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La Jolla | This week The Institutional Risk Analyst is in La Jolla for The Chairman's Conference of The California Mortgage Bankers Association. Click here to download our keynote presentation. Last Friday we got to talk banks with Brian Sullivan on CNBC . We noted that investors need to forget everything they were told in 2018 about rising interest rates. Many investors got killed last year positioning for rate increases in 2019. Hint: When your prime desk coverage is selling the short bond/long rate trade, look the other way before crossing the street. The folks on the Federal Open Market Committee may be clueless on rates, but your friends on the Sell Side are most definitely not. Banks and nonbank financials are being whipsawed by falling market yields. Look for negative marks on mortgage servicing rights (MSRs), TBA exposures, and rate hedge desks in Q1 earnings. But don’t worry, the Sell Side desks did just fine. And behind the scenes, funding costs continue to rise for US banks regardless of the moves in market rates. The relentless increase in funding costs will take a bite out of bank earnings as net interest income growth flattens out and even declines. Last month we put out a call on NIM flattening for US banks in 2019. We discuss the dynamics driving up the cost of funds for US banks in the most recent issue of The IRA Bank Book . https://www.theinstitutionalriskanalyst.com/single-post/2019/03/24/Bank-Earnings-and-QEQT China, trade, etc is all fun to talk about, but we remain in a sellers market for securities even as market yields decline. Quality issuance is getting snapped up aggressively by global funds and public sector agencies. This impacts financials because the competition between lenders and bond market execution and private equity is intense. They are all fighting over the same pool of assets, a big bucket of duration that has been rendered inadequate by the reckless actions of the Fed and other central banks. Just as the FOMC has been unable to achieve a certain level of inflation, neither can they engineer rising interest rates. This is one of the unanticipated side effects of "quantitative easing" or QE. Bank loan spreads and bond yields remain biased ON THE DOWNSIDE despite the yada, yada from the FOMC and allied media about rising interest rates. Since December, in fact, the FOMC has been rudely reminded that it only controls the short-end of the Treasury yield curve and then just barely. Steve Moore, Larry Kudlow and POTUS all are right about rates and markets, BTW. The folks on the FOMC ignored market indicators from September onward, ignored the fact that high yield credit spreads were blowing out by T-Day, and almost ran the ship aground in December. Herman Cain on the FOMC? Yes please. We need more non-economists sitting at the Fed table. Some say the Fed's independence would be hurt by having Cain or Moore on the Fed. But independence from what exactly? Remember December 2018? Wells Fargo & Co Our upbeat comment on Wells Fargo & Co (WFC) last week generated a lot of comments, but the reality is that it will take a long time for the basic operational quality inside the bank to see premium valuations. We have all witnessed a huge screw-up by the WFC board, management, and regulators. If Fed/OCC had forced CSUITE changes two years ago, then WFC would be in far better shape today. https://www.theinstitutionalriskanalyst.com/single-post/2019/03/31/Is-there-a-bull-case-for-Wells-Fargo-Co The moral of the story: regulators need to use the power that they already possess to enforce change at banks with weak internal systems and controls. The Street has negative estimates on revenue and earnings growth for WFC, in part because bank lending volumes across the industry are slowing. As we said last week, WFC balance sheet definitely gets smaller in 2019 if they continue dividend payouts at current levels. JPMorgan Chase & Co The Street has small earnings growth in Q1 for JPMorgan Chase (JPM), then the proverbial hockey stick for full year. Big question for JPM is how December massacre in fixed income and falloff in securities issuance volumes in Q1 will impact capital markets and investment banking results. Can't wait to see the March data on securities issuance from SIFMA. Of course Jamie Dimon will exceed the Street's modest estimates for earnings growth in 2019. Housing Redux? Finally, it is notable that mortgage-refinance applications were up 39% last week. An index that measures refi applications hit its highest level since November 2016. The welcome surge in volumes has brightened the outlook for the entire mortgage finance sector. Real question is whether these “green shoots” will give the industry a shot in the arm in terms of both volumes and profits after the worst year in decades. The good news is that 30 year mortgage rates have followed the 10-year Treasury note down a point in yield since last November. The bad news is that home prices have been pushed out of reach for many Americans. The inflation in home prices that occurred during and after the Fed purchase of trillions in government securities and RMBS under QE has permanently raised the price of housing in many parts of the country, preventing millions of young families from purchasing a first home. Former Fed Chair Janet Yellen confesses to be “perplexed” by the dearth of home purchases by young families, but she and the other advocates of inflation on the FOMC are the cause of this malady. Unless and until the FOMC figures out a way to gently let some of the air out of the housing bubble, low rates may not be sufficient to boost annual lending volumes back over $2 trillion annually. And without a significant increase in lending volumes, profitability is likely to be elusive in the mortgage sector -- even with lower interest rates. ♦ #WFC #JPM #Moore #Cain

New York | Last week Senator Elizabeth Warren (D-MA) finally got her scalp. Tim Sloan, CEO of Wells Fargo & Co (WFC) resigned, part of the blood letting demanded by progressive politicians in recompense for the bank’s numerous acts of fraud, stupidity and malfeasance. WFC shareholders are paying for these sins and omissions in a number of different ways. As usual, the officers and directors are largely unscathed. "Impacted consumers" are not really being made whole in any meaningful fashion. But the lawyers, politicos and regulators thrive. Once the stellar performer among the nation's four largest banks, WFC is now sidelined in terms of growth and overall performance under regulatory sanctions. These facts and the attendant media noise relegate the bank to a subordinate number three position beneath JPMorganChase (JPM) and U.S. Bancorp (USB) in terms of book value multiple of the equity shares. So here’s the question: Is there a bull case for Wells Fargo & Co? The bank’s performance is actually still quite strong despite its self-inflicted legal and reputational wounds. Indeed, we’d contend that most of the market's discount from the near 2x LT book value once enjoyed by WFC is due to operational errors and the resulting negative media coverage, regulatory actions and political noise. The bank’s financial performance has clearly slowed and capital is down, but WFC is still a peer performer compared to its largest competitors. Can WFC regain its past glory and specifically trade closer to 2x book? Maybe. Brand destruction is tough to reverse. A lot depends on who ends up running this now $1.9 trillion asset behemoth and how long the Fed and OCC keep the bank in the supervisory penalty box. But at the end of the day, as with George Gleason at Bank OZK (OZK), WFC will regain the confidence of investors and thereby regain a premium valuation by delivering earnings and otherwise being vewy, vewy quiet, to recall the advice of duck hunter Elmer Fudd. On Friday, WFC closed at 1.3x book, hardly cheap for a commercial bank and below the comparable multiple for JPM and valuation leader USB. Bank America (BAC) and Citigroup (C) trade at a book value discount to WFC of 1.2x and 0.8x, respectively. But looking at the performance reports for year-end 2018 prepared by the FFIEC , WFC has diminished in terms of size and other key performance metrics. Even with that said, WFC remains a reasonable peer of the other four largest money center banks as measured by price to book value and average market volatility (beta). Source: Capital IQ In terms of net income to average assets, for example, a key measure of any lender’s core profitability, over the past five years WFC has fallen from the top 20% of large banks to the bottom of Peer Group 1, is defined by the FFIEC and includes the 118 largest depositories in the US. At the end of 2018, the San Francisco-based bank was in the bottom quarter of all banks in net interest income vs average assets as well, whereas in the previous four years WFC was closer to the center of the pack. Likewise interest income as a percentage of earning assets puts WFC in the bottom 20% of the group. Of course, the smallest banks in Peer Group 1 tend to be the best performers, thus the peer average is well-above the average asset returns reported by the top four "zombie" banks. One interesting comparison for WFC and the other top banks is loan pricing. If you look at the top five commercial banks, WFC is doing pretty well in terms of pricing for new loans. Yet the top performer by far is Citigroup followed by JPM. And C has the lowest equity market valuation and highest beta of the top four. What gives? In simple terms, both the yield on loans and leases and the default rate at C are much higher than its large bank peers and, indeed, all of Peer Group 1. Citigroup is in a different business than the other banks, a subprime consumer lending business that is seen by investors as having greater risk financially and in terms of reputation. The bank has lower risk adjusted returns and gets a lower equity market valuation as a consequence. Remember, the only good credit comp for Citigroup is credit card monoline Capital One Financial (COF). Source: FFIEC Pricing on WFC’s loans was 20bp below peer at the end of 2018, a reflection of the competition among the largest banks for equally large assets. Smaller banks tend to get far better pricing on smaller loans. Of note, in terms of credit performance, WFC has been pretty stable over the past five years including the period of trouble due to the bank’s actions. Like most of the large banks in the US, provisions for future loan and lease losses have been trending lower at WFC as defaults have fallen. Obviously the balance sheet of WFC has been getting smaller, down 3% in 2018. Last year the bank’s capital position also fell to the lowest level since 2014 due to the high (42%) dividend payout vs net income. The Tier 1 leverage ratio of WFC is just barely 9% after a 5.1% decline in 2018, almost three quarters of a point below 2014 levels. This suggests a smaller balance sheet is likely in future quarters. Net loans and leases and non-core funding also declined, an indication that the bank is allowing its loan book to run off compared to the 7.7% loan growth rate reported by all large banks in Q4 2018. One troubling factor to consider for the future is that as WFC allows assets to decline, it is forced to also trim debt, deposits and other sources of funding. WFC is one of the most leveraged large bank holding companies in the US, in the 92nd percentile of its peer group for debt as a percentage of equity capital. WFC carries long-term debt equal to 65% of the bank’s equity capital vs the peer group average of just 13%. Back in 2014, the same LT debt/equity metric for WFC was in the 40s. To be fair, all of the larger bank holding companies have levered up again since 2008, generally with bloat in the form of derivatives and other non-loan asset types. At the end of the day, WFC is a bank that is essentially coasting along, allowing its assets to run off. Pricing for WFC loans is in the bottom decile of large banks but still quite good compared with the top four