mortgage finance this year due to rising interest rates and falling lending volumes. This is primarily due to slack demand for mortgage refinancing as a result of rising long-term interest rates. Chart 1 below shows the 12-month average price change from CoreLogic for all US homes going back to the 1970s. Source: CoreLogic Note the upward surge in average home prices during 2012-2014, which was due to the work-out of distressed mortgages. Closing the gap between the deeply discounted value of foreclosed homes and normal sales accounted for a lot of the price gains reported during this period. The more subdued average home price action in many coastal markets since 2014, however, is still a multiple of the official inflation statistics coming from Washington. Despite policies from the Federal Housing Administration and Federal Open Market Committee meant to boost house finance, regulation and extremely tight secondary market terms are hurting profitability and employment in the mortgage industry. Most of the credit flowing from Washington is going to consumers buying larger homes rather than first time home buyers. Meanwhile, prices for mortgage servicing rights (MSRs) are still trading at a discount to the underlying collateral, as the FT’s John Dizard reports . Mortgage industry maven Rob Chrisman wrote recently of colleagues working “in a business where many are experiencing contracting volumes and contracting margins. Bank of the Ozarks of Little Rock will stop originating home loans for resale on the secondary market, a line of business that had ‘operated at essentially break-even’… Every company is taking a hard look at the continued high cost of originating loans, regardless of channel, and evaluating profitability. Watch for plenty of changes in 2018.” With Mel Watt, head of the Federal Housing Finance Administration, leaving office in less than a year, speculation about the chances for reform of the housing enterprises, particularly Fannie Mae and Freddie Mac, has grown. So much so, in fact, that somebody decided to leak a letter from Watt to members of the Senate Banking Committee regarding his views of GSE reform. “Watt said that once they are returned to the private sector, Fannie and Freddie would be the first two ‘secondary market entities’ able to issue government-guaranteed mortgaged backed securities as a common security that has a mandated rate of return set by a regulator,” American Banker reports . If, as Watt suggests, the idea is to have two “private” utilities with a government backstop for catastrophic risks, then that is what we have today. The two enterprises have government ownership with private capital standing in front in the form of risk sharing transactions. The key flaw in both Watt’s plan and the Senate proposal for GSE reform is the role assigned for private equity capital in the “privatized” Fannie Mae and Freddie Mac. If Congress wants to privatize the GSEs, then they should go right ahead. But please note that private mortgage companies are trading well below book value at present. You see, there is no utility in providing two more independent mortgage banks to an industry with profitability issues. If true privatization is the object of GSE reform, then the last thing the mortgage sector needs right now is Fannie Mae and Freddie Mac in drag, pretending to be private finance companies. All ties between the federal government and the GSEs must be severed to make “privatization” a reality. Instead of continuing the strange pretense of the “private” GSEs, better to simply liquidate the two enterprises and focus the distribution of all government housing subsidies on the FHA and Ginnie Mae, as suggested in several alternative plans floating around the House of Representatives. The US government through FHA would offer insurance on eligible loans held by any issuer without providing a backstop for the corporation. The private bank or non-bank would then sell the mortgage backed securities to investors, with either GNMA cover, private insurance or no insurance at all. As today, higher quality mortgages such as prime jumbos would not require any government insurance cover whatsoever, but the real opportunity is to privatize the 60% of the market now served by the GSEs. If you think of the mortgage market today, 25% of all mortgage loans are held by banks in portfolio with no cover, about 50% (mostly prime loans) are guaranteed by Fannie Mae and Freddie Mac, and the rest of the market (including below prime loans) are covered by the FHA and GNMA. Private investors could easily accept uninsured prime mortgage securities now covered by the GSEs and do so at a lower cost to consumers. Some three quarters of all loans today have FICO scores above 720, quality loans that private investors would readily accept. The pricing for Fannie Mae’s risk transfer deals calculated by Well Fargo suggests that virtually all of the default risk