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“The great wheel of circulation is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods, and not in the wheel which circulates them” Adam Smith, 1811 Southport | This week in The Institutional Risk Analyst , we return to one of our favorite topics – namely credit spreads – as we consider the most recent statement from the Federal Open Market Committee. Fed Chair Janet Yellen made a presentation last week to the National Association of Business Economists illustrating that while she is puzzled by low inflation, Yellen is entirely clueless as to the workings of the financial markets. For some time now, we have been concerned that the FOMC’s overt manipulation of credit spreads has embedded future credit losses on the balance sheets of US banks. But now we are starting to see even greater signs of stress as the large Wall Street banks again return to derivatives in order to manufacture the appearance of profitability. The leader of this effort is none other than Citigroup (NYSE:C), which has surpassed JPMorganChase (NYSE:JPM) to become the largest derivatives shop in the world. Citi has embraced the most notorious product of the roaring 2000s, the synthetic collateralized debt obligation or “CDO” security, a product that fraudulently leverages the real world and literally caused the bank to fail a decade ago. “It’s an astonishing comeback for the roughly $70 billion market for synthetic CDOs, which rose to infamy during the crisis and then faded into obscurity after nearly destroying the financial system,” reports Bloomberg . “But perhaps the most surprising twist is Citigroup itself. Less than a decade ago, the bank was forced into a taxpayer bailout after suffering huge losses on similar types of securities tied to mortgages. Now, many in the industry say Citigroup is responsible for over half the deals that come to market, though precise numbers are hard to come by.” As we note in a new working paper appropriately entitled “ Good Banks, Bad Banks ,” large financial institutions are not particularly profitable. In times of tight credit spreads, the pressure on these banks to “cheat” when it comes to risk taking and disclosure becomes irresistible. The dilemma large banks face when credit spreads are very low is similar to retailers that cannot compete, for example, with the efficiency of Amazon (NASDAQ:AMZN). Low cost competitors compel other retailers to match prices, even if that forces them to lose money on each sale. Trying to “make up” the loss by increasing sale volume is the obvious path to retailer insolvency. In banking, high spreads eventually force borrowers to default and must be cured before the economy fails. Low spreads force banks to “match or lose customers” by cutting prices. When a “matching” bank’s costs are greater than the spread borrowers pay, the correct result is to shrink the number of deals done, eventually causing spreads to rise. But that’s disastrous for bank managers. As in retail, therefore, the initial reaction of bank managers is to make up for the “low yield” on each transaction by writing more deals. As long as government is willing to “insure” deposits of banks that speculate in this manner, it creates an obvious condition of “heads managers win” and “tails shareholders and taxpayers lose.” The most obvious use for a “synthetic CDO” is to generate a lot of fictional (“synthetic”) transactions that increase the bank’s “deal flow” without need to find actual customers that want “real” loans. Bad banks generate a capacity to make up for the low yield on each “real” transaction by creating “synthetic” transactions. Synthetic derivatives are an obvious source for permitting fraud that necessarily harms the perpetrating bank and, ultimately, the markets as a whole. “Bottom line,” notes our colleague Fred Feldkamp , “it is ‘impossible’ to convert ABS securities into a ‘risk free’ 20% return. As Goldman Sachs (NYSE:GS) proved in 1970 with bankrupt Penn Central's commercial paper, one cannot sell bad assets to customers that you want to keep.” Feldkamp observes that for a while now credit spreads have been too low for rational credit expansion. Banks are now forced to create and hide leverage off balance sheet (e. g. new "synthetic CDO" frauds and leveraged buyouts (LBOs) with outrageously high EBITDA ratios) in order to generate returns sufficient to pay employees when that is not available in the spreads associated with well-balanced bond sales. Again Feldkamp: “When I do my spread charts, I consider the upper and lower limits to define Adam Smith's concept of a ‘Complete Market.’ Above that range of spread, there is a cushion between equilibrium and a ‘crisis zone’ because experience tells me that the ‘drag’ of high spreads can be tolerated for a while as leaders ponder what to fix. Affected firms refinance when spreads fall.” He continues: “BELOW that equilibrium, however, I think there's only ‘irrational exuberance’ because (as Smith noted) ‘the Great Wheel of Circulation’ lacks the ‘grease’ of adequate net-interest margin (NIM) needed to keep it rolling and starts to wear out. The damage starts immediately and only the extent of the necessary ultimate repair is debatable. When banks die over dumb deals, we have no choice except to rescue depositors--thus it becomes ‘HEADS I WIN; TAILS TAXPAYERS LOSE’ at US-insured banks.” Feldkamp reminds us that had regulators stopped the losses generated by thrifts in the 1980s after Congress passed the ill-fated 1982 Garn-St Germain law, the cost might have been contained at a hundred billion. “By waiting seven years, however, we were just a few years away from creating a Weimar Republic collapse. Having enjoyed an eight year recovery today, the US markets are now FAR more leveraged and are therefore far more capable of a rapid descent into oblivion than 30 years ago.” We do not need to look back 30 years, however. Synthetic CDOs were a key source for the excessive and unreported “off balance sheet” leverage at Citigroup that exploded to create the Great Financial Crisis of 2008. Starting mid-September of 2007, the Fed successfully led markets back from a “mini-crisis” that began when Bear Stearns followed the path Goldman Sachs chose decades before when Penn Central went bankrupt. Bear abandoned support for two mortgage investment funds into which it had invested customers’ money. In mid-October, US Treasury Secretary Hank Paulson announced an intent to create a “Super SIV” (to be backed by the US government) that would “rescue” Citi from losses suffered in off balance sheet ”commercial paper conduits” that Citibank supported with standby liquidity facilities. Thankfully Hank’s ill-considered proposal never materialized. His announcement kicked off the Great Financial Crisis (that peaked thirteen months later). Within days, credit spreads for US corporate bonds leaped from “euphoric” lows to “crisis zone” highs. Credit markets required more than three years to regain spread levels observed before Paulson’s October 2007 announcement. To get a sense of just how tight lending spreads are for the major banks, the tables below shows the gross loan spread, and the percentage of loans and total assets, for each loan type at Citi and JPM. Source: FDIC/Total Bank Solutions The table above illustrates the great dependence of Citi on its credit card portfolio when it comes to yield, while more that half of its loan portfolio is generating less than 3% gross yields. Citi is clearly the weaker competitor compared to JPM. And as we noted last week , Citi’s dependence on offshore institutional funding sources gives it a cost of funds almost 2x JPM and other large banks. The moral of the story with Citi and other large banks is that there is no free lunch, but sadly no one on the FOMC seems to appreciate this subtlety. When the Fed pushes down interest rates and then manipulates credit spreads to achieve some illusory goal in terms of monetary policy, the result is a change in the behavior of investors and lenders that is profound. The fact that Citi, JPM and GS are now pushing back into the dangerous world of off-balance sheet (OBS) derivatives just illustrates the fact that the large banks cannot survive without cheating customers, creditors and shareholders. And just as retailers cannot compete with AMZN, Citi and GS certainly cannot compete against the monopoly power of the House of Morgan. In the case both of Citi and JPM, just half of the banks’ operating business comes from lending, while the remainder comes from risk bearing investments and trading. With some $50 trillion in off-balance sheet (OBS) derivatives, which is almost six standard deviations above the $1.8 trillion peer average for large banks, Citi and JPM are now the outliers on Wall Street in terms of derivatives exposure. A move of 30bp in the OBS derivatives book of either bank would wipe out their capital. Chart One below shows the OBS derivatives exposure of Citi, JPM, GS and the other major banks. Source: FDIC/Total Bank Solutions Notice that all three of the leading derivatives dealers have been increasing exposures since last year. Note too that the relatively small GS has a notional OBS derivatives book of more than $41 trillion, almost as large as that of Citi and JPM. More alarming, a move of just 7bp in the smaller bank’s OBS derivatives exposures would wipe out the capital of Goldman’s subsidiary bank. This gives GS an effective leverage ratio vs its notional OBS derivatives exposures of 8,800 to 1. And all three banks are clearly outliers compared to the rest of the large US banks, which generally eschew OBS derivatives as the tiny peer average suggests. So ask not whether President Donald Trump should reappoint Janet Yellen to another term as Fed Chair. Rather, ask yourself why Yellen wants to stick around Washington at all given the accumulation of risk inside the major US banks as a result of the FOMC’s manipulation of credit spreads. The combination of a lack of profitability and a huge derivatives book makes another financial collapse increasingly likely despite the apparent solidity of the US banking system. As with the S&Ls in the 1980s, Yellen and other regulators have an opportunity to throttle-back risk taking by Citi, JPM and GS now and avoid a calamity. But Buy Side investors would never tolerate such a move by regulators. As we note in "Good Banks, Bad Banks," larger institutions suffer from a fatal lack of profitability that ultimately dooms them to commit fraud and, eventually, suffer a catastrophic systemic risk event. As Fred Feldkamp never tires of reminding us: "The only thing worse than “excessive” leverage is 'excessive off balance sheet' leverage." #JanetYellen #FOMC #CDOs #derivatives #Citigroup #JPMorgan #NABE #AdamSmith #NIM

New York | We start the week in downtown Manhattan with a presentation to the International Association of Credit Portfolio Managers in New York ( click here to download slides ). We’ll refer to some of the slides in the comments below. And we appreciate the feedback about last week’s comment about the role of Equifax and the other consumer credit agencies in the mortgage market. Of note to one reader’s question, lenders do not need a FICO score to submit a mortgage to the federal housing agencies for insurance, but the GSEs do require all three raw credit reports be pulled into a “Tri Merge” file as part of the underwriting process. And by no surprise, the consumer credit bureaus also have credit scores or their own. The competition between FICO and the three credit repositories is a glorious race to the bottom in terms of credit scores for mortgages. Suffice to say we’ll be coming back to the question of credit scores in the context of mortgage lending soon. Got a cheery missive from Jerry Flum at Credit Risk Monitor ( OTC:CRMZ ): “Debt is at its highest levels since 2007, and with interest rates near their all-time low, there’s reason to be concerned about the amount of risk growing in your public company customer and vendor portfolios.” They add: “Corporate debt is becoming excessive…” Of course, Jerry is preaching to the choir when it comes to our appreciation of America’s migration towards national insolvency. To review, there are three phases of indebtedness, this progression codified by our friend Bill Janeway in a November 17, 2008 issue of The Institutional Risk Analyst kindly republished by Barry Ritholtz. The first phase is solvency, then mere liquidity sustains the growing debt, and finally default results when both interest and principal must be borrowed or "rolled." Janeway noted regarding the creation of “the largest pile of leverage the world has ever seen” via the birth of financial economics: “The core of this grand project was to reconstruct financial economics as a branch of physics. If we could treat the agents, the atoms of the markets, people buying and selling, as if they were molecules, we could apply the same differential equations to finance that describe the behavior of molecules. What that entails is to take as the raw material, time series data, prices and returns, and look at them as the observables generated by processes which are stationary. By this I mean that the distribution of observables, the distribution of prices, is stable over time. So you can look at the statistical attributes like volatility and correlation amongst them, above all liquidity, as stable and mathematically describable.” Part of the reason that the US economy is growing more slowly now than in the Roaring 2000s is that the amount of leverage on private capital from banks has actually been reduced by the forces of the progressive oversight. The other day, we heard Mike Mayo, now of Wells Fargo Securities BTW, wax effusive on Citigroup (NYSE:C) . The common stock of this zombie money center bank has moved up over 20% in the past year, trailed by JPMorgan Chase (NYSE:JPM) at +8% and Goldman Sachs (NYSE:GS) barely registering positive movement. But the thing to keep in mind about Citi and all of the big banks is that the ways of expanding actual profit margins are few. We are