banks, admittedly a less challenging hurdle. The yield on total earning assets for the bank was just 3.77% at the end of 2018 vs 4.20% for all large banks in the US above $10 billion in total assets. And in terms of all interest bearing funds, WFC’s cost is dead center of the peer group vs the bottom quartile in 2014, when WFC had one of the lowest funding costs of any large bank. Source: FFIEC WFC is the laggard among the larger banks compared with Peer Group 1, but the asset return performance of JPM is even worse owing to the fact that less than half of JPM’s balance sheet is actually deployed in lending. Like JPM, BAC is likewise not a great performer measured by asset returns. Of note, Citigroup is actually the best performer among the top five commercial banks based on nominal asset returns, this because of its subprime consumer loan portfolio. The pricing of Citi’s non-consumer, commercial loan book is poor, however, dragging down the bank’s overall gross loan yield before funding costs. U.S. Bancorp, however, is the best performer overall based upon risk-adjusted returns and equity market valuation. The chart below shows returns on all earning assets, including loans, securities and deposits with other banks and excess reserves at the Federal Reserve. Source: FFIEC Under new leadership, WFC could be turned around very quickly in financial terms, but again, we believe that the reputational and regulatory problems are chiefly responsible for the present equity market discount. And we’ll still take USB over any of the top five banks. All that said, WFC offers an opportunity, Avi Salzman writes in Barron’s this week. Ditto. But having to spend several more years in regulatory purgatory is unlikely to help the bank’s financial or equity market performance, again illustrating how shareholders are paying the tab for the grotesque failures of management and the board of directors. Even with all of the regulatory lapses and adverse public attention, WFC in financial terms still is performing better than JPM and BAC. WFC trades at a premium to book value and above the relative equity market valuation of BAC and C. Clearly there are some investors who still find WFC a compelling value, if not now then in anticipation of better times in the future. For us, however, the bank’s performance is average compared to the 118 largest banks in the US banking industry and is likely to stay that way for the next couple of years. And we expect to see a smaller balance sheet at WFC in coming years. Once the legal and regulatory issues are fixed and the signal in terms of earnings performance again is louder than the political and media noise, then we believe that WFC can eventually resume its position at the highest valuation among the top four US banks by assets. ♦

New York | In the most recent edition of The IRA Bank Book , we note that the rate of increase in funding costs for US banks in 2018 was a bit over 70% year-over year. The rate of change in this key component of bank earnings is not particularly correlated to the broad swings in market interest rates and, by implication, investor confidence. But the normalization of bank funding costs is relentless. As we describe in some detail in the IRA Bank Book for Q1 2019 , rising bank interest expense is a structural trend that heralds the end of extraordinary monetary policy, at least for now. Whereas the quarterly cost of funding for all US commercial banks was just shy of $40 billion at the end of 2018, by the end of 2019 funding costs for the $17 trillion in US bank assets should be closer to $70 billion, especially for the larger banks. Asset earnings are rising at one quarter of the rate of funding expenses, BTW, the result of a continued sellers market in collateralized loan obligations (CLOs) and straight debt. At year end 2018, the average cost of funds was well over 1.3% for large banks such as Citigroup (1.27% Q4’18) but the average for the top 100 banks is still below 1%. Despite the full stop retreat by the Federal Open Market Committee, the impact on the bank earnings is likely to be negative, albeit gradually. The fact of a flat yield curve and continued downward pressure on yields for loans and securities is not particularly helpful when it comes to keeping asset returns even with increase funding costs. The chart below shows our projections for bank interest income and expense from Q1 2019 through Q4 2019. Note that we see net interest income stop growing in Q1’19 and begin to shrink in dollar terms as the year continues. We currently project that US bank funding costs will exceed $70 billion per quarter by year-end 2019. Source: FDIC/WGA LLC "[T]he Fed already seems to have embraced the idea that inflation should be allowed to exceed 2% without immediately triggering a tightening," notes Nouriel Roubini over the weekend in Project Syndicate . Roubini correctly notes that with the addition of Governor Richard Clarida on the FOMC has the effect of “tipping the balance of the FOMC in a more dovish direction.” Additional evidence of the change in the Fed's policy orientation toward greater intervention is found in the March 20, 2019 document released by the FOMC entitled “Balance Sheet Normalization Principles and Plans.” The FOMC has slowed the rate of decrease in the central bank’s balance sheet. Specifically: The Committee intends to slow the reduction of its holdings of Treasury securities by reducing the cap on monthly redemptions from the current level of $30 billion to $15 billion beginning in May 2019. The Committee intends to conclude the reduction of its aggregate securities holdings in the System Open Market Account (SOMA) at the end of September 2019. The Committee intends to continue to allow its holdings of agency debt and agency mortgage-backed securities (MBS) to decline, consistent with the aim of holding primarily Treasury securities in the longer run. In addition, the increasingly dovish FOMC is going to continue reinvesting in both long-dated Treasury securities and agency RMBS. Again, the FOMC: Beginning in October 2019, principal payments received from agency debt and agency MBS will be reinvested in Treasury securities subject to a maximum amount of $20 billion per month; any principal payments in excess of that maximum will continue to be reinvested in agency MBS. Principal payments from agency debt and agency MBS below the $20 billion maximum will initially be invested in Treasury securities across a range of maturities to roughly match the maturity composition of Treasury securities outstanding; the Committee will revisit this reinvestment plan in connection with its deliberations regarding the longer-run composition of the SOMA portfolio. The upshot of all this is that the FOMC is going to continue the ill-advised policy of Operation Twist, buying long dated securities as part of the asset mix. It is not clear, for example, how the FOMC will reinvest MBS in Treasury securities. By purchasing long duration paper for the system open market account (SOMA), the FOMC directly contributes to the further flattening of the yield curve and maintains an effective cap on bank asset returns. This is why we see bank industry NIM growth going negative after Q1 2019. Yet of note, in the very same document, the FOMC states: “It continues to be the Committee's view that limited sales of agency MBS might be warranted in the longer run (emphasis added) to reduce or eliminate residual holdings. The timing and pace of any sales would be communicated to the public well in advance.” That's nice. Meanwhile, even a relatively modest $15 billion per month in net runoff from the SOMA will still squeeze overall liquidity in the system. As George Selgin at Cato Institute noted back in 2016 ( citing Walter and Courtois ) once the Fed started paying interest on excess reserves (IOER) banks “would be more willing to hold on to excess reserves instead of attempting to purge them from their balance sheets via loans made in the fed funds market." But the level of excess reserves in aggregate is still a function of the size of the Fed's securities portfolio. The decision to slow (and eventually reverse) the rate of SOMA portfolio shrinkage indicates that the more dovish FOMC has decided to make permanent the nationalization of the short-term money market in the United States. The FOMC accomplishes this end by continuing the reverse repo approach to managing interest rates and dealing with a larger number of potential non-bank counterparties, such as money market mutual funds. Why bother with those messy private markets, eh? As with IOER, the Fed is subsuming the functioning of private unsecured markets for cash onto its own federal balance sheet. When the FOMC mechanically reduces excess reserves by allowing the SOMA securities portfolio to shrink, the big banks will return to private markets and bid more aggressively for REPO and other low-risk capital weight substitutes, driving yields down. As we noted last week, the FOMC’s plan to maintain a “ceiling” on short-term rates via IOER may be doomed to the same fate as the Fed’s plan of a year ago to reduce the size of the balance sheet. In a market where the 10-year Treasury note already is trading below 2.5% yield, a ceiling may become a floor very quickly. Markets are likely to be a bit sloppy this week as investors digest the latest statements from the FOMC. Of course, the FOMC under Chairman Jay Powell is committed to full and complete public disclosure. But the markets may not care for the message – especially as the decidedly mixed outlook for financials become more apparent. Thus the markets will tighten and yields will fall, as started in earnest in December 2018 and has continued since then. But bank funding costs will continue to rise. #IOER #Selgin #FOMC #NIM #Earnings #Bank #SOMA #MBS

New York | We had a great trip last week, participating in Ellie Mae’s (ELLI) Experience 2019 and surveying the rich (and water sodden) agricultural sector due north of the Golden Gate Bridge. You may have seen the announcement that ELLI has agreed to a buy-out led by Thoma Brava for $99 per share. Suffice to say the valuation is well-above the 50-60% of book value that most of ELLI’s customers in the world of mortgage lending enjoy. That is, the few that are actually publicly listed. Q: Why is a non-QM mortgage loan like a corporate bond on transformational REPO? Hold that thought. One of the key topics of discussion at the ELLI event was the long-awaited growth of the market for non-qualified (QM), non-conforming, non-government loans that don’t qualify for guarantees or credit “wrappers” from Fannie, Freddie or Ginnie Mae. Today the non-QM market is limited to a few industry pioneers like Citadel Servicing Corp. of Irvine CA, the self-proclaimed “leader in Non-QM/Non-Prime Wholesale and Correspondent Lending products.” Camp Kotok -- June 2019 Subscribers to The Institutional Risk Analyst interested in possibly joining June Camp Kotok 2019 Maine fishing trip should email via www.rcwhalen.com . Four days of the best small mouth bass fishing in North America, and discussion of markets and the world. Citadel originates the non-QM paper and retains the servicing, and earns an appropriate return for the risk. But the basic problem with non-QM lending is that outside of the prime market for jumbo loans dominated by banks, non-QM lending is limited to a few highly specialized non-bank lenders, industry veterans who hand-underwrite these loans much like a serious garage in southern California builds race cars. Non-QM lenders have cash capital and an audience of hard money investors to “take out” the loan from the underwriter. Each non-QM loan is different – even more so than with your typical conventional loan. Each has a story and all have limited liquidity in terms of short- and long-term financing. Whereas you can finance a QM loan that has received an agency endorsement like a T-bill and get execution over par and with no margin on the security, for non-QM loans financing is far more costly. Thus we speak about “specified