from GSE mortgage exposures could be underwritten by the private sector and at a cost that is a fraction of the guarantee fees charged today by the GSEs. Meanwhile, across town, acting Consumer Finance Protection Bureau director Mick Mulvaney also leaked a memo outlining how the agency will operate in future. The head of the Office of Management and Budget made clear that the bad old days of the CFPB extracting settlements from mortgage companies and banks is over. He wrote: "We are government employees. We don’t just work for the government, we work for the people. And that means everyone: those who use credit cards, and those who provide those cards; those who take loans, and those who make them; those who buy cars, and those who sell them. All of those people are part of what makes this country great. And all of them deserve to be treated fairly by their government. There is a reason that Lady Justice wears a blindfold and carries a balance, along with her sword." More significantly, Mulvaney confirmed that the CFPB will no longer regulate through enforcement actions and that fines and penalties will only by imposed when there is actual harm to consumers . This changes the inquisitorial approach of former director Richard Cordray, who extracted billions in wrongful settlements from private banks and mortgage companies during his reign of terror. Cordray is now seeking the OH governorship with a war chest filled to overflowing with contributions from the trial bar. Mulvaney stated in his memo: “So, what does all of this mean, in terms of how we will operate at the Bureau? Simply put, we will be reviewing everything that we do, from investigations to lawsuits and everything in between. When it comes to enforcement, we will be focusing on quantifiable and unavoidable harm to the consumer. If we find that it exists, you can count on us to vigorously pursue the appropriate remedies. If it doesn’t, we won’t go looking for excuses to bring lawsuits…. On regulation, it seems that the people we regulate should have the right to know what the rules are before being charged with breaking them. This means more formal rulemaking on which financial institutions can rely, and less regulation by enforcement.” Under the tyranny of Richard Cordray at the CFPB, the cost of servicing a performing mortgage rose three fold in the US, one reason why many smaller independent mortgage banks have shut their doors. Larger firms are under pressure as well, which is why half of the top ten independent mortgage banks are in bankruptcy or for sale. It is fair to say that there will be a significant number of business closures and acquisitions in the mortgage sector during 2018. Even with the welcome regulatory changes in Washington, it will take years for the mortgage finance industry to recover to something like a reasonable cost structure. In the meantime, millions of Americans could lose their businesses and their jobs in 2018 – not primarily due to rising interest rates, but because of the abuse of power in Washington by ambitious progressives seeking higher office. While the changes at the CFPB are welcome in the mortgage finance sector, the fact remains that 2018 is going to be a very tough year. The entire mortgage banking and REIT sector has been selling off since the end of December, reflecting investor concerns about rising interest rates and a flat yield curve. Regulatory changes in Washington are welcome and long overdue, but for the mortgage finance industry, it is still the depths of winter. #RichardCordray #CFPB #FHFA #FHA #mortgage #MSR

New York | With the global punditry assembled in Davos this week, the topic of the dollar seems to have bubbled to the surface again. Down more that 10% from the December 2016 peak, the greenback has started to sag at just the time when Treasury deficits are climbing and the Fed is paring back its purchases of US government debt and agency mortgage bonds, as shown in Chart 1 below. With the 10-year Treasury back over 2.6% yield, gravity seems to have been restored to the global economy. The last peak of the trade weighted dollar was in mid-2002, after which the US currency slid steadily into the 2008 financial crisis. Did investors and government officials outside the US perceive the approaching contagion? You bet -- but especially in China, where the political leadership understands the process of “dollar recycling.” Simply stated, if China stops buying US Treasury debt or other dollar assets, the surging yuan strengthens even more. And even as President Trump starts a trade war with China, the yuan is already soaring against the dollar. Duh? Starting in 2008, the dollar climbed steadily even as interest rates and credit spreads remained suppressed. But from 2009 through 2011, the dollar actually gave back ground even as the Federal Reserve ramped up purchases of Treasury debt and mortgage securities via QE. By 2012, the flood of