witnessing multiple expansion in the stock prices of financials, but no margin expansion to validate the higher equity market valuations. With a gross loan spread of 6.42% vs 4.40% for the large banks in Peer Group 1, Citi does have a higher return on assets but with a higher cost of funds, mostly in deposits raised from institutional investors. The notion that somehow larger banks are going to develop pricing power in the current loan market is kind of laughable. Loan margins have been under pressure for years, so even if the Federal Open Market Committee could make market rates go up, slack volumes in new C&I lending suggest that pricing dynamics could get even more competitive. The chart below from the St Louis Fed’s FRED system illustrates the slowing in new commercial lending. Part of the issue here is that magical notion known as macro-prudential regulation. Even as the FOMC and other world central banks have been busily purchasing trillions of dollars worth of private securities to encourage investment, bank rules have effectively lowered loan-to-value or LTV ratios. Bank borrowers must have more skin in the game, which lowers the leverage on private capital throughout the US economy. Home builders, for example, must have more equity in deals compared to the 2000s. Today a homebuilder must have 50% equity in a deal for a 50 LTV loan instead of 30% capital in a 70 LTV loan. As George Gleason of Bank of the Ozarks (NASDAQ:OZRK) told us , he has less leverage on his book than he did decades ago. Prospective short sellers please take note. The result of regulation is less growth, but lower loan default rates and, at least partly, improved recovery rates for banks. But the other obvious effect is lower levels of economic activity. This is the pound of flesh extracted by supporters of the Dodd-Frank law in their crusade against Wall Street excess. Even as global bank regulators try to reduce leverage levels inside bank portfolios, the FOMC is engaged in a massive experiment in social engineering to encourage borrowing and investment by keeping rates artificially low. The Fed bought almost $2 trillion mortgage bonds to help the housing market, this even as prudential regulators discourage lending on construction and development loans. Indeed, C&D lending is perhaps one of the greatest opportunities today in financials. In Washington, one hand does not know what the other hand does. Fed Chair Janet Yellen expresses puzzlement about inflation, but clearly the lower levels of leverage on capital in the US banking system seemingly provide part of the explanation. A home builder can start three new homes at 70 LTV, but can support only two new housing starts at 50 LTV. Hmmm. Meanwhile back to Citi, we love to hear analysts talk about margin expansion at a bank with “stable funding” that is two-thirds foreign deposits, placing the bank in the top quintile of banks in terms of funding costs. The bank’s premium cost of funds is almost 2x the 43bp average for Peer Group 1. And did we mention that the bank’s return on earning assets is actually lower that its large bank peers? Even with the high-yielding returns on Citi’s subprime consumer book, the bank’s paltry overall yield on earning assets is a function of low returns on the bank’s business loans. With the large US banks as a group and Citi in particular, there ain’t no leverage pickup apparent in the latest financials. The all-important factor of loan demand is constrained by the idiocy of macroprudential regulation. This will not prevent Sell Side managers from bidding up Citi and other large caps, however, because quite simply there is nothing else to buy. Kudos to Pete Najarian for holding his ground against the bull stampede into financials. #Citigroup #Najarian #Janeway #Ritholtz #Yellen #FOMC #leverage #LTV #creditscore

Washington | Some of the housing industry’s largest trade groups reportedly want housing finance agencies Fannie Mae and Freddie Mac to look at using new types of credit scores for assessing default risk on residential mortgages. These groups argue that existing scores are "unfair" to low income borrowers. Housing Wire reported last month that the groups sent a letter to Federal Housing Finance Agency Director Mel Watt, the Mortgage Bankers Association, National Association of Realtors, the National Association of Home Builders, and other groups pressing Watt on the issue. Watt, a former congressman from North Carolina and long-time member of the House Financial Services Committee, threw cold water on the idea that Fannie and Freddie would begin using alternative credit scoring models at any point in the next two years. “Watt said that making any changes to the government-sponsored enterprises’ credit scoring models before 2019 would be a “serious mistake,” reports HW . Ditto. FHFA chief Mel Watt is nobody’s fool and in particular understands the state of pay to play in Washington. The push for new credit scores is not really about competition or access to credit for low income households, but rather the corporate ambitions of the major consumer credit bureaus. “In 2006, VantageScore Solutions was introduced as a joint venture between three national credit bureaus – Experian plc , Equifax Inc. and TransUnion – aimed at providing an alternative solution to the widely used FICO score through the introduction of the VantageScore,” writes DBRS in a June 2017 report . “Recently, evidence points at VantageScore gaining traction in consumer lending and, by extension, in structured finance.” The three national credit bureaus or data “repositories” share a monopoly on individual credit reporting in the US. Yet as we’ve learned recently with Equifax (NYSE:EFX), the repositories take no responsibility for protecting consumer data or even telling consumers when they have been compromised. Nor do the repositories take any responsibility for the accuracy of data gathered or how it is used, as with identity theft and credit fraud. Because the GSEs require three credit reports for conventional and government mortgages, the repositories apparently decided to come together in an anti-competitive alliance to promote the new VantageScore as a way of displacing Fair Isaac Corp (NASDAQ:FICO) , publisher of the FICO score traditionally used to assess consumer credit. By spending money on marketing and Washington lobbying activities, the three credit repositories have orchestrated a seeming groundswell of support for the VantageScore. But to us, the combination of the three data monopolies in the world of housing finance sure looks like anti-competitive behavior. Of course there are instances where an anti-competitive business combination constructed as an ancillary restraint will survive antitrust tests, but this situation with the three incumbent consumer credit repositories looks like an illegal attempt to stifle competition – namely FICO -- and create a vertical monopoly atop the existing horizontal data franchise shared by the three firms. In the rest of the world of consumer credit, there is competition between the three credit rating bureaus. By maintaining an accurate profile of a consumer’s credit, auto lenders, employers and other parties can quickly assess a subject’s basic credit standing with one report. Only because the GSEs require credit reports from all three agencies is a competitive market transformed into a murky, monopolistic alliance between the three incumbent credit data repositories. Some consumer advocates and Washington policy organs, including many that receive direct financial support from the owners of VantageScore, argue that the new score is more fair than the multiple versions of FICO scores, which are tuned for different industries and can vary by as much as 10% either way depending on the credit type. They also argue that the inclusion of limited rental payment data gives lower income borrowers a better chance of approval. Both private research and internal assessments reportedly conducted (but not published) by the GSEs, however, raise significant doubts as to the numbers of additional low income borrowers that might be approved using VantageScore vs FICO for mortgage lending. Some policy advocates have claimed that seven million new borrowers might be added to the mortgage rolls by wide adoption of VantageScore. “The credit score model used by the GSEs needs to be updated,” writes Laurie Goodman at Urban Institute. “The credit score model the GSEs essentially require mortgage originators to use for mortgage lending— FICO 4—is outdated, based on models estimated in the late 1990s. Both FICO and VantageScore have much more recent models, including FICO 9 and VantageScore 3. VantageScore is also rolling out VantageScore 4.0 this fall.” Goodman and other market participants note that the GSEs and the rating agencies are still using antiquated versions of the FICO model in their own models, versions that ignore advancements in new data and how events such as medical expenses are weighted in credit models. Credit professionals operating in the ABS market also wonder whether either the GSEs, the rating agencies or bond investors are ready to make a change, especially if it results in any expense to make the transition. Many policy advocates in Washington are innocently unaware of the magnitude of change that shifting to, say, FICO 9 would entail for the housing agencies, the credit rating firms and for major bond investors. In tactical terms, the GSEs are the source of the problem when it comes to antiquated credit scores in the world of housing finance. By mandating universal usage of raw credit reports from all of the three repositories, on the one hand, and then dragging their feet on adoption of new credit scoring models – from either FICO or Vantage – the GSEs have created an intellectual and operational bottleneck in the US mortgage industry. But ultimately this Washington conversation is ignoring the most important constituency, namely global bond investors in the US and around the world. One of the dirty secrets of the pro-VantageScore, access-to-credit crowd in Washington is that not all consumers have enough of a credit history to get a FICO score. If you can fog a mirror, you can pretty much get a VantageScore. In fact, VantageScore 3.0 can generate a score for up to 35 million more people than conventional models, according to company claims. And the VantageScore model is about to get even more forgiving, according to The Washingtton Post . The basic credit models used by FICO and VantageScore are similar, but not comparable. An 800 FICO is not the same as an 800 VantageScore. The rental and utility payment data included in Vantage is limited and, to the earlier point on FICO, really does not tell you about the obligor’s ability to pay a 30-year mortgage and take care of the house. These differences between FICO and VantageScore make the credit rating agencies, lenders and servicers, and end investors in residential mortgage backed securities (RMBS) nervous about depending upon newer scores to judge default risk. Think about the folks at the Bank of Japan, for example, who are traditional and size buyers of GNMA securities. Goodman notes that the newer version of FICO and VantageScore are more closely aligned, but the fact remains that you cannot compare a FICO and VantageScore because of differences in the data and methodology. Yet the GSEs could do a great deal to help illuminate and clarify these issues. She writes: "In their 2017 Scorecard, the FHFA directed the GSEs to 'Conclude assessment of updated credit score models for underwriting, pricing, and investor disclosures, and, as appropriate, plan for implementation.' In addition, 'The Credit Score Competition Act of 2017,' HR 898 in the House and an expected companion bill in the Senate, would encourage the GSEs to consider alternative credit risk scoring models when making mortgage purchasing decisions. In particular, the GSEs would be required to establish and make public their procedures for validating and approving credit scoring models." Watt told an industry group last month that the FHFA is supposed to issue a request for information this fall addressing the impact of alternative credit scoring models on access to credit, costs and operational considerations. We agree with Goodman and others that it would be helpful to understand the rationale behind how the GSEs assess different consumer credit agency models for the purpose of default probability. But we also think that the GSEs moving from FICO to VantageScore is probably not practical either. There is not enough of a significant positive difference between the two models to make a change worth the time and money. We also think the idea of the lender selecting the credit score to be used in the underwriting process is a non-starter with investors – and prudential regulators. Real simple: the answer is no. More, there are some far bigger analytical issues that must be settled before the industry moves forward to new credit scores. Last week, Jack Kahan and Steve McCarthy of KBRA wrote an important research note on this issue of default risk estimates in residential RMBS: “Investors and originators alike tend to use the 2001-2003 mortgage origination vintages to establish underwriting standards and to benchmark base case default expectations on newly originated loans. Many industry participants have expressed the view that the market struck the perfect balance between credit availability and prudent underwriting during this period, pointing to pristine mortgage performance for those loans as evidence. Indeed, depending on the metric chosen, defaults for crisis vintage loans were 5.9x that of loans originated between 2001 and 2003. However, our research suggests that credit standards seem to explain only a fraction of this increase when judged through the lens of expected default rates. Based on the Urban Institute‘s HFPC Credit Availability Index, average GSE default risk due to borrower attributes was five percent between 2001 and 2003 and six percent between 2005 and 2007, a 20 percent increase.” More that just a request for information, we’d like to see a public, head-to-head comparison of the different scores supervised by the GSEs and their respective regulators, and with input from the credit community. The last word on this topic is not going to come from Mel Watt or anybody in Washington, but from the bond investors who hold $9 trillion in RMBS. Remember, if the GSEs were to mandate VantageScores, the entire analytical infrastructure of the credit, ratings and regulatory community would need to be revamped. And then the SEC would need to evaluate and validate the new models, especially given the new rules governing RMBS in Dodd-Frank. But of course this all implies that the three monopoly credit repositories would allow their “private” data on millions of consumers to be exposed to the public. Stay tuned. #Experian #Equifax #TransUnion #VantageScore #creditscore #FHFA #MelWatt #FannieMae #FreddieMac #FairIssaac