pools” of hand picked loans that have characteristics such as credit or geography. The same financing cost barrier that inhibits the growth of non-QM lending, especially by non-bank lenders, also is an effective obstacle for an important subset of the non-QM universe, namely home equity lines of credit (HELOCs). There was a lot of discussion at the ELLI conference about the impending return of HELOCs as an asset class for 2019-2020. Some even see HELOCs as a potential replacement for reverse mortgages. Not on both counts. And why not? Three reasons: Home equity loans or HELOCs are a traditional bank product that is frequently treated as an unsecured, 100% risk weight loan by regulators and are typically held in portfolio and serviced by the lender Non-banks are ill-equipped to originate HELOCs because of funding costs and the lack of liquidity in terms of a natural take out by end investors Investors dislike the attributes of HELOCs which are priced against 1st liens and do not reflect the credit and prepayment risk of the asset With the rare exceptions of banks and non-bank firms such as Citadel or Angel Oak Mortgage , the non-QM and HELOC markets are owned by banks and really are a product meant to be retained in portfolio and serviced by a bank lender. Large banks have a cost of funds averaging 1.25% as of year end or 3-4 points below the cost to a non-bank. Small banks fund even lower, closer to 50bps than 1%. The larger banks such as JPMorgan Chase (JPM), Wells Fargo (WFC) and Bank America (BAC) will aggressively bid for large prime jumbo loans which are non-QM mostly due to size, whether as first liens or HELOCs. Yet overall the banking industry’s portfolio of HELOCs has been steadily shrinking for the past decade. Source: FDIC So the big obstacle to the growth in non-QM loans and also HELOCs can be summarized in three factors: 1) high funding costs for non-bank originators, 2) crazy high pricing/low yields due to the bid from the larger banks and 3) end-investor reluctance to take default risk on a non-QM loan with no guarantee from Uncle. The fact of government guarantee on agency mortgages and regulatory requirements for banks, insurers and pensions has made Buy Side investors lazy over the years. Letting Uncle Sam subsidize the default risk on residential (or even multifamily) mortgages is much easier than paying for the servicing and loss mitigation. Indeed, were the true credit costs born by investors in agency RMBS the real returns would be negative by several points, an illustration of the huge subsidy that the federal government provides to the US housing finance sector. Imagine the coupon on current FHA production sans the credit loss cover from Uncle Sam. Double the coupon and keep going. While the federal government subsidizes some sectors, it acts as a brake on others, specifically in the way that regulation post 2008 limits liquidity and risk taking. Last week in our discussion with David Kotok of Cumberland Advisors , we spoke about how the rules for demonstrating liquidity imposed upon the 29 largest banks, the supposed “globally systemically important banks” or GSIBs, almost caused a market meltdown in December. But there are many other areas where global regulators have changed the rules in such as way as to make the financial system more, not less, fragile. Such an area is the wild and woolly world of “repo collateral transformation” used to finance trading in over-the-counter (OTC) derivatives. Collateral Transformation So we asked above why the world of non-QM lending is like a corporate bond? Answer is collateral, namely non-agency, non-US Treasury risk that is subject to haircuts when used as security to raise cash. "Collateral upgrades" is another possibility suggested by Ralph Del Guidice. Just as a non-bank lender often lacks the collateral to finance its business effectively, non-bank funds and financial firms operating in the OTC derivatives markets now face even higher capital requirements as a result of the post-2008 regulatory onslaught. The Dodd-Frank law and various regulations since adopted required many changes in the world of finance, particularly derivatives. Both the Dodd Frank Act and the European Market Infrastructure Regulation (EMIR) mandated that all eligible OTC swaps traded by Swap Dealers (SDs) and Major Swap Participants (MSPs) be cleared centrally with central counterparties (CCPs). In theory, this meant that the good old days of the prime brokerage desk trading OTC swaps with non-bank clients with little or no collateral were over. But think again. While some of the larger Buy Side firms became actual clearing members of the major exchanges post 2008, most non-banks remain dependent upon banks for financing and, in some cases, collateral finance. How does this work? Say you are a non-bank with little working capital outside of your warehouse for non-QM loans or a fund invested in barely or even non-investment grade corporate debt. Your friendly securities firm takes your corporate bond paper, does a repo transaction to raise cash, and uses that cash to cover the margin on your derivatives trades. The dealer bank trades corporate debt for cash (for a fee), but uses its own government or agency collateral to meet the margin call for the customer. Thus the bank holds the crap and all of the risk – sometimes for its own book, sometimes for clients. Tales of MF Global. Recall that the margin rules in Dodd-Frank and other laws and regulations around the world are meant to increase the proverbial “skin in da game” for swaps customers, especially the non-bank customers of banks. Since most of these Buy Side customers did not have the capital to actually meet the new margin requirements, the Sell Side of the Street had to come up with a solution to circumvent the true intent of the new rules. The alternative would be to limit client positions as intended by Dodd-Frank and greatly reduce the fee income to the largest Wall Street banks. Keep in mind that in the world of actual securities, the rules on cash margin are set in stone. Only is the magical world of OTC derivatives are large banks allowed to explicitly evade margin requirements in such a reckless fashion. Back in 2013, the folks at Sapient Capital Markets asked some obvious questions about collateral transformation. We provide our answer . Will there be unintended consequences for putting the repo market between the buy side and CCPs? A: Yes How will collateral transformation react in a stressed market? A: Badly What is the potential for liquidity risk and rehypothecation? A: Depends how quickly the old plunge protection team can fix the contagion What are the dangers in the new OTC landscape? A: Numerous and growing Now of course, in a stressed scenario, a non-bank mortgage lender can liquidate a pipeline of fully government guaranteed agency loans within a day, posing little risk for the firm or the fully secured warehouse lender. The portfolio is essentially self liquidating. Even a portfolio of low-LTV non-QM loans would be reasonably easy to sell, remembering that this is a first lien claim on a real asset. But in a transformational repo trade, the bank is exchanging corporate for risk free exposures, this to guarantee a margin call of OTC derivatives. Kinda makes us feel a bit queasy. Bank of New York Mellon (BK) noted in a June 2017 presentation ominously entitled “Collateral: The New Performance Driver.” “Over 90% of participants noted a direct impact on their collateral obligations due to regulations such as OTC uncleared margin requirements. Both the demand for high-quality collateral and the frequency of margin calls have increased for almost all participants.” Indeed, it is fair to say that today most of the major banks and non-bank dealers offer some sort of transformational repo product. The rub is that there are so many companies clustered around the neutral zone between investment grade and junk that we can see ratings volatility figure prominently in the forward analysis of value-at-risk (VAR). And we have not even talked about the leverage coming from the particular derivatives trade. To us, the risk on a fully secured first lien mortgage loan, qualified or not, is an order of magnitude lower than leveraging selected portfolio assets to finance the margin on a derivatives trade – especially to the futures commission merchant is not affiliated with BK, JPM, WFC, etc. And we’re pretty sure that the intent of Congress when Dodd-Frank was passed in 2010 was that “skin in the game” was meant to be cash equity available to absorb first loss. Using borrowed money to finance a margin call in transformational repo seems almost absurd, but perhaps this is just a sign of the times, an environment where market behavior is increasingly distorted by well-intentioned regulations and open market operations. Should we be more critical of the over-aggressive FCM financing a non-bank’s junk corporate bond collateral or the mortgage servicer or REIT that leverages capital invested in a servicing asset to generate free cash to finance new lending or acquisitions? Fortunately we don't need to answer that question. The Federal Reserve Board is proceeding apace with the nationalization of the US money markets. And it seems pretty clear reading the proverbial tea leaves that the central bank stands ready to buy all of the detritus of Wall Street as and when the markets go through the next tantrum. "Minutes from recent FOMC meetings suggest the Fed is exploring an O/N repo facility, which could potentially replace the pre-crisis era temporary open market operations used to target the fed funds rate," notes Goldman Sachs (GS) in a research report appropriately entitled: "Global Rates Insights: From leaky floors to leaky ceilings." GS continues: "How such a facility is implemented can have material consequences for market functioning. In this report, we explore the design choices for such a facility, along with market implications of these choices. Our analysis suggests that the Fed can continue to effectively control unsecured overnight rates using IOER adjustments, especially given the Fed's signals that it intends to stop balance sheet reduction early." Reading List Investors should encourage a resurgence of local community banking CNBC Don’t Assume That the Fed Is Done Raising Rates William Dudley, Bloomberg Worried about next downturn? U.S. credit funds may offer early clues David Henry, Reuters #elliemay #kotok #HELOC #transformationREPO #JPM #GS #BK #WFC #BAC