foreign capital pouring into US real estate and financial assets finally began to lift the dollar, which by 2014 began a sustained rise in value that finally peaked at the end of 2016, just after the election of Donald Trump. The peak in the dollar in December 2016 came after years when strong capital inflows helped to reflate the US equity and real estate markets, the latter both for commercial and residential properties. But as prices for US stocks and real estate reached absurd levels, foreign purchases began to decline. In particular, changes in US tax rules for foreign investors in real estate as well as political changes in nations such as China have caused the dollar to slump over the past year, as shown in Chart 2 below. Notice that the yuan/dollar exchange rate and the dollar/euro rate have both seen the value of the dollar deteriorate over the past year under the leadership of Donald Trump. Of course, some observers would blame the slump in the value of the dollar on President Trump, especially now that Treasury Secretary Steven Mnuchin is publicly lauding the benefits of a weaker dollar. In Davos, for example, Mnuchin said: “Obviously, a weaker dollar is good for us as it relates to trade and opportunities.” Secretary Mnuchin is said to think President Trump is an "idiot," but compared to what? In reality the factor which seems to govern the movement of the dollar is not the pronouncements of Mr. Mnuchin but rather mounting federal budget deficits. The US deficit fell to “only” $438 billion in 2015 and has been growing substantially ever since. With the just passed tax legislation thrown into the mix, US deficits are expected to surge to more than 5% of GDP annually. Chart 3 shows the US fiscal deficit vs the trade weighted dollar. It’s interesting to note that while President Trump and Secretary Mnuchin may think that they are driving the proverbial bus when it comes to the value of the dollar, in fact the deteriorating fiscal situation for the US seems to be the key determinant. Indeed, the passage of the tax legislation at the end of 2017 makes us somewhat more cautious about our bullish view of the 10-year Treasury, which now seems headed lower in price and higher in yield under the weight of expectations regarding Treasury debt issuance. But while we may be less bullish on the 10-year Treasury bond, the curve flattening trade is still a very real scenario because of the Treasury’s huge debt issuance calendar. The fact that the Federal Open Market Committee is slowly allowing its portfolio to run off is an important factor in the analysis. We continue to think that the Fed is being overly optimistic as to how quickly the late-vintage MBS in the System portfolio will prepay. Let’s review the questionable actions of the FOMC under Chairs Ben Bernanke and Janet Yellen from 2008 to 2014: QE1 (December 2008-March 2010) : The FOMC started with $600 billion in “sterilized” purchases of MBS (funded with sales of Treasury debt), then increased to a further $750 billion in outright purchases of MBS funded with excess bank reserves. QE2 (December 2010-June 2011) : Fed purchased another $600 billion in longer dated Treasury paper funded with bank reserves, extended duration of System portfolio. Operation Twist (2011) : The FOMC sold short term Treasury paper and bought longer dated Treasury maturities, significantly extending the duration of the System portfolio. QE3 (September 2012-December 2013) : FOMC committed to buy $40 billion per month in MBS and purchased an additional $45 billion in Treasury debt funded with excess bank reserves. Since then, increased interest rates and falling prepayments have extended duration of System portfolio. The FOMC under Chairs Bernanke and Yellen did everything possible wrong in managing the System portfolio. Now the Fed is illiquid, trapped in a long duration position in a rising rate environment because they violated the cardinal rule of central bankers: stay short duration. As we've noted previously, the FOMC dares not sell any of the System portfolio out of fear of generating losses. So the Mnuchin Treasury is planning to fund its spending deficits with short-term debt issuance, but the runoff from the Fed’s MBS portfolio may, in fact, be so slow that the central bank will not be able to purchase much of the Treasury’s new debt. As the FOMC tries to rebalance the System portfolio back to 100% US government debt, it may take years longer than currently estimated by the Fed staff for the System MBS positions to actually runoff. This means that the full weight of Treasury issuance of short-term debt will hit the markets with no support from the Fed and at a time when the dollar is falling. So the good news is that the FOMC has ended its long, strange period of social engineering known as QE. The bad news is that the Republicans in Washington have just cut taxes and the resulting red ink could see the US dollar