Austin | Last week we heard optimistic noises coming from some of the top executives in the world of mortgage finance at the Americatalyst 2017 event. Falling interest rates have managed to get new applications for mortgage refinancing even with purchase loans for the first time in months, this as the 30-year mortgage has fallen back to pre-election levels. We're still calling for the 10-year Treasury to go to 2% yield or lower. The good news for Q3 ’17 earnings is that production volumes and spreads are improving for many lenders after a dreadful start of the year. Bad news is that falling yields on the 10-year Treasury implies a significant mark-down for mortgage servicing rights (MSRs). The movement of benchmark interest rates, coupled with significantly lower lending volumes and surging prices for collateral, could make Q3 ’17 a very interesting – and treacherous – earnings period for financials with exposure to MSRs and other aspects of residential housing finance. Away from the blissful consideration of the housing sector, tongues were set wagging late last week when Liz Hoffman at The Wall Street Journal reported that Goldman Sachs (NYSE:GS) commodities head Greg Agran will leave the firm. “Mr. Agran’s departure follows the worst slump in Goldman’s commodities unit since the firm went public in 1999. Bad bets on the prices of natural gas and oil contributed to a second quarter in which the unit barely made money,” The Wall Street Journal reported. The GS “Fixed Income, Currency and Commodities Client Execution” (FICC) arm has seen performance fall by double digits sequentially and year-over-year, causing investors to ask whether Wall Street’s preeminent trading shop has lost its edge. With investment banking and asset management essentially flat last quarter, GS’s net income dropped sequentially. Only a strong performance in equities prevented GS from seeing the Institutional Client Services income line break below $3 billion last quarter . Even though our contacts in the world of credit have been reporting better-than-expected results in the world of energy production, many Wall Street firms have been playing the long-side of energy (and bond yields), and with disastrous results. GS under Agran’s direction in particular was reportedly stung by taking principal exposures related to the Marcellus shale market in OH and PA. This fact is significant for several reasons. As we discussed last week with Paul Murphy , CEO of energy lending specialist Cadence Bancorp (NASDAQ:CADE), prices for natural gas are unlikely to see great upward volatility any time soon. Oil prices too remain under considerable downward pressure as domestic producers continue to develop new ways to cut production costs. “The Permian is still red hot with people paying high prices for acreage,” Murphy reports. “The Permian works at $49 per barrel all day every day.” While most commercial banks can make money primarily by lending, GS is forced to earn its profits by being smarter than other market execution platforms and thereby attracting institutional client trading volumes. Many buy side investors give their business to GS because they believe – rightly or not – that the boys of Broad Street have an edge when it comes to market intelligence. But the past few quarters of underperformance by FICC and the particular misstep with respect to the Marcellus trade suggest that GS may be losing its premier cachet when it comes to market acumen and related mindshare among institutional customers. Indeed, since the start of 2017, GS has significantly under-performed its peers and the S&P 500. With a price-to-book ratio over 1 and a beta of 1.4, GS is still quite fully valued – especially when you consider that the Street has negative revenue growth rates for the bank for the rest of the year. But magically the Street has GS showing a 4% positive revenue growth rate for 2018 and a 20% positive earnings growth rate to boot. Wall Street, after all, is about selling hope. Looking at the big picture for all US banks, commodities trading for customers has not be a strong contributor to total earnings since the implementation of the Volcker Rule in 2012. First comes investment banking fees, followed by credit products which contributed significantly to Q2 ’17 results. Income from commodities and other exposures has significantly trailed other components of non-interest income for all US banks. Notice how the big negative swings in credit contributed to losses in the 2008 and 2012 periods. Source: FDIC For universal banks such as GS, a lot of trading and other types of capital markets activity is conducted outside of the bank in the broker-dealer and is not captured by the FDIC data. For GS, total non-interest income of $14.9 billion at Q2 ‘17 is about 3x the bank’s $5.9 billion in net interest income, the reverse of the distribution seen in most large banks in Peer Group 1. Or to put it another way, the net interest income of most US banks averages 2x the non-interest income. With non-interest income at GS equal to 3.37% of total assets vs 1.3% for most large banks, the dependence of GS on transactional income is pretty much total. In many respects, GS is a hedge fund with FDIC insurance and access to the Fed's discount window. But not being able to overtly trade its own account represents a huge disadvantage compared with its larger peers. There are an awful lot of former GS bankers running around Washington, but the fact that Chief Executive Lloyd Blankfein and his colleagues actually allowed a bet on rising gas prices anywhere makes us wonder. Just about anybody and everybody The IRA speaks to regarding energy prices thinks that natural gas is a dead trade for years to come. The fact that GS chose to bet on whether a privately funded pipeline would be completed on a date certain illustrates the risks that universal banks must take to earn their keep. More, as Liz Hoffman reported in the Journal in August , the ill-fated Goldman trade with Marcellus apparently was to ride the price up as the transportation related discount for production from that region ended, but that sure looks like a principal trade to us. Why is GS even making wagers on Marcellus shale for its own account given the Volcker Rule? Good question. You can be pretty sure that nobody in the bank regulatory community will deign to ask that question so long as former Goldman President Gary Cohn remains employed at the White House. But then again, just about every major Wall Street bank has its own list of exceptions to the Volcker Rule. Look at the earlier chart and note the way that income from credit positions has languished until last quarter. Isn’t that remarkable? Could it be that the largest Wall Street banks are already starting to cheat with respect to Volcker Rule compliance by trading credit exposures for their own account on the assumption that this part of Dodd-Frank will eventually be repealed? The banking industry has made repeal of the Volcker Rule its number one priority in Washington, perhaps explaining the large number of GS alumni operating inside the Beltway since the election of Donald Trump. But to us, the real question with GS and the Volcker Rule is whether the smallest of the major universal banks can survive long-term without being able to aggressively trade its own account. With larger players such as JPMorgan (NYSE:JPM), Bank America (NYSE:BAC) and Wells Fargo (NYSE:WFC) able to use their balance sheets to win business, GS is the low man on the proverbial totem pole of big banks. Will the firm that survived the Great Crash of 1929, the Mexican peso crisis and the financial collapse of 2008 be the next name to follow in the unfortunate footsteps of Lehman Brothers and Bear, Stearns & Co? #GS #JPM #WFC #BAC #GoldmanSachs #lloydBlankfein #VolckerRule

Brooklyn | In this issue of The Institutional Risk Analyst, we speak to Paul Murphy , Chairman, Chief Executive Officer and Director, Cadence Bancorporation (NYSE:CADE) and also Chairman of its main business unit, Cadence Bank, N.A. Paul formerly spent nearly 20 years at Amegy Bank of Texas, helping grow that institution from just double digit millions in assets and a single location to a bank with assets of $11 billion, offices across Texas and a growing book of business with a focus on energy. Amegy was sold to Zions Bancorp (NASDAQ:ZION) in 2005. Cadence was created five years later to invest in the US banking sector, starting in 2011 with the purchase of $1.6 billion asset Cadence Bank of Starkville, Mississippi. Today, Cadence is $10 billion in total assets and is rated “BBB” and “stable” by Kroll Bond Rating Agency. The IRA: So Paul, tell us your perspective on the hurricane and its aftermath for the City of Houston, which is an important part of your bank’s footprint. Murphy: Harvey has truly been an unprecedented weather event. Throughout the storm, our banking services remained fully functional and contingency capabilities were activated to ensure ongoing customer service was not impacted, despite local office closures. As challenging as it was, it served to validate the effectiveness of our contingency planning and preparedness protocols, which withstood this test well. The IRA: That is good news. What did you do early on in the storm’s aftermath? Murphy: Employee safety was our #1 concern. We are happy to report that all our team members are safe and secure, for which we are grateful. Sadly, a number of our staff and their families reported water damage to their homes, and many were subjected to mandatory evacuation orders in the Houston area and forced to seek shelter in alternate locations. The IRA: What is the situation in Houston today? Murphy: First responders did an incredible job supporting those impacted by the storm, as did thousands of volunteers. It’s often in trying times like these when we see the best in others. Managing the follow-up to this natural disaster will take a monumental and city-wide effort, and we are committed to helping our clients and communities rebuild and continue to prosper. The IRA: Apart from the tragedy of last week, how are you feeling about the world? We’ve been through the great oil credit bust that wasn’t in 2015, then the election of Donald Trump and related euphoria, and now the long, tormented disappointment? Murphy: We had a really good second quarter. Made $29 million, core deposits are up nicely, a whole 9 basis points of charge offs. Efficiency ratio at 53%. Return on assets is 1.19% and tangible capital is 12%, so we are feeling pretty good. These are pretty decent numbers. The IRA: You are a solid performer in the small regional category. We got to find you another bank to buy. We have a long list of non-bank mortgage firms that need to get married to a double-digit asset regional bank, of note. Create a whole bunch of Flagstar (NYSE:FBC) clones to bolster the profitability and stability of the mortgage sector, especially the FHA market. But we digress. Talk to us about the focus of Cadence since we first got to know you and there was a real focus on banking the energy business. Murphy: At the peak we were almost 19% energy exposure. Today we are closer to 11%. Going into the oil price downturn, we had about $1.1 billion in loans and about 100 energy clients banking with us. We had one disaster in the portfolio with a really tough set of facts. A couple of others got beat up pretty badly and were severely stressed, but just one out of a hundred was a huge disappointment. These were pretty good results, in part because more than half our exposures were in midstream companies where we’ve had zero charge-offs. We’re still in the business. The IRA: These are very good results and beg the question, why? You and the industry as a whole were preparing for the apocalypse in energy coming up to 2015, but the credit losses simply did not materialize as expected. Provisions were way, way too high vs the actual losses. What happened? Is this another impact of the secular rise in the value of financial assets? As with other asset classes, it suggests that credit events have no cost. Murphy: Equity markets have been wide-open for oil field services and E&P. Some of these deals that are getting done are priced against a 2018 EBITDA growth J curve that is just stunning. I don’t think it is going to happen. There is not so much of an expectation of an oil price increase but rather an assumption that there will be an increase in activity. We’ll see. The Permian is still red hot with people paying high prices for acreage. The Permian works at $49 per barrel all day every day. The IRA: So when we see these breathless articles about oil producers operating at a loss, in part because investors are funding the operations, is this accurate? What is the big picture from your perspective as a lender in the energy belt? Murphy: As with most things, you have to be careful with generalizations. The Energy business is still stressed given the prolonged low price environment. Costs have come down and producers are surviving but returns for investors have declined. In the right area, some operators are reporting 20% IRRs. Our portfolio is appropriately 55% Midstream, and that business is doing