San Francisco | In this issue of The Institutional Risk Analyst , we feature a conversation with David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors in Sarasota, Fl. David is a savvy investment counsellor, a keen observer of the evolving American political economy and an experienced fly fisherman. David and his colleagues at Cumberland Advisors publish commentaries on the global financial markets and the world which may be found at www.cumber.com . David Kotok and Stephen Sexauer, Paris 2014 The IRA: David in your commentary last week (“ JAY POWELL, GSIBS, CHRISTMAS EVE MASSACRE ”) you refer to December as a “massacre.” We concur. In fact, we are gathering more and more data that suggests our friends on the Federal Open Market Committee almost ran the proverbial ship aground at the end of 2018. New issuance in the bond market went close to zero for several weeks and the flow of new home mortgages also cratered and has not yet recovered as of February. There seems to be a lot of collateral damage here. Tell us what you see. Kotok: I am in agreement. What I did in the commentary last week was to go through the estimates of the “global systemically important banks” or “GSIBs,” some 29 banks. I looked at the capital cost of a prudential rule which came together with tightening monetary policy creating a perfect storm in December. Under the radar, except for those who looked for it, was a multi-hundreds of billions or even trillions of dollars in liquidity contraction. Why? Because the big banks pulled back from the markets at year-end in compliance with the GSIB rule. A mispricing of whole segments of the so-called riskless market was triggered and resulted in a massive cost to the markets that we can estimate. Trillions of dollars in meltdown of market value were triggered because of billions in reallocations. This occurred because of the cost of a rule regarding the 29 designated large banks or GSIBs. Note that this is a rule which is totally unnecessary. Fed Chairman Jay Powell has said that he is satisfied with the capital structure of the big banks. I agree with him. The IRA: Ditto. The tightening of the REPO markets was very visible in December, long before the end of the month. Customers with collateral were shunned by the big banks, benefitting the smaller desks. Kotok: The GSIB rule caused the big banks to step back from the market. On December 31st, the SOFR rate which is supposed to reflect a risk free overnight rate for funds was 60bp over referenced Treasury yields. The cost increase came because the big banks were encouraged to shrink, to convert assets into cash and other risk-free exposures. You can see the spike in REPO rates and the change in holdings. Any Bloomberg terminal demonstrates the visual spike. People who have expertise in the money markets saw it. You saw it. We saw it. But 99% of investors had no idea why the money markets were seizing up. They didn’t see that this is a temporary liquidity crunch that has nothing to do with default risk or credit risk. The risk is derived from the imposition of a rule, a regulatory provision called GSIB. But investors did not see that. They saw markets shifting violently and volatility spiking. They saw the spread on the credit default swaps (CDS) of the United States rise by 50%. They didn’t understand that CDS is hedging device used when such spikes happen. The IRA: To add another datapoint to your analysis, in Q4 2018 the securities holdings of all US banks fell modestly, but there was a huge surge in Treasury holdings roughly equal to the runoff of the Fed’s portfolio. And there was continued erosion in certain types of deposits. This may be why Chairman Powell had to back off on further shrinkage of the Fed’s balance sheet. Kotok: Individual banks around the world were acting rationally to protect their institutions. Can’t blame them for that. Collectively the 29 GSIBs imposed a temporary liquidity crunch on the entire system. And the result was that at one point the Treasury REPO rate shifted to a five hundred basis point spike. If riskless paper spikes in one day by hundreds of basis points, what is the cost? I computed what one basis point costs per trillion of market move in SOFR. The 29 GSIB banks represent hundreds of trillions of dollars in balance sheet and derivatives. And they wonder why the equity markets almost melted down? By the way, this fact may explain the bizarre December phone call that Treasury Secretary Mnuchin made to the biggest US banks. He was just "checking in to see if they were okay," according to press reports. Since the reason for his call was never fully explained, the reports of the call only worsened the market sentiment which was already based on faulty understandings. The IRA: Agreed David. We think that the accumulation of evidence suggests that the Fed and other prudential regulators came dangerously close to running the global economy aground. This is a terrible refutation of the whole idea of “macro-prudential regulation.” Monetary policy goes one way, prudential rules go another and none of the agencies involved have any idea as to the net effect on the financial markets or the economy. Kotok: Well, they sure were focused on a lighthouse or what they thought was a lighthouse but it turned out to be a pile of rocks. The IRA: We have this strange situation where the FOMC is reversing past monetary policy. The Treasury is issuing and the Fed is now buying short-term paper again, essentially unwinding “Operation Twist.” And then, on the other hand, we see prudential policies that restrict liquidity. And nobody seems to understand what it all means for the markets or the economy. When they close the door of the Fed’s boardroom, are they focused on the markets or on the DSGE models? If we cannot rely on the numbers we see on the screens every morning to govern market risk allocations, isn’t the FOMC doing more harm than good? Kotok: Yes. Those who are looking at DSGE models and those who are in the throes of the debate over whether the Phillips Curve is reliable need to answer a question. If we know that these tools are unreliable, then why are the dot plots used by the FOMC still measuring two of the main Phillips Curve components? This reminds me of the General Eisenhower story about D-Day. In January 1944, Eisenhower was planning the invasion of Europe. And he asked his staff advisors for the long range weather forecast of weather for June, 1944. The experts replied that long range weather forecasts were notoriously inaccurate. But General Eisenhower's staff insisted on a forecast because they needed it for planning purposes. We can put the Fed's "dot plots" and long range Fed forecast models in the same category. The only thing we know about dot plots is that they are wrong at the time they are created. The IRA: Since we are talking about WWII history and General Eisenhower, our next book is tentatively titled “False Mandate” and goes back to the origins of the Humphrey-Hawkins law. Do you remember Rep. Augustus Hawkins (D-CA)? He was the first African American from California in the United States Congress and co-authored the 1978 Humphrey-Hawkins Full Employment Act. Hawkins never lost an election in 58 years of public service. Rep. Maxine Waters (D-CA) inherited his seat in Congress. Speaking of long-term economic forecasts, can you tell us when the FOMC decided that zero and two are the same number when it comes to inflation? The Humphrey-Hawkins statute of 40 years ago says zero is the definition of price stability. Kotok: Ha! May I invite a corollary? Two percent inflation means that the real value of your wealth will be cut in half in forty years. A person born today under the current Fed 2% policy who inherits $1 million at birth will have a quarter million worth of buying power remaining when they die, if they fulfill their current life expectancy. If the Fed is successful with their current policy objective, they will destroy three quarters of the real wealth of the average young person living today. Sounds rather harsh doesn’t it? The IRA: No, you are quite right. The Humphrey-Hawkins statute says pursue full employment, then seek price stability which is defined as zero. Because of what has changed over the past forty years, the Fed staff in Washington has come up with this convoluted construction whereby zero = two. Two is really “price stability” because the system cannot tolerate deflation, which means that savers will never get a chance to buy a stock or distressed property and create future wealth. All of the bias of US monetary policy is on the side of the debtor (by using inflation as a hidden tax) and thus transferring wealth from savers to debtors. Certainly makes a mockery of Thomas Piketty’s assertion that the return on wealth is greater than nominal growth, yes? Kotok: Precisely. Now it would be one thing if the Fed were to say, listen, we are incapable of handling monetary policy affairs at zero. Let’s admit our frailty. And, by the way, I think this would be a fair statement. One needs only to look at the Bank of Japan and ECB to see the mess that can be created if you stay at zero long enough. And we are witnessing both the BOJ and the ECB at the point where there is zero probability of a policy change that leads to extraction. The BOJ balance sheet size is about equal to that nation's GDP. And the assets are yielding near zero percent. Imagine a Fed balance sheet of $20 trillion size. That would be a similar metaphor. The ECB will soon roll €700 billion in TLTRO . What they must wrestle with is that if, they do not increase the amount to €900 billion or €1 trillion, then they will have done zero stimulus. The IRA: Well, that is because they call QE stimulus. There are many people who see QE as and engine of market distortion and eventually deflation – unless it is made permanent and indefinite. Taking away the carry from trillions of dollars in securities around the world implies liquidation. Kotok: Of course, but whatever the impact, it will be nothing if the amount is not increased. We will have neutralized an already neutered neutrality. The IRA: Agreed. But what the FOMC has learned over the past few months is that you cannot withdraw the liquidity provided by QE without destroying the system. You can maintain neutral and have economic stagnation. But you cannot withdraw the liquidity once it is put into the system. In Europe, even the cessation of new asset purchases has put the EU economy into a tailspin. Without the constant heroin drip of QE, the enfeebled European economy has started to contract. And the US is not much better. Kotok: But we are not as bad off as the ECB or BOJ. There is still a chance in the US to get this right. The current FOMC, in my view, has ignored Chairman Ben Bernanke’s warning, which he repeated several times, that if we shrink the balance sheet we will only be taking it back up in due time. He very politely said “why shrink it?” And no one can answer that question. There is at least discussion now of a $3.5 trillion baseline for the Fed balance sheet as a target. We both have friends in the Fed System who believe that the balance sheet should be reduced back to the pre-crisis level, but that it not going to happen. In my view that would be a horrible mistake. I would size the balance sheet at close to $4trillion target to meet all upper thresholds for required reserves, survey-based (ask the banks what they want and need) desired excess reserves , Treasury operating balances, special items and currency. That mix today requires a balance sheet size of about $3.5 to $4 trillion and will require balance sheet growth of between $100 and $200 billion a year, The IRA: Our friends represent a more tradition view of the world, a more prudent view. But when the Treasury, which is the dog in this story, is borrowing $100 billion per month, traditional views about taking the Fed balance sheet down to required reserves misses the point. Once the FOMC under Bernanke made the decision to pursue QE, there was no way to take it back. Add the larger deficits to the analysis and the FOMC is clearly the tail on the doggie. So the FOMC must obviously allow the balance sheet to grow to keep pace with Treasury debt issuance. The alternative is political suicide. The Fed’s first priority is whether the Treasury issue debt tomorrow, correct? Kotok: We cannot afford anything that introduces a risk perception about the US Treasury's ability to finance itself. May I add a second priority? Can the Fed grow its balance sheet so that the Treasury may enjoy $100 billion addition each and every year in seigniorage? This keeps the US banking system stable and the lender of last resort status of the Fed intact. Can we maintain the status as the least worst major reserve currency in the world and thereby finance $1 trillion in deficits every year? That is the unspoken truth. My stump speech now has four charts that focus on what a $1 trillion deficit and a four percent unemployment rate means year after year. We are less than a decade away from a $1 trillion interest bill for the United States. The IRA: Thank you David. #Kotok #fishing #GSIB #JayPowell #FOMC #SOFR #DSGE