test post-WWII lows. Because of fears regarding future deficits, the 10-year Treasury bond may not rally appreciably. Yet there remains a dearth of long-dated Treasury paper available in the markets, in part due to purchases by the FOMC. The surprise for newly installed Fed Chairman Jerome Powell is that the short-end of the yield curve could surge above the Fed’s target for short-term interest rates once Treasury begins to seriously increase issuance to an expected deficit of 5% of GDP annually. By 2022, the annual US deficit could be a trillion dollars. And even with significantly higher short-term interest rates, the dollar may continue to fall under the weight of rising fiscal deficits and the falling credibility of the US government. Doug Bandow stated the situation nicely in The American Conservative last week: “The United States is effectively bankrupt, but that doesn’t matter to the GOP. Once evangelists of fiscal responsibility and scourges of deficit spending, Republicans today glory in spilling red ink. The national debt is now $20.6 trillion, greater than the annual GDP of about $19.5 trillion. Alas, with Republicans at the helm, deficits are set to continue racing upwards, apparently without end.” So two questions: First, will the surge in US fiscal deficits cause short-term interest rates to rise and the dollar to fall faster than currently expected? Second, what happens to the overheated prices for stocks and US real estate in such a scenario? Further reading: No good reason for banks to offer more government-backed mortgages American Banker January 23, 2018 https://www.americanbanker.com/opinion/no-good-reason-for-banks-to-offer-more-government-backed-mortgages #dollar #deficit #mnuchin #trump #FOMC #Yellen #Bernanke

“To exactly solve the problem of corruption, we must hit both flies and tigers” Xi Jinping New York | In December this past year, Chinese lender Citic Bancorp warned that the high-flying HNA Group was having trouble paying its considerable short-term debts. After building a $40 billion pile of investments around the world largely funded with debt, HNA seems to have reached the end of its ability to grow further, both in financial and political terms. Thus western investors and banks began 2018 wondering whether the Chinese government will come to the rescue. HNA symbolizes China’s schizophrenic approach to economic growth, an on again, off again roller coaster which reflects the changing political priorities of the country’s communist leaders. Whereas in 2016 China’s leaders allowed and even encouraged Chinese investments offshore, both by companies and individuals, since last summer the situation has changed. Paramount leader Xi Jinping is reasserting the government’s control over the economy. And perhaps the highest priority for China’s rulers is reining in the overheated financial sector symbolized by firms like HNA. Think of HNA Group as a Chinese version of Softbank, but with considerably less transparency and more debt leverage. The firm exploded onto the global financial scene several years ago, acquiring New Zealand’s largest financial services firm, and stakes in companies such as Hilton and Deutsche Bank. It ostentatiously hung its name on office buildings in major world financial centers. HNA created its own aircraft leasing company, Avolon, to compete with global banks in this lucrative financial market. Incredibly, it even acquired SkyBridge Capital from hedge fund manager Anthony Scaramucci before he briefly joined the Trump Administration last summer. The public face of HNA is Adam Tan, who is identified as chief executive officer and co-founder. The company’s ownership and corporate structure remains shrouded in mystery, however, causing investors increasing disquiet. To fuel its growth, HNA aggressively leveraged existing assets to fund the purchase of new ones, the Financial Times reported last summer, a process known in Chinese as “a snake swallowing an elephant”. Rating agency S&P has cut the company’s debt rating deep into junk territory, causing some analysts to predict that the firm will eventually default. There has been talk of asset sales to deleverage and pay down debt. But the key question is whether the founders of HNA, which started off as a regional airline, have lost the political support of China’s leaders. “There has been a lot of commentary focusing on the notion that China is deleveraging,” notes Leland Miller, CEO of China Beige Book . “China is not deleveraging right now, at least in terms of where it really counts, the corporate sector. What is happening is a crackdown on certain shadow products across the financial sector. The government is clamping down on instruments it thinks are running amok, such as wealth management products, trust products, negotiable certificates of deposits, and others.” Miller notes that he expects there to be some high profile defaults in China during the