well. Natural gas prices are going to remain low for some time to come, but this is spurring an industrial renaissance along the Gulf Coast that is not widely understood. Cheap gas is a huge boost for industry and the economy. The IRA: We’re waiting for somebody to invent a teeny gas turbine that can go in a car and then maybe Elon Musk will have something with Tesla (NSADAQ:TSLA). In addition to energy, talk about the rest of your credit book. Cadence has a good amount of C&I loan exposure and also some residential. Talk about how you view the rest of the business. Have you participated in the great Texas real estate boom over the past few years? Murphy: We are heavy on commercial lending. Our residential portfolio is about $1.1 billion and we like the single family asset. Over the past couple of years, we’ve originated over $2.3 billion in residential loans and have charged off $220,000. We sell about half of our new residential originations, the longer-term fixed rate paper. We tend to keep the floating rate jumbos, the private banking paper. The IRA: And this sounds like well-underwritten production with a 50% risk weight presumably. Murphy: Correct. Its granular and diverse from a risk perspective. Great paper really. The IRA: Do you retain the servicing on the residential loans that are sold? Murphy: We do retain the servicing on some of the fixed rate paper. Over time I expect that we will retain servicing on more of our production. The IRA: Well, the large banks tend to overpay for loans and servicing, then have to play games with the average life to justify their earlier acts of optimism. But skyrocketing prices have choked off the move-up home purchase market thanks to the Federal Open Market Committee. Dan Perl at Citadel Servicing taught us years ago that the real average life of a mortgage is generally about four years, which is the decision cycle for most families. But maybe that is changing. How has Houston real estate come through the decline in oil prices? Murphy: Texas, in particular, is growing nicely. If you had asked me three years ago if we’d be adding new jobs every year, I would have said no way. But we have. But to the point about the duration of new production mortgage loans, if you account conservatively for the mortgage servicing rights created when the loan is sold, it is not a problem and can be a very nice business. You also have a choice as to how much of the MSR to capitalize. The IRA: Subjecting MSRs to fair value accounting has always struck us as a complete waste of time and money. Non-banks are so strained having to finance the purchase of the entire MSR, when all they really want is the 8 basis points servicing fee. Then they end up selling the excess strip for a concessionary price to a financial investor. What is your footprint in terms of residential production vs commercial lending? Murphy: We are throughout the service area on residential and our biggest originations team is in Houston, and Birmingham is where we have most of our loan production people. There are some soft spots in both residential and commercial credits in the energy corridor going up I-10. There was overbuilding in multifamily and they have some real problems. But in town, no. The mid-town, east side of Houston is booming. We have one client giving away maybe a little too much free rent to sign new tenants, but they are 93% leased. We hold the construction loan, but they will have no problem getting that project refinanced. The IRA: We would agree in the current environment. Loss given default (LGD) on bank owned multifamily loans has been negative going back several quarters, suggesting a very strong asset market. Residential LGDs are in the 50% range, the lowest in decades. How do you see the retail sector in particular? Your economic footprint is growing faster than most of the country. Is retail headed for a serious contraction? Murphy: Retail is the sector that worries me the most. This thing with Amazon (NASDAQ:AMZN) is a real problem. Everybody is talking about it. For us, we do not do unanchored retail loans. We must have WalMart (NYSE:WMT) or Kroger or somebody of that quality. And we have very low loan to value ratios. We have 40% and more equity in these deals, going back to your point about strong asset prices. But part of the reason for the great credit performance is the economy. Houston in 1975 had a million jobs. Today we have three million jobs. Over forty years we added 50,000 jobs per year on average. The IRA: What has been driving this remarkable growth in Texas? Murphy: The Port of Houston is a huge factor, the Texas Medical Center is growing, the pro-business environment, no state income taxes, attractive demographics and in bound migration all contribute. If Houston were a stand-alone country, we would be #25 in GDP. We have more jobs than 35 other states. It is a great place to live and do business. The IRA: Talk about the rest of your book. Murphy: We do commercial lending and real estate primarily within our footprint, though we will support national customers as well. Our restaurant team has a national focus. We’ve done great in that space. We have almost $900 million in exposure and have experienced almost zero credit events in that book. We sold one credit we did not like a while back at a discount, but that has been it. We have participated in a number of technology credits with Silicon Valley Bank (NYSE:SVB) and have our technology team in Austin. The IRA: Have you been involved with any of the new consumer lending platforms? Murphy: We are talking to a couple of players as an add-on to our production capacity. There were 400 of these on-line lenders at the peak, now there are 20 of them. We are interested in having that capability to originate loans. If they can meet our lending criteria, we’re interested. And we can help them finance and sell production that we don’t necessarily want to keep in portfolio. The IRA: Given how the FOMC has manipulated credit spreads, how much do you worry about the underlying credit risk that is currently masked by frothy asset values? Murphy: We worry about macro factors and everything else, but where I come back to is underwriting the specific credit risk. We don’t approach it with over-confidence, but we do depend on our lenders and credit people to manage the individual credits. There is more equity in deals today, in part because of regulatory guidance. But we have flexibility as well. We had some E&P credits that were real banged-up in 2015, but we came to the table, told them they had to recapitalize, then offered some ideas on how to get that done. But we worked with these credits and they all did in fact get it done. We looked through the cycle and had a more patient approach to helping what were truly viable businesses add equity and stay right side up. The IRA: Credit management is one of the main reasons that the $1-10 billion asset class banks in the US have the best financial performance. Thanks for your time Paul. #CADE #Houston #Birmingham #energy #MSR #PaulMurphy #hurricane

New York | Fed Chair Janet Yellen’s defense of the benefits of regulation last week in Jackson Hole probably killed her chances for reappointment , but the more pressing reason to see Yellen return to the private sector is visible in the US real estate market. Chair Yellen and her colleagues have created large bubbles in many assets classes from residential homes to commercial real estate to construction lending. As in the 2000s, this latest bout of asset price inflation will not end well for banks or investors. In this issue, The Institutional Risk Analyst looks at the most recent bank portfolio data from the Federal Deposit Insurance Corp for Q2 2017 to see what it says about asset prices and inflation. For some quarters now, the credit statistics for the $16 trillion asset banking system has been too good to be true, in some cases suggesting that credit events have no cost. The last time that this circumstances existed was the mid-2000s, when several large mortgage banks were reporting a negative cost – that is, a profit – from default events. The same real estate market dynamic that allows growing numbers of Americans to take cash out of their homes is depressing the cost of loan defaults to half century lows. Even faced with this rather striking situation, our faithful public servants on the Federal Open Market Committee can actually stand up in public and say that inflation is too low. The skews in the credit world are so large that some banks are actually earning a profit on recoveries after a loan balance is repaid in full. First let’s examine credit trends for 1-4 family mortgages, a $2.4 trillion asset class for US banks. Loss given default (LGD), a fancy way of expressing net charge-offs, shows the average loss for 1-4 family mortgages. At the end of Q2 2017, the LGD for this asset class was just 24%, the lowest loss rate net of recoveries since at least 1990. Last quarter, the volume of defaults on 1-4s fell below $1 billion or less than 1/10th of one percent of total loans. Source: FDIC The chart above suggests that residential assets prices are quite high, as reflected by the high recovery value -- 76% -- implied by the 24% LGD in Q2 '17. Since 1990 the average loss rate after a default for 1-4 family loans is 67%, thus it seems reasonable to ask when US home prices will adjust downward. How you feel about that depends upon whether you view the extraordinary home price inflation seen since 2012 as being permanent and thus immune to mean reversion. The situation in the world of construction lending is even more profound, with LGD’s well into negative territory for the first time since the 1990s. In Q2 ’17, LGD on those few construction loans that actually defaulted was negative 94% . Given that C&D loans tend to be mostly multifamily paper and have loan-to-value ratios around 50%, when you see a bank reporting such unusual profits on defaulted loans it suggests that the value of the real estate has basically doubled since the loan was made by the bank. Note that the downward move in LGD coincides with the end of quantitative easing by the FOMC. Source: FDIC Of note, home equity lines of credit are showing similar behavior to the 1st lien mortgages, which typically stand in front of HELOCs in the credit stack. LGD for HELOCs reached a mere 31% in Q2 ’17, implying that banks are recovering almost 70% of the value of a loan when a borrower default occurs. The 25-year average LGD for HELOCs is 65%, illustrating that Chair Yellen and her colleagues on the FOMC have literally turned the world of real estate credit on its head. As the chart below suggests, the value of the collateral backing HELOCs has surged since 2012. Source: FDIC Next we move to the $780 billion in credit card loans held by US banks, an asset class that has seen recent growth after years of flat to down portfolio levels. The interesting thing about credit card loans is that they are totally unsecured. Thanks to the generosity of Chair Yellen and the other members of the FOMC, credit card loss rates have fallen dramatically since 2008. First let’s take a look at default and non-current rates, which are both turning up after the years of irrational easing by the FOMC. Source: FDIC Notice in the credit card chart that charge-off rates are above that for loans which are non-current, the opposite of this relationship for most other loan types held by US banks. This is due to the fact that, being unsecured, these credits tend to be charged-off before they have an opportunity to be classified as non-current. The next chart below shows LGDs for credit card loans, which at 83% is at the lowest levels since the mid-2000s. Source: FDIC The real question that the previous two charts raise is much on the minds of bank analysts, namely how much future default risk has been buried under the comforting blanket of low interest rates. The average rate of net-charge offs for credit cards is almost three quarters of a point above current levels, again begging the question as to when we shall revert to the mean. The answer to that question will have a significant impact on bank earnings and the ability of banks to return excess capital to shareholders. Finally, let’s take a look at the $1.9 trillion portfolio of commercial and industrial (C&I) loans, traditionally one of the most important indicators of future US economic growth. Defaults and non-current rates are both below the averages going back to the 1980s, while credit spreads are as compressed as ever over that same time period. The chart below shows net defaults and non-current rates for all bank-owned C&I loans. Notice that net charge-offs are below non-current loans, which may end up being worked out or restructured short of a formal default. Source: FDIC While the chart for net-charge offs for C&I loans looks relatively normal compared to the real estate related asset types, loss rates measured by LGD have been climbing since 2015. More important, new loan production rates (as well as sales) are falling so that the portfolio of bank owned C&I loans is no longer growing very much. This suggests that the US economy is slowing and demand for credit is therefore on the wane. The chart below shows LGD for all C&1 loans. Source: FDIC It’s important to note that the charge-offs and recoveries reported in each period by FDIC insured banks are disparate events. A recovery reported today might be related to a loan charged off three years ago. But the key element of price is reflected in the aggregate data reported by each bank, so that a rising recovery rate/falling LGD strongly suggests that prices in the underlying market are quite frothy. Just as in the 2000s and the 1990s, the Fed again has stoked an asset price bubble in real estate that may lead to significant losses for banks and bond investors should prices correct. Whoever gets the top job at the Fed, the FOMC must live with the balance sheet and market conditions served up by Chair Yellen and her predecessor, Ben Bernanke. While the Fed’s initial focus on narrowing credit spreads was correct, the FOMC should have stopped after QE1 ended in 2010. Instead, concerned that banks were not lending, the Fed continued to buy securities. The Fed has kept the pedal to the metal, repeating the errors of the 2000s by fueling a credit driven bubble in residential real estate. This time around, the bubble is more focused on affluent areas of the country, but the result is likely to be more tears. BTW, we’re rooting for Kevin Warsh as the dark horse candidate for the Fed job in the event that White House chief of staff Gary Cohn decides to stay put. But the biggest challenge facing Yellen's successor as Fed Chair is having the courage to admit that inflating asset bubbles does not create jobs or prosperity, just future financial crises. #inflation #janetyellen #FOMC #credit #KevinWarsh #bubble