In this edition of The Institutional Risk Analyst , we announce the release of The IRA Bank Book for Q1 2019. We focus on some of the key financial and credit factors affecting the US banking industry. We also provide the detailed credit charts that have become one of the favorite features for readers of our publication. And with this edition of The IRA Bank Book, we include the Top Ten list of US banking organizations, this quarter selected and sorted by return on equity for the subsidiary bank. Here they are: Now the really astute members of the group will notice that none on the largest money center banks -- JPMorganChase (JPM), Bank of America (BAC), Wells Fargo & Co (WFC) or Citigroup (C) are on the list. You don't see Goldman Sachs & Co (GS) or Morgan Stanley (MS) either. In fact, U.S. Bancorp (USB) is the only large commercial lender to make the grade. The large zombie banks are just not that efficient and really are more transaction platforms than traditional lenders and depositories. The other thing to notice is that the first two banks on the Top Ten list American Express (AXP) and Discover Financial Services (DFS) are credit card specialization lenders rather than commercial banks. That's a hint. All of the banks on this list are exemplary performers and all have unique business models all their own. As our colleague Dennis Santiago at Total Bank Solutions likes to say, the banking industry is a coral reef. Just remember that the smaller fish are more nimble and better able to adjust to changing market conditions. In this issue of The IRA Bank Book for Q1 2019, we focus on some of the key trends facing the industry in 2019 and beyond, including rising funding costs, the sharp drop in securities holding by banks last year, the prospect for lending growth and securities issuance. The big question for banks and investors in 2019: Did the Federal Open Market Committee kill the market for residential mortgages and asset backed securities (ABS) with the fun and games in December? Many of our readers ask how they can support our work. The simple answer is to buy our publications. And for you institutional investors, commercial bankers and mortgage professionals looking for professional advice, please feel free to contact us at webmaster@theinstitutionalriskanalyst.com . #AXP #DFS #SIVB #EWBC #CMA #NTRS #USB #BOKF #FITB #HBAN

Scottsdale | In this issue of The Institutional Risk Analyst, Ralph Delguidice expounds on the world of leveraged investing in the post-QT markets. Suffice to say that we expect the world of leveraged loans and CLOs to be the catalyst for a larger reset in the world of fixed income. Sure there is equity underneath these deals, but with over 60% of all CLO collateral comprised of intangibles, so what? We heartily endorse those few brave souls in the ratings community who believe that post default recovery rates in late vintage corporate exposures will be far lower than the historical norms. As Tracy Alloway noted on Twitter: "CLOs are just repackaged intangible assets like goodwill & trademarks, which are tough to price, verify and sell to someone else when the company's in trouble." THE CARRY TRADE IS DEAD Ralph Delguidice The companies know it. The analysts covering the industry and working for the bankers who underwrite the deals know it. The institutions that buy the offerings on the dip, hold for a dividend and wait for retail to bid the stock back up to near book value (AKA the "zone of issuance") know it. And even the hapless dividend obsessed retail investor is starting to smell something bad in the refrigerator. The pace of the issuance is simply torrid. Mortgage REIT New Residential Investment (NRZ) has raised $1.3 billion plus with 90 Million new shares issued in just 3 months. Meanwhile little if any guidance is given on the deal calls regarding any use of proceeds, aside from vague hints about “looking to add revenue away from the portfolio of investments” and" bigger pieces of the pie" (whatever that means). And where is that next trade? It is obvious what is happening here. The likes of NRZ are raising capital BECAUSE THEY CAN, and because they know the market access window can close suddenly—and finally—at any second. The “core” business—that is the basic carry trade and NOT the way they practice non-GAAP accounting using so called “core earnings”—is in trouble. It is in trouble for the same reason banks in general are in trouble, namely a flat yield curve. The real cost of QE —a decade of FED controlled "price discovery" in the credit markets—is always visited worst on the financials when all is said and done. Inevitably it is as a totally flat “Japan-style” yield curve that offers little or no real carry, risk adjusted or otherwise. Last time the FED “paused” in the hiking cycle, in late 2015, the 2-10 spread was 250 basis points (bps). Today it is 15 bps. So much for maturity transformation. Mortgage REITs can and will try as hard as they can to throw asset mix, accounting and hedge pixie-dust complexity at the model, but at the end of the day it is matter of simple subtraction; and nothing can change the fact that there is just no there-there anymore. The carry trade described last week in The Institutional Risk Analyst in terms of cheap funding for banks is also gone. Start with the plain Agency REITs. They buy GSE paper and finance it in the REPO markets, using swaps and US Treasury hedges to minimize the duration gap between assets and funding. There are a few moving parts here, but the return—to a REIT company that is running a legacy portfolio of existing assets and swaps built over the last decade—has collapsed almost entirely. This is regardless of how “tasty” the next trade (done with incremental capital of course) is said to be. Case in point: Last year AGNC Investment Corp (AGNC) lost almost $3 per share in book value while the 10 year US Treasury —and the corresponding agency pass through securities—moved less than 15 BP. "It’s the VOLATILITY, STUPID.” Adding credit exposure to the mix (like Annaly (NLY) and others) and/or negatively convex IO’s in the form of crazy scary MSRs (like NRZ, Two Harbors (TWO) and Cherry Hill Mortgage CHMI) are REITs that “self hedge” the portfolio, which serves only to increase the raw complexity of the accounting. And while it may change the timing and recognition of the state of the basic trade, it will do little to offer any real diversity or protection in the long run given current curve environments. At the end of the day these companies were all really just a longer term trade, and not a business. The almost insatiable retail yield hunger—courtesy of the same FED that crushed their effective yield curve—has attracted too much attention; and too much capital has flowed in to these trades that are (much like getting married too young) easy to get into but incredibly hard to live with. Non REIT investors such as BlackRock (BLK) and PIMCO—who need not pay out taxable earnings—or dividends at all for that matter—and that are now happy to accept HALF the indicated returns (especially on the more esoteric asset classes) have crashed the party. MSRs are a good case in point. They have DOUBLED in price over past three years, and most of the demand has been SINCE rates peaked and began to fall again—actually undermining their hedge value. The same is true with all kinds of commercial real estate credit. As the FED-blown bubbles have exploded, cap-rates have collapsed—and of course leverage has increased to fill the holes. We have reached the point of economic no return. This is what tops look like. The story is an old one, and like every other time we have told it the end of cycle dynamics are always the same. “Yes," we hear, "the party will end someday—badly we know—but not today, right?” So let’s keep dancing. But that said, right there at the top of the long and growing list of reasons to expect the credit market eschaton in 2019 should be this insane capital raising behavior we are seeing here. It is like they teach pilots. “Climb, conserve, confess.” Have enough capital to meet the inevitable margin calls and then hunker down to wait for the OTHER GUYS FIRE SALE. Res Ipsa

New York | First a travel note. The Institutional Risk Analyst will be at the Structured Finance Industry Group (SFIG) conference in Los Vegas this week to participate in a discussion about permanent financing for MSRs. Please come say hello if you are attending this important event. And if you're really lucky, you'll meet former GNMA head and new SFIG CEO Michael Bright. We’ll also be speaking at the Docutech event at the Phoenician later in the week about the outlook for interest rates, the Federal Open Market Committee and the mortgage finance sector. Gestational REPO anyone? Look forward to the discussion with Docutech CEO Amy Brandt and Americatalyst founder Toni Moss . Last week the FDIC released the banking industry data for Q4 2018. Profits are steady, default rates are low but credit loss provisions are starting to rise. Interest expense rose 55% year-over-year to $37 billion in Q4, while income rose 14% YOY. The dollar rate of change in interest expense should catch up to income by Q2 2019. This data point regarding bank funding costs also reveals that the level of financial repression is slowly falling. The Financial Times defines the term financial repression thus: “Financial repression is a term used to describe measures sometimes used by governments to boost their coffers and/or reduce debt. These measures include the deliberate attempt to hold down interest rates to below inflation, representing a tax on savers and a transfer of benefits from lenders to borrowers.” We measure financial repression in the $17 trillion US banking sector, but you can impute a similar skewed distribution to other fixed income asset classes. The Financial Repression Index was first described in a 2018 paper (" The Financial Repression Index: U.S Banking System Since 1984" ). In Q4 '18 it fell below 80% for first time since the 2008 financial crisis. Now "only" 79% of bank interest income is going to equity holders vs a bit over 20% for creditors such as depositors, lenders and bond holders as shown in the chart below. Since the 1980s, bank depositors and investors have been the victims of significant financial repression as public sector debt balances have increased and interest rates have fallen to accommodate. Since the 1990s and particularly since the 2008 financial crisis, it is possible to precisely measure a dramatic shift in net interest income in favor of banks, their equity holders and all manner of debtors public and private. Prior to the 1990s, depositors, bond investors and lenders received the lion’s share of the interest income earned by banks, but today most of the flow is taken by equity. The biggest beneficiaries of financial repression are governments. The trend toward providing explicit subsidy to debtors and particularly sovereign nations via Quantitative Easing or “QE” is a key component of financial repression. When some observers criticize the use of cheap debt to fund share buybacks, they are also reacting unknowingly to the effect of financial repression. Thanks to the Trump tax cuts, equity investors are getting an even bigger share of the interest income dollar from all enterprises. But with the benefits of QE there are also costs beyond the permanent inflation of asset prices and lower asset returns. Though US banks and non-banks have received a significant subsidy due to financial repression, banks and other intermediaries have also suffered decreased asset returns as a result of the low interest rates policies and open market operations of the Federal Open Market Committee. The clearly demonstrated diminution of income as interest rates fall would seem to conclusively refute the idea of negative interest rates as a valid policy tool, but instead economists persist in thinking that merely lowering the cost of debt can solve the challenge of employment much less price stability. Negative interest rates of course represent the confiscation of capital by a heavily indebted administrative state. Reducing the equity stock of a the private economy to feed the indebted public sector seems completely absurd but that is the substance of US monetary policy today. At present, return on earning assets (ROEA) in US banks is moving sideways at about 83bp on $15.9 trillion in earning assets as shown in the chart below. This may be the peak in ROEA for this cycle. Notice that the ROEA was low during the inflationary period of the 1980s, then spiked to over 1% in the 1990s, but today is a good 20bp below the average peak earnings on the 1990s through 2008 period. Of course, the same market dynamic that reduces income to depositors and bond holders also reduces the gross spread on loans, encouraging the use of leverage in all manner of asset classes. When you consider the clustering of investment grade rated issuers around the “BBB” cliff edge, it is pretty clear that monetary policies such as QE and negative interest rates are in direct conflict with the legal responsibility of the central bank to ensure the safety and soundness of banks and non-banks alike. Just how does one ensure financial stability while pouring gasoline on the fires of asset price inflation? In the next issue of The Institutional Risk Analyst, Ralph Delguidice will be talking about the end of the carry trade and what it implies for the leveraged mortgage sector. Also, the next issue of The IRA Bank Book will be out in March, including the most recent IRA Top Ten list of banks, ranked by equity returns. * * * #financialrepressionindex #returnonearningassets #SFIG