coming months. It is critical that Beijing sends the message that people can and will lose money when they invest blindly into the shadow banking system, he notes: “They have to eviscerate the idea that the Great Chinese Government Backstop continues to remain in place.” Many foreign investors and corporate managers find it convenient to believe that firms like HNA are private companies that are similar to their western counterparts, but in fact all businesses in China are ultimately subordinate to the Chinese Communist Party (CCP) and Xi Jinping. Last summer, Chinese regulators began restricting liquidity to acquisitive Chinese firms, Reuters reports, ordering a group of lenders to assess exposure to some of the more aggressive dealmakers, including HNA, the property-to-film conglomerate Dalian Wanda and Anbang Insurance Group. Foreigners also like to believe that the party will support companies such as HNA when they get into financial trouble, but in fact the decision of whether to bail out an insolvent bank or company is ultimately political. HNA’s roots are also political, as a June 2017 feature article in the Financial Times makes clear, but this could ultimately lead to the firm’s undoing. When Xi Jinping ascended to become the unquestioned leader of the CCP and co-equal with Mao last year, his coronation marked the conclusion of a “anti-corruption” campaign to systematically destroy any potential rivals in the party apparat . Insecurity drives Xi’s relentless focus on abolishing alternative sources of economic and political power. His father Xi Zhongxun was persecuted during the Cultural Revolution, and Xi was for many years shunned because he was deemed “not suitable” to be a member of the party. Now firmly in charge of both the CCP and the Chinese military and police, however, Xi now appears intent upon remaking China’s economy in his own image and deemphasizing foreign influence via increased party control over “private” companies. When Xi proposed his ‘Thought on Socialism with Chinese Characteristics for a New Era’ – the opening phrase of his report to the CCP congress last year, he was starting a process of economic and political reform that is ultimately designed to focus power into his hands indefinitely. And this new stage of the “reform” process will be focused on domestic firms such as HNA as well as foreign companies with roots in China. “The [anti-corruption] campaign was aimed at the public sector; it cleaned out a rotten bureaucracy and helped Xi to wrest power from China’s provincial barons and powerful figures in the military,” writes Qi Gua in The London Review of Books . “It looks as though the next five years will see it extend to the private sector, and the first task will be to bring the tech giants to heel.” He continues: “The government is now proposing to increase its stake in our big tech monsters, Alibaba, Tencent and Baidu. According to Bloomberg, it already has holdings in Tencent (0.8 per cent) and Alibaba (1.3), but wants to acquire another 1 per cent in each: an approach they’ll find hard to refuse, even though the objective is to penetrate the two companies and oversee every key decision they make. Mao called this steady infiltration ‘mixing the sand into the hardened soil’.” As Xi prepared to take control of the CCP, China began to tighten capital outflows in the second half of last year. This change in the official tolerance for foreign investments has slowed the hectic pace of deal-making by domestic companies looking to scoop up overseas assets. The imponderable question for foreign investors, banks and companies with exposure to HNA is whether China’s leadership views the Hainan-based conglomerate as an ally or a threat. The same analysis must be done with respect to other Chinese companies with significant foreign participation. So long as China’s banks are willing to work with HNA to restructure its debt and sell off assets, then the company is likely to survive. But any such analysis must recognize that more than ever under Xi Jinping, it is the CCP representative that ultimately validates the decision by the bank’s management. If Xi Jinping finds the continued existence of HNA to support his political objectives, particularly the renewed focus on investment in China, then it is likely that China’s state-controlled banks will continue to be constructive when it comes to unwinding HNA’s massive pile of debt. If not, then HNA may be pushed into a forced restructuring that will mark a further confirmation that China’s leadership has changed the way in which views foreign investments by corporate “tigers.” This article was previously published in The National Interest and is reproduced with permission. Further reading: Cutting Through the Fed’s Orwellian Doublethink: Will the new chairman continue to say one thing and do another? The American Conservative January 12, 2018 #HNA #XiJinping #China #Creditrisk #CCP