New York | After several weeks on the road talking to mortgage professionals and business owners, below is an update on the world of housing finance. We hope to see all of the readers of The Institutional Risk Analyst in the mortgage business at the Americatalyst event in Austin, TX , next month. The big picture on housing reflected in the mainstream media is one of caution, as illustrated in The Wall Street Journal. Borodovsky & Ramkumar ask the obvious question: Are US homes overvalued? Short answer: Yes. Send your cards and letters to Janet Yellen c/o the Federal Open Market Committee in Washington. But the operating environment in the mortgage finance sector continues to be challenging to put it mildly. As we’ve discussed in several forums over the past few years, home valuations are one of the clearest indicators of inflation in the US economy. While members of the tenured world of economics somehow rationalize understating or ignoring the fact of double digit increases in home prices along the country’s affluent periphery, sure looks like asset price inflation to us. In fact, since WWII home prices in the US have gone up four times the official inflation rate. “Houses weren't always this expensive,” notes CNBC . “In 1940, the median home value in the U.S. was just $2,938. In 1980, it was $47,200, and by 2000, it had risen to $119,600. Even adjusted for inflation, the median home price in 1940 would only have been $30,600 in 2000 dollars, according to data from the U.S. Census.” Inflation, just to review, is defined as too many dollars chasing too few goods, in this case bona fide investment opportunities. A combination of slow household formation and low levels of new home construction are seen as the proximate cause of the housing price squeeze, but higher prices also limit the level of existing home sales. Many long-time residents of high priced markets like CA and NY cannot move without leaving the community entirely. So they get a home equity line or reverse mortgage, and shelter in place, thereby reducing the stock of available homes. Two key indicators that especially worry us in the world of credit is the falling cost of defaults and the widening gap between asset pricing and cash flow. Credit metrics for bank-owned single-family and multifamily loans are showing very low default rates. More, loss-given default (LGD) remains in negative territory for the latter, suggesting a steady supply of greater fools ready to buy busted multifamily property developments above par value. We can’t wait for the FDIC quarterly data for Q2 2017 to be released later today as we expect these credit metrics to skew even further. Single-family exposures are likewise showing very low default rates and LGDs at 30-year lows, again suggesting a significant asset price bubble in 1-4 family homes. The fact that many of these properties are well under water in terms of what the property could fetch as a rental also seasons our view that we are in the midst of a Fed-induced investment mania. For every seller in high priced states that finds current prices impossible to resist, there are several ready buyers. But the crowd of buyers is thinning. Charles Kindleberger wrote in his classic book, “Manias, Panics and Crashes,” in 1978: “Financial crises are associated with the peaks of business cycles. We are not interested in the business cycle as such, the rhythm of economic expansion and contraction, but only in the financial crisis that is the culmination of a period of expansion and leads to downturn.” One of the interesting facts about the mortgage sector in 2017 is that even though average prices have more than recovered from the 2008 financial crisis, much of the housing stock away from the desirable periphery has not really bounced. This is yet another reason why existing home sales at a bit over a million properties annually have gone sideways for months. The 600,000 or so new housing starts is half of the peak levels in 2005, but today’s level may actually be sustainable. We had the opportunity to hear from our friend Marina Walsh of the Mortgage Bankers Association at the Fay Servicing round table in Chicago last week. Mortgage applications have been running ahead of last year’s levels, yet overall volumes are declining because of the sharp drop in refinancing volumes. We disagree with the MBA about the direction of benchmarks such as the 10-year Treasury bond. They see 3.5% yields by next year, but we’re still liking the bull trade. But even a yield below 2% will not breath significant life into the refi market. Though prices in the residential home market remain positively frothy in coastal markets, profitability in the mortgage finance sector continues to drag. Large banks earned a whole 15 basis points on mortgage origination in the most recent MBA data, while non-banks and smaller depositories fared much better at around 60-70bps. But few players are really making money. During our conversations over the past several weeks, we confirmed that the whole residential housing finance industry is suffering through some of the worst economic performance since the peak levels of 2012. The silent crisis in non-bank finance we described last year continues and, indeed, has intensified as origination margins have been squeezed by the market's post-election gyrations. Looking at the MBA data, if you subtract the effects of mortgage servicing rights (MSR) from pre-tax income, most of the industry is operating at a significant loss. The big driver of the industry’s woes is regulation, both as a result of the creation of the Consumer Finance Protection Bureau and the actions of the states. Regulation has pushed the dollar cost of servicing a loan up four fold since 2008. From less that $100 per loan in 2008, today the full-loaded cost of servicing is now $250, according to the MBA. The cost of servicing performing loans is $163 vs over $2,000 for non-performing loans. Source: MBA As one colleague noted at the California Mortgage Banker’s technology conference in San Diego, “every loan is a different problem.” But nobody in the regulatory community seems to be concerned by the fact that the cost of servicing loans has quadrupled over the past eight years. The elephant in the room is compliance costs, which accounts for 20% of the budget for most mortgage lending operations. Technology Driving Down Costs To some degree, technology can be used to address rising costs. But when it comes to unique events spanning the range from legitimate consumer complaints to a phone call to follow-up on a past request or spurious inquiries, none of these tasks can be automated. The obsession with the wants and needs of the consumer has led the mortgage industry to some truly strange behaviors, like Nationstar (NYSE:NSM) deciding to rename itself "Mr. Cooper." Driven by the atmosphere of terror created by the CFPB, the trend in the mortgage industry is to automate the underwriting and servicing process, and make sure that all information used is documented and easily retrieved. The better-run mortgage companies in the US use common technology platforms to ensure a compliant process, but leave the compassion and empathy to humans. By using computers to embed the rules into a business process that is compliant, big steps are being made in terms of efficiency. Trouble is, this year many mortgage lenders are seeing income levels that are half of that four and five years ago. Cost cutting can only go so far to addressing the enormous expense inflation resulting from excessive regulation and revenue compression due to volatility in the bond market. Avoiding errors and therefore the possibility of a consumer complaint (and a regulatory response) is really the top priority in the mortgage industry today. As one CEO opined: “Sometimes the best customer experience is consistency in terms of answering questions and quickly as possible and communicating in a courteous and effective fashion.” All of this costs time and money, and then more money. Our key takeaway from a number of firms The IRA spoke with over the past three weeks is that response time for meeting the needs of consumers and regulators is another paramount concern. Being able to gather information, solve problems and then document the response to prove that the event was handled correctly is now required in the mortgage industry. But as one senior executive noted: “Sometimes people are easier to change than systems.” So in addition to the FOMC, banks and mortgage companies can also thank the CFPB and aspiring governors in the various states for inflating their operating costs for mortgage lending and servicing by an order of magnitude since the financial crisis. This is all done in the name helping consumers, you understand, but at the end of the day it is consumers who pay for the inflation of living costs like housing. Investors and consumers pay the cost of regulation. Over the past decade since the financial crisis, the chief accomplishment of Congress and regulators has been to raise the cost of buying or renting a home, while decreasing the profitability of firms engaged in any part of housing finance. We continue to wonder whether certain large legacy servicing platforms -- Walter Investment Management (NYSE:WAC) comes to mind -- will make it to year-end, but then we said that last year. Like the army of the dead in the popular HBO series “Game of Thrones,” the legacy portion of the mortgage servicing industry somehow continues to limp along despite hostile regulators and unforgiving markets. Profits are failing, equity returns are negative and there is no respite in sight. Even once CFPB chief Richard Cordray picks up his carpet bag and scuttles off to Ohio for a rumored gubernatorial run, business conditions are unlikely to improve in the world of mortgage finance. Winter is here. #mortgages #CFPB #Cordray #FOMC #housingfinance #rent #affordability

In this issue of The Institutional Risk Analyst, we speak to George Gleason, II, Chairman and CEO of Bank of the Ozarks (NASDAQ:OZRK). Since acquiring a controlling stake in the bank in 1979, Gleason has built the $20 billion total assets institution into a regional powerhouse with over 250 offices in 9 states and a national commercial lending business. As we noted in our discussion with John Kanas of BankUnited , short-sellers have lost a lot of money betting against Gleason and his team at OZRK. The IRA: George, you have been running OZRK for almost four decades in some of the fastest growing areas of the US. Looking back over that period, how have things changed for the bank and the regions that you serve? Gleason: At the risk of sounding like Charles Dickens, I would say that everything has changed, and nothing has changed at all. In my 38-year career, the pendulum has swung from Paul Volker pushing the fed funds target rate over 20% to Ben Bernanke pushing it to almost zero. The seemingly inexorable trend of suburbanization has given way to a massive trend of re-urbanization. Technology has evolved rapidly with a rate of acceleration that seemingly increases every day. The changes are almost unlimited, but at the outset of my first day on the job 38 years ago, I articulated to our staff the principles of pursuing excellence in everything we do, always striving to be the best we can be, improving every day, working hard and adhering to the highest standards of ethics, integrity and fair dealing. Those values and principles have not changed. Whatever success we have had is attributable to our dual abilities to rapidly evolve with the constantly changing macro environment, while relentlessly holding true to the core principles and values that define our bank. The IRA: OZRK is known for being aggressive when it comes to commercial real estate lending, but also for excellence when it comes to managing credit. Of the bank’s $15 billion or so in total loans, $12 billion is in real estate. Looking back over the past three decades, OZRK has reported loan losses that are significantly below its peers. How have you been able to manage the bank so impressively including through the financial crisis? Gleason: The word “aggressive” is often used to describe our real estate business, and I don’t think that is accurate. I view us as “very active” in the real estate space, but very conservative. Real Estate Specialties Group (RESG), our large real estate group, does business across the nation with many of the best sponsors on many of the best properties on extremely conservative terms. At June 30, 2017, assuming every loan in the group was fully advanced, our weighted average loan-to-cost would be about 49% and our weighted average loan-to-value would be about 42%. We are extremely conservative, approving a mid to low single digit percentage of the loans we see. Because of our expertise in CRE and the value we bring to our clients, we see a huge volume of business and that allows us to be very selective. The IRA: Looking at some of the bank’s credit and performance metrics, you have above-average asset returns and margins, excellent operating efficiency, and a default rate that is a half a standard deviation below your asset peers. Your loan book also has a very short duration, less than three years and again well-below peer. Finally, your level of unused credit lines is above