Washington | Consider the irony of the American housing sector. In the District of Columbia, various pundits, market retreads and spin-meisters (many employed by hedge funds) obsessively focus on "reforming" the government sponsored enterprises known as Fannie Mae and Freddie Mac, together the “GSEs.” The third and largest GSE, the Federal Home Loan Banks, along with the fourth, the Government National Mortgage Association or Ginnie Mae, are also included in the prospective policy mix. None of these agencies are in distress or in need of financial assistance, but no matter. Meanwhile, the US mortgage sector is undergoing a massive and truly terrible period of restructuring that conjures up biblical images of the apocalypse. Literally dozens of private mortgage firms are for sale or simply shutting down. As we have long anticipated, Ditech Holdings was forced to again file for bankruptcy protection last week. The company and its creditors are seeking bids to buy some or all of the business, but it remains to be seen whether there is any value in the remaining assets. The big question: who will buy the Ditech reverse mortgage business, Reverse Mortgage Solutions. RMS is consuming cash to such an extent that the company’s DIP lenders had to allocate a big portion of resources -- $1 billion in working capital – to RMS as part of the bankruptcy filing. As we’ve noted in the past, Ginnie Mae as the guarantor of the bonds that hold the reverse mortgage loans, is on the hook in the event that the business is abandoned in bankruptcy. But hold that thought. All this talk of doom and destruction in mortgage finance may come as a surprise to some readers of The Institutional Risk Analyst. After all, aren’t home prices near record levels? Loan trading in the secondary market is brisk and mortgage servicing rights or MSRs are likewise trading at all time high multiples of cash flow, around 6x annual servicing income or 6-7% yields. What’s the problem? In a word, government. And in several words, the Federal Open Market Committee. As we noted last week , sales of mortgage loans into residential mortgage backed securities or RMBS plummeted in the fourth quarter, reflecting the difficulty faced by mortgage banks in pricing loans during the market volatility seen in November and December. And as we noted in our previous missive, new issuance of mortgage RMBS has fallen by nearly 40% since the end of September last year. In fact, the happy campers on the FOMC came awfully close to running the good ship lollipop aground in December 2018. New securities issuance activity across many sectors basically went to zero and mortgage lending volumes fell to levels not seen in decades. After almost touching 5% in mid-November, the 30-year fixed rate mortgage has since fallen to 4.4%, this as the yield on the 10-year Treasury note has rallied to 2.6% from a high of 3.25%. If you see Fed Chairman Jerome Powell in the hallway, please tell him that this sort of roller-coaster in terms of gyrating benchmark interest rates is not particularly helpful. The estimates from the Mortgage Bankers Association released last week still show Q4 2018 coming it at just shy of $400 billion in total purchase and refinance originations, but based upon what we are hearing from the origination channel we’d be surprised if the actuals are not lower. See chart below showing the actuals and projections. Source: MBA Now of course the mortgage origination estimates from the MBA assume that interest rates are rising . Yes, rising. The most recent projections show the 30-year mortgage at 4.8% and the 10-year Treasury note at 3%. But what if the bullish assumptions about the US economy are wrong? What if we are in fact headed into a recession or at least a period of economic stagnation? Keep in mind that the near-5% print for the 30-year fixed rate mortgage back in November 2018 was close to the 10-year high for that key benchmark. The RESI market prices off the 10-year Treasury because it is close to the double digit average life in many pools, as shown in the chart from FRED below. Should the FOMC actually end the runoff of the system open market account (SOMA) portfolio later this year, then assumptions about rising interest rates may need to be recalibrated. “Federal Reserve governor Lael Brainard said she expected the central bank could end the runoff of its asset portfolio later this year,” reports Nick Timiraos at The Wall Street Journa l. “Ms. Brainard said she is comfortable ending the balance sheet runoff this year because she favors an operational system with a much larger level of reserves than before the financial crisis.” Brainard’s comment confirms our suspicion that the economist-led FOMC and, more specifically, the Fed Board of Governors, has decided to permanently nationalize the short-term money markets in the US. In effect, the Fed is discarding any hope of restoring private function and particularly unsecured lending in the US. The decision to again grow the portfolio is being made without the advice and consent of Congress and carries with it profound implications for mortgage lenders, the REPO market and investors. But the reason for the decision obviously is the accelerating fiscal deficits of the United States. By manipulating all manner of asset valuations, the FOMC has created two very specific risks for holders of mortgages and MSRs that are not well understood in the equity or debt markets. First, by gunning prices for homes, mortgage loans and MSRs to ridiculous levels, the FOMC has essentially created a short-put position for holders of mortgage credit and servicing exposures. Once the FOMC resumes net purchases of government securities, long-term interest rates will fall under the dual pressure of investor demand and the artificial asset shortage that is the essence of “quantitative easing.” Like shooting heroin, once a central bank gets onto the QE habit, it is impossible to stop without deflating the financial markets. And since the Dow Jones Industrial Average and S&P 500 are the benchmarks for the political class, no deflation will be tolerated. Second, using the forward TBA market to hedge this “SOMA Risk” may not be entirely effective because of the absurd “fair value” accounting rules brought to us by the happy squirrels at the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission. Tell us again why we need to value cash flow generating "intangibles" like MSRs every quarter please? These same folks at FASB are responsible for the new idiocy known as Current Expected Credit Loss or “CECL,” whereby owners of 1-4 family loans have to guess the probability of default over the full life of a 30-year mortgage. Obviously such a task is impossible, but don’t tell that to the FASB and the SEC. As benchmark interest rates fall, the modeled prepayment speeds for mortgage exposures will accelerate, this on the assumption that mortgage refinancing activity will increase -- maybe. Holders of MSRs, specifically, will be forced to take “fair value” non-cash losses on their mortgage exposures, even if they are running aggressive hedge positions. Should the 10-year note continue to rally and perhaps get back down to a low 2% or even a 1% handle, for example, those 6x annual cash flow multiples that we see in the MSR market today will evaporate overnight. And the next shoe to drop, of course, will be credit risk, a currently unrecognized danger that is not really priced into asset valuations or the calculations of the FOMC. Ralph Delguidice noted recently (“ Bigger Balance Sheet Bullish? Really? ”) that an increase in the SOMA portfolio may not actually be “stimulative” to the economy. In fact, the embedded credit risk in all of the 1-4 family mortgages that were originated during QE 1-3 may start to emerge in the next 18-24 months, pushing up the cost of servicing for holders of MSRs. If you own the servicing asset, then you are responsible for the capital cost of resolving a distressed mortgage. “A report released… by the Federal Reserve Bank of New York revealed that the rate of delinquencies was steady at 4.65% in the last quarter, but Moody’s says this is a cycle low that will change in the coming quarters as loosening underwriting standards and rising interest rates impact loan performance,” reports HousingWire . The default and past due rates for the $2.5 trillion in prime bank-owned 1-4 family mortgages are shown below. Source: FDIC Assuming that Governor Brainard’s pontification about the imminent resumption of QE is correct, operators and investors in the world of mortgage finance need to take notice. With MSR valuations under the twin pressure of again falling long-term interest rates and rising capital costs of default servicing, investors could see the double digit gains in the best performing asset class in the fixed income market suddenly reversed, with catastrophic consequences for the mortgage market and certain publicly traded mortgage REITs. Given the impending resumption of QE, investors who are long servicing need to take pause. MSRs carry both interest risk and, as many have forgotten, default risk garnished with reputational hazard. As John Dizard wrote in The Financial Times on December 16, 2018: “If the homeowner defaults, it is up to the servicing company, i.e. the MSR holder or a sub-servicer they contract with, to persuade the homeowner to pay up, to restructure the mortgage if the original terms are too burdensome, or, if necessary, to carry out a foreclosure. You can see where MSRs can become an unromantic asset.” So what is an independent mortgage banker to do? Lenders who are owners of MSRs need to seriously consider the following trade: 1) sell the mortgage servicing asset at the record multiples now available in the market to some willing, leveraged financial investor and 2) purchase a federally insured depository from which to safely operate a lending and mortgage sub-servicing business. Go long a bank charter and short the capital risk in the MSR to a friendly mortgage REIT. Trade the haphazard and at times arbitrary regulation by the 50 states for the kind supervision of the Fed and FDIC. And the best part is that when defaults rise and prepayment rates accelerate, you'll be able to buy the servicing asset back at a lower valuation if you want. But we'd argue that the risk adjusted equity returns of sub-servicer + depository are superior to owning the actual MSR asset. If our suspicions are correct that long-term interest rates are headed for another down leg, then holders of MSRs may be facing a considerable “emerging risk” to paraphrase our contributor Ralph Delguidice. They don’t teach you about such risks in the textbooks, but suffice to say that in the age of QE we might as well just throw the old corporate finance books into the trash. If you have been thinking about going short residential mortgage default risk and long a federally insured depository, then do give us a call. Mo' Reading Moody's: Mortgage delinquencies are on the rise https://www.housingwire.com/articles/48175-moodys-mortgage-delinquencies-are-on-the-rise Fed’s Brainard Says Balance-Sheet Runoff Should Probably End This Year https://www.wsj.com/articles/feds-brainard-says-balance-sheet-runoff-should-probably-end-this-year-11550159755 #JohnDizard #MSR #servicing #yellen #bernanke #QE #bank #REIT #NRZ #Ditech #freddiemercury