peer. How did you come to formulate this remarkable business model? Gleason: We are fortunate to have been among the best performers in the industry year after year for many years. The explanation for that performance is not simple. It is not just the CEO or the head of this unit or that unit or a few great strategies. It is a result of hundreds of skilled and highly motivated people working hard, as a team, in a constant pursuit of doing a better job today than yesterday – always striving to get better. It also has a lot to do with our mission to be the best bank in the eyes of four competing constituencies with very different goals – our customers, shareholders, employees and regulators. Simultaneously making all four of those competing interests view our bank as the “best bank” is like putting a twin fitted sheet on a king bed. They have very different interests, but solving that complex equation of reconciling those competing interests is exactly the goal we vigorously pursue every day! The IRA: Last year seemed to be a peak in terms of bank lending, both for C&I and CRE exposures. How do you see your local markets and also the national CRE market where OZRK is one of the most prominent players? Gleason: We feel good about the current environment. After the Great Recession, there were a few years where new CRE supply did not keep pace with demand growth, and that was followed by a few years where a robust level of construction occurred due to the pent-up demand. Today in most markets, submarkets and micro-markets, supply and demand is pretty much in balance for most product types. There are of course exceptions both ways, but most markets are exhibiting reasonably healthy conditions. New construction in certain markets and product types continues to be justified by population growth, household formation, job growth, changing demographics and other such trends. You just have to do your supply/demand homework on each project and make sure that the demand is going to be there to justify the new supply. Working with intelligent and discerning sponsors helps in that regard, as it means two of us are very critically and thoughtfully looking at the supply/demand metrics. The IRA: Given the bank’s consistent financial performance, you trade at a premium valuation of almost 2x book value and have 80% institutional ownership. Yet there is a certain constituency on Wall Street that seems bound and determined to short OZRK’s stock. Do you think that these pessimistic souls actually understand the bank’s business or are they simply looking at the real estate exposure? Gleason: No, I don’t think they understand our business. My guess is that they screened for banks with a high growth rate and high levels of CRE. Their dual assumptions are probably that CRE is bad and all CRE is more or less the same. That is silly. First, we see great CRE opportunities and we see bad CRE opportunities every day. Our track record over several decades suggests we are good at knowing which is which. Second, at 49% LTC and 42% LTV our RESG CRE exposure has a massively different risk profile than some other banks’ CRE portfolios at 75% or 80% LTV. The IRA: The US economy has been through five extraordinary years of Fed monetary policy where our central bank has deliberately manipulated credit spreads. How concerned are you about the impact of the Fed’s action distorting asset prices in sectors such as commercial real estate? Gleason: It has been a fascinating time to be either a commercial banker or a central banker! You probably recall that even before the official arbiters announced that the Great Recession was in fact a recession; people were all abuzz about what shape the recovery would be. Would it be “U” shaped, or “V” shaped or whatever? When asked that question back then, I always gave this answer: “The U.S. economy has fallen from a ten story window and is battered and bruised on the sidewalk. The recovery will be the economy crawling down the sidewalk, battered and bloodied, for years to come.” As we expected, it has been a long, slow and erratic path back from the bottom. Understanding that we operate in a very complex global economic and geopolitical environment with a constantly changing array of risks, our bank has become more conservative over the last ten years than ever before. For example, the leverage in our CRE portfolio is about 25 points lower on average than it was a decade ago. That doesn’t mean we have a negative view of the future, it simply means that we want to be prepared no matter what the future holds. Maybe thinking like that, I can keep my job another 38 years! The IRA: OZRK is in the process of shedding its parent holding company to save costs and boost returns. Can you talk about what drove this decision and how the change will impact the bank going forward? Gleason: For many years we did nothing in our holding company that we could not do in the bank. Early this year, I asked myself the question, “Why do we have a holding company?” When I couldn’t answer that question, I started asking others. We began to realize that we were incurring a lot of accounting, administrative and regulatory costs and work for a holding company we weren’t using. I analogized it to paying taxes, insurance and maintenance on a beach house you never visit. We got rid of it. We don’t believe it limits or changes our business strategy at all for many years to come. The IRA: Finally, talk a little about your plans for the bank going forward. You have done a series of acquisitions over the past two decades. What should your investors and customers expect to see in the future? Gleason: Last week some of our directors and a few of our top officers joined me to ring the NASDAQ opening bell to celebrate our 20th anniversary of going public. That sort of thing is not really my cup of tea, but the people at NASDAQ were wonderful and it was a great experience. I told our directors the night before that as we were ringing the bell, I was going to be thinking 1% about the last 20 years and 99% about the next 20 years. And that’s exactly what I was thinking. Our focus is clearly on the future. The IRA: No surprise there, but will we see more acquisitions? Gleason: We expect great organic growth, and some very accretive acquisitions. We are confident that the world in which we operate will continue to rapidly change, and we believe that our unchanging principles and our great people will achieve some remarkable things. I firmly believe that our best years lie ahead! The IRA: Thanks George. #GeorgeGleason #OZRK #BankoftheOzarks #JohnKanas #BankUnited #hedgefunds #CRE

"When we get piled upon one another in large cities, as in Europe, we shall become as corrupt as Europe." Thomas Jefferson New York | When William Clay Ford Jr., Chairman of Ford Motor Co. (NYSE:F), fired CEO Mark Fields earlier this year, he in part confirmed the view expressed in our book “Ford Men: From Inspiration to Enterprise,” that figuring out which supposed techno trend to believe (and invest in) will be a challenge. After surviving the automotive equivalent of nuclear winter in 2008-2011, Ford and the rest of the auto industry rebounded nicely in terms of sales and profits, peaking last year at 18 million units sold in the US. But beyond next quarter’s financial results, every leader of every major global automaker is worried about one greatly glorified word: mobility. “If there’s one takeaway from Ford ditching Fields,” concludes Wired magazine, “it’s that in our current transportation environment, ‘mobility’ isn’t so much a strategy as it is a euphemism for ‘we have no idea what’s happening next.’” Bill Ford recently told The Wall Street Journal that his company lacks vision , but he’s going to fix it – by bringing in yet another new Ford Man, Jim Hackett. We warned in “Ford Men” that Fields was starting to sound like Jacques Nasser, a view that turned out to be prescient. But Bill Ford’s prattle about vision also sounds like some of his ill-considered comments about safety and the environment of a couple decades ago. For long-term observers of the auto industry, this leadership transition at Ford Motor Co. raises concerns, in part because of what it says about the Blue Oval in a period of technological consolidation. We worry that Ford’s board of directors clearly liked the style of leadership under former CEO Alan Mulally, but still does not fully trust Bill Ford, especially given the widespread confusion over how to deal with the challenge of “mobility.” Alan Murray wrote for Fortune in May 2017: “Mark Fields’ ouster as CEO of Ford yesterday is another example, if anyone needed one, of just how hard it is to lead a company in the midst of disruptive change. The auto industry is actually riding the waves of three separate disruptions, all at the same time: electric engines, ride sharing, and autonomous vehicles. Fields enthusiastically embraced all three, investing in a Silicon Valley research center, becoming a regular at the CES tech fest, and talking of making Ford a ‘mobility company,’ with one foot firmly in the present and one boldly in the future. But shareholders weren’t buying it.” The mainstream auto business is being distracted by a growing number of irrational players and attendant consultants. The most obvious of these is Tesla (NASDAQ:TSLA), the love child of serial entrepreneur Elon Musk, who has spent billions pursuing the dream of an electric car powered by a battery with little hope of generating a profit. TSLA is in the high yield market even now borrowing another couple of billion, funds which will cover well less than a year of the company’s prodigious capital burn rate. TSLA cars are heavily subsidized by US taxpayers and are not especially green either , especially when you consider the manifold inputs needed to make these pricey toys for wealthy car aficionados. There is no question but that DC motors powered by the appropriate generator are the best way to propel a train or a ship, but using batteries to power an automobile is a strikingly retrograde development. As we note in "Ford Men," a century ago Thomas Edison was fascinated by battery powered electric cars, but ultimately advised Henry Ford to use gasoline as a power source. But specific to the idea of mobility, there are a growing number of players outside of the auto industry that have decided to ride a wave of changing consumer preference when it comes to how people use transportation. These new entrants to the world of conveyance include global limousine network Uber, online search engine provider Alphabet (NASDAQ:GOOG) and computer giant Apple (NASDAQ:AAPL). None of these names have any competency in manufacturing cars and trucks, but all are attracted by the relevance and potential audience for mobility worldwide. The tech incursion into the auto sector marks a strategic attack by one industry against another in a contest for consumer attention. Like TSLA, AAPL, GOOG and Uber are not particularly focused on making a profit – thus providing a serious problem for F and other incumbent automakers. The culture of growth that surrounds all of these new economy interlopers does not require profit – only liquidity and, for the profitless, a steady supply of greater fools. This is the economic environment defined by a growing list of money eating global monopolies – Amazon (NASDAQ:AMZN first and foremost -- that are managed for expanding market share rather than operating income and equity returns. Part of the “collateral damage” from the Fed’s zero interest rate policies (referred to by economist Paul McCulley in a past IRA comment ) is that investors how readily accept the idea of deploying capital into big, new ventures with no expectation of income or even the immediate return of principal. GOOG and AAPL spend billions of shareholder cash annually pursuing various speculative notions, while TSLA spends both equity and the proceeds from debt raised with its “B“ junk credit rating. But investors don’t seem to mind. The fact of growth drives valuation ever higher. How does Bill Ford or any sane leader in the auto industry plan strategy when surrounded by seemingly irrational competitors such as these? One of the interesting threads driving the mobility narrative in the auto industry is the idea that everyone is moving into the revived inner cities and fleeing the suburbs. Retailing clearly is in a state of apocalypse, but in part because of a huge surfeit of retail space built with cheap money. The debt placed upon the major retailers and their commercial real estate was “crazy”, to paraphrase retail expert Howard Davidowitz, “built by the lunatic ideas for growth led by Wall Street.” The other factor in the deflationary spiral in commercial real estate for retail is AMZN, which is leading the world in online fulfillment for consumer purchases. But is it really the case that the suburbs are being abandoned? We spent some time with our friends at CoreLogic recently, specifically deputy chief economist Sam Khater, who has done a lot of work on trends in population and pricing for residential housing. No surprise, Sam confirms that house prices in the outer rings around major cities have displayed more weakness than cities. He also notes that prices in the cities and inner suburbs have skyrocketed in recent years. But do these data points necessarily suggest that we are headed for a sharing economy where we’ll never own a car or go to a suburban mall or own a single-family home or travel long distances by car? What Sam’s work does suggest is that prices in the outer rings around major metros are starting to accelerate after years of under-performance. He also identifies some interesting areas of risk for lenders, investors and loan servicers (aka “asset managers”) involved in consumer lending for things like homes, automobiles and other significant credit exposures. The weakness of home price appreciation (HPA) in the outer bands around major cities could support a couple of conclusions: High HPA in cities will intensify the relative attractiveness of the outer suburbs, causing an acceleration of the long-term shift in populations that is already underway. Households with lower incomes and with young children will continue to be attracted to the relatively lower cost and greater living space of suburban housing, but will also face the cost of commuting into the city center for work and to access services. Lower price appreciation in the suburbs means less equity accumulation for home owners and thus higher spatial income inequality compared with inner city households. CoreLogic shows that HPA in outer suburbs is half the rate of cities. Changes in home buyer behavior, such as the shift to a multi-family model in heretofore single family communities, suggests pressure on outer suburban localities in terms of zoning and taxes. Lending to lower income borrowers in urban areas has fallen dramatically since 2008, one side effect of the Dodd-Frank legislation, forcing many potential home owners into rentals. These households are not able to purchase a home, meaning that they will not even be able to participate in the increase in urban home prices. The low income share of suburban home purchases is slowly rising, but still trails the overall rate of lending to all home buyers. For lenders investors and managers, the movement of less affluent populations to the suburbs suggests that the credit profile of these geographies will decline accordingly. To paraphrase Sam: “The credit risk gradient is shifting to the suburbs.” Whether the household is in a home with a mortgage or a rental, the changing demographic of the suburban dweller will be of concern to investors in mortgages and REITs specializing in residential rental properties. And for the car industry? The future is unclear. Bill Ford apparently shot long time Ford Man Mark Fields because of F’s slumping share price vs. aspirational and irrational competitors like TSLA, GOOG and Uber. AMZN will probably get into the mobility game too at some point. But the bigger problem at Ford is that the board of directors still does not have confidence in either Bill Ford or the incumbent management culture. John Baldoni wrote in Forbes : “When a company hires from the outside it is an acknowledgement that things are not working well. What the board is really saying to senior management: “We don’t trust you guys to run the company.’ No matter how you spin it, bringing in a new CEO is a slap in the face to the people already there.” For our money, we think Bill Ford ought to focus on making cars and leave the vision thing to the markets. And Jim Hackett may turn out to be a great CEO, whether he’s got the idea on mobility or not. If Ford and the other automakers listen carefully (and ignore the consultants), their customers will inevitably tell them what type of mobility solution is required for their needs. Those families rotating out to the suburbs will all need wheels, whether powered by gasoline, hybrids or batteries, private car or public transportation. But for investors focused on housing, no matter how you cut it, the dramatic trends in HPA and demographics already suggest big changes in the years ahead. The wall of hot money created by the Fed has so inflated urban commercial real estate values from London to New York to Hong Kong that the repricing of housing is likely to drive many low income households out the cities for good , what one activist likens to “ethnic cleansing.” Mobility, at the end of the day, is a trend that favors the most affluent members of our society. #Ford #GOOG #Tesla #mobility #housing #retail #ZeroHedge #AAPL

“While the US and the UK have been mired in political chaos this year, the EU has enjoyed improved economic conditions and some political windfalls. The question now is whether this good news will inspire long-needed EU and eurozone reforms, or merely fuel complacency – and thus set the stage for another crisis down the road.” Philippe Legrain Project Syndicate Dana Point | This week The Institutional Risk Analyst takes a look a the recent reports out of the EU regarding a proposal to “freeze” the retail accounts of failing European banks. The original story in Reuters suggests that our friends in Europe actually think that telling the public that they will not have access to their funds, even funds covered by official deposit insurance schemes, is somehow helpful to addressing Europe’s troubled banking system. Investors who think that Europe is close to adopting an effective approach to dealing with failing banks may want to think again. Judging by the reaction to the story by investors and on social media, it appears that the EU has learned nothing about managing public confidence when it comes to the banking sector. In particular, the idea that the banking public – who generally fall well-below the maximum deposit insurance limit – would ever be denied access to cash virtually ensues that deposit runs and wider contagion will occur in Europe next time a depository institution gets into trouble. “The plan, if agreed, would contrast with legislative proposals made by the European Commission in November that aimed to strengthen supervisors' powers to suspend withdrawals,” Reuters reports, “but excluded from the moratorium insured depositors, which under EU rules are those below 100,000 euros ($117,000). While some Wall Street analysts are encouraging investors to jump into EU bank stocks, the fact is that there remains nearly €1 trillion in bad loans within the European banking system. This represents 6.7% of the EU economy, according to a report and action plan considered by EU finance ministers earlier this month. That compares with non-performing loans (NPL) ratios in the US and Japan of 1.7 per cent and 1.6 per cent of gross domestic product, respectively. But the most basic point to make about the proposal for a “temporary” suspension of access to cash is that such moves never work. Moratoria are part of the banking laws in Germany and many other European nations, but they are never used because once invoked the institution is dead for all practical purposes. In Spain, for example, the government had the power to impose a temporary suspension of access to deposits in the case of Banco Popular, but did not do so because it would have killed the franchise. Jochen Sanio, the former president of the German Federal Financial Supervisory Authority (BaFin), commented about banks subject to “temporary” deposit moratoria that “they never come back.” Sanio, who guided Germany through the 2008 financial crisis and forced the clean-up of insolvent state-owned banks, was retired and gagged for the rest of his life for challenging Germany’s corrupt political status quo of covert bailouts. So again, one has to wonder, why any responsible official in Europe would support the plan reported by Reuters . As the US learned the hard way in the 1930s and with the S&L crisis in the 1980s, the lack of a robust national deposit insurance function to protect retail depositors leaves an entire society vulnerable to banks runs and debt deflation. Until the EU is prepared to do “whatever is necessary,” to paraphrase ECB chief Mario Draghi, in order to protect retail bank depositors, the EU will remain far from being a united political economy. Readers of The IRA may recall the comments of German Chancellor Angela Merkel last Fall, when she suggested that the German government would not support Deutsche Bank AG (NYSE:DB) in the event that the institution got into financial trouble. At the time, DB was trading at about $12 per share in New York. We spoke about DB and the ill-considered comments made by US and German officials from Dublin on CNBC on September 30th. At the time, we reminded investors that political officials should never talk about a depository institution while it is still open for business. This is a basic, well-recognized rule that has been followed by prudential regulators around the world for many years. Yet because of the popular political pressures on elected officials such as Merkel, the temptation to engage in absurd hyperbole with respect to big banks is irresistible. We see this latest piece of news out of Europe as further evidence that there is still no political consensus about how to deal with troubled banks. As we learned last year, Merkel could not even make positive public comments about DB for fear of committing political suicide. The more recent bank resolutions in Spain and Italy were made to look like touch measures in public terms, even as the Rome government quietly subsidized the senior creditors of two failed banks in the Veneto. We noted in an earlier comment, “Fade the Great Rotation into Europe,” that the EU pretends to play tough on bank rules while bailing out the senior creditors: “Of note, Italy is being given control over the remaining ‘bad bank’ to wind down as the assets and deposits are conveyed to Intesa SanPaolo. This permits a bailout of senior unsecured creditors. So Italy gets what it wants – continued circumvention of EU bailout rules. If a bank disappears, notes a well-placed EU observer, ‘state aid rules do not apply.’” The Europeans appear to be playing a very dangerous game. On the one hand, EU officials talk publicly about getting tough on insolvent banks and even suspending access to funds for retail depositors. On the other hand, EU governments are continuing to bail out banks and large creditors in a display of cronyism and business as usual. “Under the plan discussed by EU states, pay-outs could be suspended for five working days and the block could be extended to a maximum of 20 days in exceptional circumstances,” Reuters reports. “Existing EU rules allow a two-day suspension of some payouts by failing banks, but the moratorium does not include deposits.” Contrast the EU proposal with standard practice in the US, where the Federal Deposit Insurance Corporation (“FDIC”) begins to market troubled banks before they fail and tries to execute bank closures and sales on a Friday to avoid frightening the public. The branches of the failed bank then open on the following business day as part of a solvent institution without any interruption in customer access to funds. Importantly, all insured depositors, as well as brokered deposits and advances from the Federal Home Loan Banks, are always paid out by the FDIC when the failed bank is closed in order to avoid precipitating runs on other institutions. In Europe, on the other hand, there appear to be a significant number of officials who seriously believe that denying retail bank customers access to funds covered by deposit insurance will not result in financial contagion. If such a proposal is adopted, the sort of bank runs seen in Cyprus and Greece could intensify and spread to the major countries in Europe. Imagine that a large bank failure occurs in Italy next year and Italian officials tell retail customers that they will not have access to any funds for several weeks. As we saw in 2012 in Spain and Cyprus and 2015 in Greece, retail bank runs tend to spill over into other countries and markets, creating a situation where fear takes over from rational behavior. The trouble is, Chancellor Merkel cannot commit Germany to supporting an EU accord to support the banks in the Eurozone without ending her political career. “If capital flight from the peripheral economies gathers pace, it could trigger runs on entire banking systems,” notes the infamous “Plan B” memo prepared for Merkel in 2012. “That would put the ECB—and thus, indirectly, the Bundesbank and Germany—on the hook for deposits worth trillions of euros.” In the dark days of 2012, Merkel’s government prepared for “Plan B” and was essentially ready to allow the weaker nations on the EU’s periphery – including Spain, Greece, Italy and Ireland -- to fail and drop out of euro as Germany withdrew to a core group of nations. Just as the EU still refuses to deal with Greece’s mounting debt, likewise it cannot seem to accept that protecting the small depositors of European banks is the price to be paid for preserving social order and the EU itself. Otmar Issing, former Chief Economist and Member of the Board of the European Central Bank and the German Bundesbank, summarizes the situation: “The euro crisis is not over.” #euro #banking #DeutscheBank #AngelaMerkel #MarioDraghi #ECB