New York | This week in The Institutional Risk Analyst , we note a couple of reader comments. First, we’ve been accused of having a fixation on the insolvent Chinese aviation conglomerate HNA. Another reader claims we have a CLO fetish in the wake of several posts on the subject. Guilty on both counts. And it was suggested by a reader that we don’t give leveraged loans sufficient credit for the equity cushion included in the capital stack. Sure we do. But since the median debt levels of non-financial companies relative to earnings now exceed levels seen before the last financial crisis, this according to the Standard & Poor’s rating agency, we’ll stand our ground. When it comes to risk management, watching the fastest changing datapoint on the proverbial dashboard is usually a good practice. HNA fits that description and is a modern day Icarus, an archetype for the crazy rich Asian business model so prevalent in China prior to the political crackdown by paramount leader Xi Jinping. Then there are CLOs, our favorite asset type and the driver of the bull market in equities. The November 2018 Financial Stability report published by the Federal Reserve Board tries to spin the central bank's culpability in boosting asset prices since 2010. Notice in the table below the astronomical growth of CLOs as well as the 3x inflation rate of growth in real estate. Why the eye-popping growth rate for leverage loans, the asset class du jour of the global speculative classes in this cycle? Low rates of course. And strangely, the figures for “real” annual price growth for commercial and residential real estate seem to be a tad low. Maybe the Board is using real inflation data to deflate the surreal real estate valuations caused by QE? Sad to say for millions of young American families, the Bernanke-Yellen asset price inflation in commercial and residential real estate may be largely permanent, depriving a whole generation the opportunity to own a home or build wealth by investing in distressed properties. But meanwhile mortgage lending and sales volumes are in the proverbial dumper. The FRB noted last year: “Asset valuations appear high relative to their historical ranges in several major markets, suggesting that investor appetite for risk is elevated. Spreads on high-yield corporate bonds and leveraged loans over benchmark rates are near the low ends of their ranges since the financial crisis. Equity price-to-earnings ratios have been trending up since 2012 and are generally above their median values over the past 30 years despite recent price declines. Commercial real estate (CRE) prices have been growing faster than rents for several years, and, as a result, commercial property capitalization rates relative to Treasury securities are near the bottom of their post-crisis range. While farmland values have fallen in recent years, they remain very high by historical standards. Residential real estate price-to-rent ratios have generally been rising since 2012 and are now a bit higher than estimates of their long-run trend.” Long run trend. That’s great. Now a cynic might argue that the collapse of the CLO market in the fourth quarter and with it the larger high yield debt market was the catalyst for the latest dovish turn in the Federal Open Market Committee. We seriously doubt anyone on the FOMC actually worries about a precipitous drop in something as banal as mortgage lending, but now would be a good time to pay attention. In particular, looking at the total issuance data from SIFMA, Q4 ’18 was a particularly bad quarter for CLOs but also saw a marked slump in issuance of all types of mortgage-backed paper as well as asset-backed securities. Could this be a sign from on high? Source: SIFMA The US has seen a ~ 40% decrease in issuance of mortgage backed securities since the end of September 2018, certainly reason for alarm in our book. The US residential mortgage industry is looking at doing a lot less than $1.5 trillion in new mortgage origination volumes in 2018. This slump in activity is due to the volatility in the markets, which makes it impossible to accumulate and hedge new residential and commercial mortgage backed securities (CMBS) deals. Recall Q1-Q2 of 2016. Market factors aside, the slump in residential lending volumes is more of the same, premium pricing for loans killing profitability for aggregators and banks, which are bidding points through the curve to buy larger jumbo assets for portfolio. Smaller retail lenders are dying due to high origination and funding costs. And even though rates have fallen since December, better yielding refinancing volumes are not yet returning. But hope remains: Several operators in mortgage land tell The IRA that January will be a great month. BBT + STI: "Big Deal" or Not? Listening to some analysts and members of the media waxing effusive about the merger of BB&T (BBT) and SunTrust (STI) last week, as in the union of two strong residential mortgage businesses, sure makes us wonder. Some 55% of BBT’s loan book is real estate loans, but the gross spread before funding and SG&A is just 440bp. At STI, real estate exposures are 40% of the loan book with a 390bp gross spread. When you subtract the cost of funding (~1.2%), commissions to the loan officer and overhead and compliance, there is not much left. Risk-adjusted returns are negative of course. Remember that banks generally don’t care about high LTV loans with borrowers below 700 FICO, so the competition for prime mortgages is intense. The crazy high bid for mortgage assets, even as volumes drop, is why valuations for mortgage servicing rights (MSRs) are being "pulled" up to meet the execution in the secondary loan market. The result is nosebleed 6x annual cash flow MSR multiples that cannot be validated vs, say, mainstream prepayment assumptions from the major third party advisors. And this "execution" ripples through all of the fair value MSR valuations models of the major banks. Again, special thanks and big kisses to Chairs Ben and Janet. When investors ask if the BBT + STI combo will lead to more deals, the answer provided to the FT by no less than Rodgin Cohen at Sullivan and Cromwell pretty much sums it up. He told Robert Armstrong and Laura Noonan that the tie-up would cause “acceleration of thinking about deals, and accelerate conversations, but whether it leads to actual deals we will have to see.” He might also have said that merging two medium sized banks together at a premium to book value in an all-stock deal is hardly reason for great excitement. A few years back, when we'd drop off documents at Sullivan & Cromwell on the way home from the Federal Reserve Bank of New York, banks did not trade much above book value. The reason for this, quite simply, is that well run banks have low double digit equity returns, but that it about it. At present BBT’s cost of funds is about 1.4% vs 1.5% for Peer Group One, which includes all 120 banks in the US above $10 billion in assets. BBT’s gross spread on total loans and leases was just 4.69% at the end of Q3 2018, according to the FFIEC. This is just below the peer average. In other words, BBT and STI are middle of the fairway performers, consistent earners and with strong capital, but not great sources of alpha. Together these banks are not worth much more than the current 1.4x book value. Net loan and lease growth for BBT over the past five years is modest at best, begging the question as to why certain analysts are getting so excited about “the biggest bank deal since 2008.” To be fair, the larger banks are even worse in terms of risk adjusted returns on real estate loans. JPMorgan Chase (JPM), has 42% of total loans in real estate loans for a gross spread of 384bp. That includes both residential and commercial exposures. Bank of America (BAC) has a third of its loan book in real estate loans and is working for a whole 386bp gross, before funding costs or sales costs or overhead expenses. Layer on a charge for the reputation risk element of facing consumers and the equity returns on residential mortgages quickly go negative. H/T to Liz Warren and Kamala Harris. We might have been tempted to own BBT prior to the transaction, but adding STI to the mix does not make us want to own the post-merger bank. Much rather add to the position in U.S. Bancorp (USB), which has lower funding costs and a more diverse revenue mix. And even after the market volatility seen that the end of 2018, the financials as a group are not particularly cheap. Just remember that in a ranking of large US banks based upon equity returns, USB is the only bank in the top 10 by assets that makes that illustrious list of exemplars in terms of equity returns. Of course, for all of you who still think that rising rates are good for banks, the fact that the 10-year Treasury note has rallied since last Thanksgiving is probably not welcome news. And the bond market rally is unlikely to slow the "normalization" of bank interest expense, which has seen the cost of funds for the industry rise 75bp in 2018 by our calculations. Indeed, after almost touching 5% around turkey day, the 30-year fixed rate mortgage has fallen below 4.5% and seems to be following the surging T-note lower in yield. Since early January, high yield spreads have taken their queue from the equity markets and rallied more than a point in yield. Option-adjusted spreads have essentially collapsed. Indeed, just about every bank asset class we can think of from loans to securities and mortgage servicing rights are surging higher, buoyed by "the new confidence." Echoing ECB head Mario Draghi, the FOMC will do whatever it takes to keep the world safe for heavily indebted corporations, Italian banks and anyone else with the slightest potential for causing a deflationary market event. Have a great week. Extra Reading The Vice President’s Men Seymour M. Hersh The London Review of Books , 24 January 2019 https://www.lrb.co.uk/v41/n02/seymour-m-hersh/the-vice-presidents-men Jim Grant on the Bond Market’s 35-Year Bull Run Barron's , February 1, 2019 https://www.barrons.com/articles/sizing-up-the-bond-market-51549050648 The Fed's Killing Floor Zero Hedge , 2/6/19 https://www.zerohedge.com/news/2019-02-06/feds-killing-floor #BBT #STI #JPM #Noonan #FT