“I came of age on Wall Street when the Chairman of the Federal Reserve Board—he was William McChesney Martin—condemned even trace amounts of inflation as an economic and moral evil. In the interval of 1960-65, there was not one year in which the CPI registered a year over year rise of as much as 2%.” Grant’s Interest Rate Observer New York | BTW, below is my latest comment on housing finance reform in American Banker , “Fannie, Freddie are irrelevant to a government-backed mortgage system.” I'll be participating at the CoreLogic Risk Summit next week in Dana Point. Come say hello! We’ve all heard of fake news, but consider the growing possibility of fake or at least virtual assets. Investors face a deliberately orchestrated shortage of real investments c/o global central banks in markets such as stocks and real estate. Is there any wonder that the financial engineers of Wall Street have again begun to manufacture new derivatives leveraging the real world? Case in point, bitcoin. The most recognized “digital currency,” bitcoin is a form of high-tech gaming instrument that fulfills just one of the traditional roles of money, but is among the world’s fastest appreciating – and most volatile-- “asset" classes. Adherents call the limited supply of bitcoin the ultimate expression of Milton Friedman style monetarist discipline. They view the digital medium as a rational response to the fiscal and monetary chaos visible in most of the industrial nations. But despite the huge gains seen in bitcoin vs conventional currencies, Jim Rickards says he’s sticking with his preferred investments: gold, cash and silver. “I don’t own any bitcoin, but for those who have a preference for bitcoin, good luck,” he told Kitco News . Bitcoin has been blessed by a federal regulatory agency in Washington. “On Monday, a bitcoin options exchange called LedgerX won approval from the Commodity Futures Trading Commission to clear bitcoin options, making it the first U.S. federally regulated platform of its kind,” reports The Wall Street Journal . LedgerX’s chief executive Paul Chou is on the CFTC’s Technology Advisory Committee. Not surprisingly, a CFTC spokeswoman said “no committee, including the Technology Advisory Committee, plays any role in any registration decision.” OK. Regardless of whether you view bitcoin as an investment or the electronic version of tulip bulbs, the fact of a traded options contract is intriguing. It allows speculators to take a flutter on bitcoin without actually touching the ersatz currency or the varied folk who are said to traffic in this ethereal world. To be fair, drug dealers, terrorists and members of organized crime organizations in nations like China, Russia and North Korea are not ideal counterparties for a US bank or fund. But a US traded option contract may allow you to play the bitcoin game, pay your taxes, and sleep at night. A lot of managers may find that degree of separation attractive. Of note, less than 24 hours after the CFTC announcement, the Securities and Exchange Commission has declared that “tokens” such as bitcoin can be considered securities, and therefore, may be need to be registered unless a valid exemption applies,” Reuters reports. "The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets," said Stephanie Avakian, the co-director of the SEC's enforcement division. Part of the “problem” with bitcoin is that it is not easy for an individual to move in and out of the stateless, “offshore” market. It will be interesting to see which financial institutions are willing to provide the infrastructure to allow a bitcoin options contract to settle in dollars and in size large enough to satiate institutional players. But the more interesting question is how investors will deploy capital in this volatile and entirely opaque market. The idea of an option on bitcoin certainly seems to have some utility. Bitcoin may not be a store of value or a unit of account, but it serves that same purpose as the dollar in terms of acting as a means of exchange. Like the dollar, bitcoin promises to pay, well, nothing, so the two moneys have rough equivalence in that regard. Our guess is that a successful launch of the bitcoin option contract could significantly increase cash trading volumes, which will manifest in higher value vs traditional currencies. But the real issue is how to gauge the ebb and flow of demand for the bitcoin tokens. A large portion of the “float” in bitcoin cannot trade because the “owners” have lost their ID numbers, thus measuring how much supply is available to meet a given amount of demand is a challenge. Additional bitcoin cannot be issued beyond the 21 million limit of the system, although the coins can be subdivided. In the short run, the only variable that can change with demand is the spot price. Also, high and sometimes variable settlement costs add to the complexity of trading bitcoin. In many respects, a conventional option contract may be significantly more efficient than the cash market for bitcoin driven by the clunky blockchain technology. While the news of the CFTC’s approval of the bitcoin options contracts may turn out to be good news for the digital currency, please note that our dim view of the blockchain clearing technology that enables bitcoin has not changed. The Journal reports that CFTC Acting Chairman Christopher Giancarlo states publicly that he’s optimistic about blockchain technology’s future. We’d like to see him explain why, paying specific attention to operational efficiency and cost. A derivative contract on a derivative digital currency has a lot more promise that the technological dead end known as blockchain. To date, we have yet to see a single commercial application of what people call “blockchain” that has real commercial potential. The same robust and expensive encryption technology that helps the bitcoin market ward off attempts at manipulation also makes blockchain unsuitable for other business uses. As Saifedean Ammous wrote in American Banker last year : "[D]espite banks' attempts to test and use blockchain technology for their own commercial gain, it is outside the realm of possibility for the technology to serve any useful purpose for the intermediaries it was designed to replace. That is akin to burdening horses with engines in the name of technological innovation: the approach would only slow down the horse and alleviate none of its problems. Such a ridiculous notion will find no real world demand." In simple terms, blockchain is just a form of industrial grade encryption tied to a bulletin board for the public portion of the keys. When it comes to clearing options contracts, the existing centralized technology solutions are far more attractive in terms of speed and cost. Indeed, it will be interesting to see how LedgerX manages delivery of bitcoin as contracts expire or whether it will require cash settlement, as is customary with gaming instruments. So let’s keep our eyes on this bitcoin options contract. It promises to expose a far greater number of investors to this global gaming instrument. We suspect that the SEC is right when they refer to them as tokens, albeit ones that can only be settled electronically. If bitcoin are eventually determined to be securities by the SEC, however, it both validates and changes the market forever. With recognition comes regulation and reporting. What the success of bitcoin says about the world of dollars, euros and yen is unsettling at a number of levels, but then again, bitcoin is ultimately just a brilliantly designed virtual market that, initially at least, promised security and anonymity. Whether those qualities can endure as the audience grows is a very intriguing question that investors need to consider. #bitcoin #blockchain #GSEs #SEC #CFTC #token

New York | Earlier this week we appeared on CNBC’s “Squawk Box” to talk about bank earnings and the Fed. The results from the top-four banks – Bank America (NYSE:BAC), JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) – are really no surprise to readers of The IRA . The largest banks all beat small on revenue and earnings, but showed weakness on fixed income and the mortgage banking lines. We suspect that there will be even more pain on the mortgage banking line for WFC, JPM and BAC next quarter. As we told Andrew Ross Sorkin, bank stocks have essentially been going sideways since February and are likely to continue side-stepping because most of the large cap names are fully valued after the Trump Bump. But the biggest obstacle to rising bank stock valuations is the Federal Reserve System’s policies of low rates and open market purchases of debt. At the Fed of New York back in the 1980s, one and a quarter times book was seen as the natural limit for bank valuations. Have a look at our previous note if you have any questions on the particulars. Suffice to say that 1x book value for BAC is about right given the bank’s asset and equity returns, and the state of the credit markets. Tight credit spreads make life tough for all but the best run banks. When we suggested US Bancorp (NASDAQ:USB) to Squawk Box as our favorite large cap, that was because of the operational excellence as opposed to the stock price, which trades above 2x book value. But the more interesting question from CNBC's Andrew Sorkin had to do with the choice of the next Fed Chairman. News reports suggest that White House chief of staff Gary Cohn is the leading contender to take over from Fed Chair Janet Yellen. We would welcome Cohn’s appointment not because he is an alumnus of Goldman Sachs (NYSE:GS), but because he understands financial markets and is not a PhD economist. For too long the Fed’s internal deliberations have been dominated by academic economists who do not understand the real world impact of monetary mechanics much less the workings of the financial markets. Having Cohn and other non-economists on the Federal Open Market Committee would be a welcome change that would support economic growth by encouraging investment. During our trip last week to Jackson Hole, we had the pleasure of hearing from Paul McCulley, an American economist and former managing director at PIMCO who is now teaching at Cornell. Paul is an articulate and unabashed advocated of neo-Keynesian economics (aka “socialism”). He is noted for authoring such memorable phrases as “shadow banking” and “Minski Moments.” Like most of the members of the FOMC, Paul believes that additional deficit spending was the proper response to the financial crisis of 2008. And like Chair Yellen, he apparently thinks that the fact that Congress refused to ratchet up public spending five years ago was a sufficient excuse for the unelected central bankers to “do something” in their stead in the form of near-zero interest rates and, more important, quantitative easing or “QE.” Paul explicitly equates democracy and socialism, believing that people of modest means will always vote for the smiling bureaucrat offering a bag of free groceries or subsidized health care. He also says that the Fed has too much independence and should coordinate its actions with fiscal policy. To his credit, McCulley at least concedes that while QE was the right policy "there is collateral damage.” There are two basic problems with the pro-fiscal spending argument of liberal economists. First, it is pretty clear from the literature that deficit spending does not produce any benefit in terms of increased consumer spending or jobs. For decades, American policy makers have been pulling tomorrow’s sales into today by using cheaper credit, but the efficacy of such policies has been pretty much exhausted. Some even believe rising public deficits choke off growth. The second and more important issue is that Congress has shown itself to be completely incapable of restraining spending during good times to balance off Keynesian stimulus during slack times. Keynes was no apologist for debt and explicitly assumed that government would in good times promptly repay debt incurred to fund public spending. Today repayment of public debt is never even discussed. Davidson (2003), for example, notes that Keynes believed that government should always maintain a balanced operating budget. When considering the arguments of economists such as McCulley and others who advocate increased federal deficits, the only conclusion possible is that they implicitly are taking us down the road to eventual debt default and hyperinflation. Since they never once suggest that the debt incurred to fund deficit spending should be repaid in kind, as Keynes would have insisted, the only reasonable scenario would be for the FOMC to eventually make QE a permanent feature of the American political economy. In such a scenario where the FOMC explicitly and continuously suppresses interest rates and credit spreads, and monetizes the Federal debt with open market purchases, private sector entities such as banks, companies and pension funds soon will become superfluous. Quaint notions about private property and free enterprise would be discarded in favor of a “single payer” model for the entire US economy – namely the Fed. The free market capitalism of the US would mutate into something that looks a lot like the state-directed economy of Communist China. Fortunately there still are enough Americans who understand the fallacy of the neo-Keynesian socialist model. The path to making America “great again” has nothing to do with who is in the White House, but a great deal to do with who occupies those seven seats on the Federal Reserve Board. In particular, we need a Fed Chairman and governors who are not afraid to say “no” to the fiscal profligacy in Washington. Rather than facilitating the issuance of public and private debt as the FOMC has done under Yellen, the US central bank needs to become an advocate for savers and private investment, and a vocal critic of the dissolute fiscal policies of the Congress. The members of the FOMC need to appreciate that the polices followed by Chair Yellen and the FOMC after QE1 (which re-liquefied the US banking system) were detrimental to job growth and economic expansion. Subsidizing public and private debtors at the expense of savers is no formula for private sector economic growth and job creation. For example, the folks on the FOMC don’t seem to understand that low interest rates and artificially tight credit spreads retard private business investment and advances in productivity. Since 2012 when the Fed started QE, public companies have eschewed new investment – and instead bought back trillions of dollars worth of stock financed with debt. As Ben Hunt wrote in his blog Epsilon Theory : “In exactly the same way that QE was deflationary in practice when it was inflationary in theory, so will the end of QE be inflationary in practice when it is deflationary in theory. That’s the real world impact I’m talking about, the world of wages and output and productivity. You know, the real world that used to be the touchstone of our markets.” We told Andrew Ross Sorkin today that we like the idea of Gary Cohn as Fed Chairman because he would normalize monetary policy. We like the idea of JPM CEO Jamie Dimon running for President in 2020 even better. Based upon on his recent public comments, Dimon seems to be interested: ““And you know at one point we all have to get our act together [so that] we will do what we’re supposed to do [for] the average Americans.” Ditto Jamie. America hungers for credible leadership that can truly foster a positive environment for the US economy to grow and create opportunities for our people. The markets were hopeful that Donald Trump would provide that leadership, but this hope has been dashed. If Cohn takes the job as Fed Chairman, that is a pretty good sign that the former GS partner has given up on Trump and is looking for his next challenge. But that could be the most bullish signal investors see coming from Washington this year. #YellenBACGSJPMWFCUSB #BANKING #BAC #JPM #WFC #USB