New York | This week in The Institutional Risk Analyst, contributor Ralph Delguidice ponders the aftermath of the retreat last week by the Federal Open Market Committee following the latest market volatility tantrum. Suffice to say that the FOMC has no stomach for deflation of any duration, thus we see the magical appearance of the "Powell Put" in financial commentaries. But riddle us this: When is easing really tightening? First the Fed backed off further rate hikes, now we are talking about resuming asset purchases for the system open market account or SOMA. Sadly, the impact of renewed “quantitative easing” will be a further tightening of private credit as the FOMC does what is does best, namely caters to the debt issuance needs of the US Treasury. None of these developments are a surprise to readers of The Institutional Risk Analyst and illustrate the growing conflict between prudential rules meant to ensure liquidity in banks and the voracious cash needs of Washington. Last week's events illustrate that the FOMC cannot pursue price stability in the face of $1 trillion annual deficits. A Bigger Balance Sheet? (careful what you wish for) By Ralph Delguidice The credit-cartel-consensus has concluded that the Fed has made up its mind to end the balance sheet roll-off “early;” whatever that means. Chairman Jerome Powell suggested a near term equilibrium where reserves are “plentiful,” and that may indeed mean soon; but on closer examination it may surprise many and turn out to imply TIGHTER credit in the hard money markets where real companies fund and leverage on a secured basis. A larger balance sheet—with all of the associated moving parts like currency demand and the Treasury General Account (TGA)—will mean more reserves for banks to use to satisfy the Liquidity Coverage Ratio (LCR) and Resolution Liquidity Adequacy and Positioning (RLAP) requirements that already see Fed reserves as BY FAR the most efficient of all qualifying assets. In fact, for global systemically important banks (G-SIBs), RLAP is calculated intra-day and that leaves ONLY Fed reserves as effective. With more bank assets tied up in Fed reserves—and more “sponsored REPO” giving Money Market Funds and CCPs direct access to the Fed as a counter-party to REPO sellers-- the supply of credit that can flow into private REPO markets will fall all else equal. This will be coming at the same time that VASTLY increased US Treasury (UST) issuance will need to be cleared into the private bond markets. The Treasury Borrowing Advisory Committee Members (TBAC) report last week was VERY clear that much more US savings were going to be needed go forward as foreign demand for UST could not be counted on. With rates where they are these UST positions will increasingly need to be financed—either by intermediary dealers or end users--, and this turns banks that were SELLERS of REPO into BUYERS of REPO. Yesterday was month end, and we saw UST GC printing at 2.90% Source: Scott Skyrm Yes, it was one day. But the quarter end spikes are higher and last longer, and the Year End is flat out crazy. Remember that this is all the time when then SOMA balance sheet roll-off was intact (it still is, of course) and the Fed was encouraging dealer banks to lend back into the private money markets. AKA: “normalization.” Now stop the run-off music and tell the banks to hold more reserves at the Fed, what do we think happens? Policy honchos need to ponder the conflict of LCR/G-SIB rules with monetary policy. Isn’t that called “macropru”? Bottom line here is that the global money markets are a complex cascade of arbitrage that recent history shows can-- and certainly will —amplify any changes to the Fed footprint in reserve demand in uncertain and sometimes counter-intuitive ways. As BAML said in a recent piece on the possible need for a Fed Backstop the REPO market: “has become increasingly fragile and sensitive to shifting behavior of key market participants, especially banks and dealers, the strategists wrote.” https://www.reuters.com/article/us-usa-repos/u-s-federal-reserve-may-need-to-backstop-repo-market-baml-idUSKCN1P5273 Chris Whalen wrote recently in The IRA that the Fed wanted to “nationalize” the money markets once and for all as a way to ensure financial stability. This rings increasingly true as we get visibility into the eventual size, tenor and composition of the SOMA account, and buyers of financial stocks would do well to remember that structural changes to the money markets that involve a permanent Fed presence may change the REPO alchemy (Hey!! it’s a loan AND a sale!!) that they have taken for granted for all these many years. Just Sayin', #Delguidice #PowellPut

“How did you go bankrupt?” “Two ways. Gradually, then suddenly.” Ernest Hemingway, "The Sun Also Rises" New York | Last week the Federal Open Market Committee under Chairman Jerome Powell blinked, again. Last week, The Wall Street Journal reported what bond traders and the readers of The Institutional Risk Analyst have known for months. Rate hikes are on hold and the FOMC is preparing to end the shrinkage of the Fed’s system open market account (SOMA) portfolio. With the financial economy slowing and housing in a swoon, there may be no rate hikes at all in 2019 and maybe even a resumption of quantitative easing (QE). But no surprise. The post 2008 world has seen the death of many long-held beliefs, in particular the idea that the US central bank is here to fight inflation. Jim Cramer of CNBC hit the proverbial nail on the head last November when he questioned how the Fed can talk about “normal” when things are decidedly not normal at all and largely as a result of FOMC policy actions. Bernanke likes to pretend that he saved the world following 2008, yet in fact he actually sacrificed any notion of Fed credibility with respect to inflation for another experiment with -- wait for it -- the wealth effect. This widely discredited notion remains today the key driver of FOMC policy actions. “While critics may dispute the wealth effect’s magnitude, few have challenged its conceptual soundness,” notes Christopher Casey of Mises Institute . “The wealth effect is but a mantra without merit.” Ben Bernanke noted in 2010 that “higher equity prices will boost consumer wealth and help increase confidence, which can spur spending.” The Fed's fixation with perception rather than data is illustrated by the way in which former Fed Chairs Bernanke and Yellen deliberate chose to inflate the value of financial and real assets to "stimulate" the economy. The WSJ’s Nick Timiraos reported last week: “Former Fed Chairman Ben Bernanke often argued that it was the maturity and risk-profile of the Fed’s holdings, not the overall size of its reserves or securities portfolio, that determined how much it stimulated markets and the economy.” The Fed’s dual mandate from Congress includes full employment and price stability. But to look at recent policy suggests members of the FOMC cannot read federal statute or do simple sums. Causing asset prices to soar by double digit rates is not price stability – it is inflation, plain and simple. Please, Chairman Bernanke, do show us where it says in the Federal Reserve Act that the FOMC is allowed to employ asset price inflation as a policy choice. In the Orwellian newspeak of the Federal Reserve System, inflating the value of stocks, bonds and real estate to absurd levels is a form of economic “stimulus.” Never mind that this vast act of asset price inflation did not help the majority of Americans. Indeed, the biggest impact of the Bernanke/Yellen asset inflation seems to be preventing a whole generation of younger Americans from buying a new home. As you read these words, real estate markets around the US are starting to revert to the mean, suggesting that the great Bernanke experiment with the wealth effect is ending. Mind you, the adjustment in real estate markets is not happening gradually, but all of a sudden to paraphrase Hemingway. Similar to the volatility seen in debt and equity markets, the price discovery pattern visible in many heretofore red hot residential housing markets is similar to recent equity market volatility – huge downward spikes in home price sales volumes. Prices will eventually follow when sellers capitulate. One large market caught in the downdraft is Chicago, a sleepy Midwest MSA that only started to see home price appreciation relatively late in the game. Markets such as Southern California and Florida started to rebound even before 2012, but Chicago was essentially dead until 2013 but then began to climb steadily. Since then, the index value for homes in Chicago has risen 25 points, according to Weiss Analytics (WA) home price index. Note: WGA LLC is a shareholder in WA. In the 12 months through October 2018, residential home prices rose 3.6% and condos by better than 5%. In the past three months, however, prices have begun to collapse in Chicago as volumes have disappeared. So, Chairman Bernanke, is this an example of “price stability?” Nope. Let’s go east to New York City, where prices along Billionaire’s Row on Central Park South are down single digits in the past year after rising 30% over the past decade. Indeed, condo prices along CPS have been falling since 2016. As in Chicago, sales volumes in NYC's more toni areas have dried up as the gap between buyers and sellers has widened. Of note, single family residential homes in the greater New York MSA have barely moved in the past decade, but are expected to increase a couple of percent on average even as prices in New York City’s most desirable areas sag. Of course, housing price charts are great fun, but the truly scary chart is the one that also remains our favorite, namely loss given default (LGD) on the $2.5 trillion in single family mortgages owned in portfolio by US banks. In Q3 2018, the LGD or net credit cost on this portfolio, which represents one quarter of all mortgages in the US, was negative by almost 16%. This means that, on average for every mortgage that defaulted, the bank make a profit after repaying the loan in full. Source: FDIC Think about how much the prices for homes backing the average bank owned mortgage had to rise to generate such a result as shown in the chart above. Again, Chairman Bernanke, is this sort of behavior in asset prices consistent with “price stability?” Nope. Did this enormous skew in home prices caused by QE and “Operation Twist” help Americans create jobs, or build or buy a home? Nope. We generated a lot of real estate commissions, but much of the benefits, at least for now, have gone to the banks and investors who own residential credit risk. As US home prices revert to the long-term mean, the key question that arises in the minds of many risk managers is when will loan default rates start to rise? Even if the FOMC does not raise the target for Federal Funds or ends the runoff of the Fed portfolio earlier than expected by investors, the pace of Treasury debt issuance will continue to drain liquidity from the credit markets and force rates higher. Source: FDIC Indeed, as we’ve stated previously, we full expect the Fed to reverse course entirely, end rate increases and start growing the SOMA portfolio to keep pace with US government debt issuance. But none of these expedients are likely to prevent the repricing of the US housing market, which after half a decade of irrational exuberance c/o the FOMC is falling back to earth due to a lack of customers. Look for housing credit costs to rise significantly by the 2020 general election. Meanwhile next door in the leverage loan space, the modest rebound in January 2019 has only taken some of the pain away from the slaughter that occurred in November and December, when dozens of loan conduits were caught off base holding loans for collateralized loan obligations (CLOs). The same weakening macro market dynamic that is causing home prices to slum is prompting investors to flee this asset class. The astute folks at TCW describe the carnage: “As risk sold off globally, retail funds recorded record outflows. At the same time, CLO liabilities widened. As CLOs ceased to be manufactured due to liability costs, demand for loans became negative as retail funds were forced to sell positions to raise cash and meet redemptions. There is a unique component of this weakness: Investment bank trading desks have much smaller balance sheets than they had prior to 2009. Therefore, as CLOs stopped buying and retail funds began selling – there were few investors left to take the other side of the trade.” The CLO market, for the record, saw its largest ever issuance in 2018. As in Q1 2016, when China concerns killed the ABS market for six months, the Street is crossing its collective fingers, hoping that spreads will narrow so that some of these deals will get priced. Don’t hold your breath. Institutional new issuance of CLOs declined in December to $3.9 billion, which was the lowest institutional issuance in 2018. The liquidity that has exited the sector since Thanksgiving is unlikely to return. And again, as with residential credit exposures, the key question in the minds of CLO investors is this: When will default rates start to rise significantly? Nobody has the precise answer to that question, but a reasonable assumption is that the volatility of the change in default rates will be markedly higher than in previous credit cycles thanks to QE and "operation twist." Stay tuned. #BenBernanke #Cramer #wealtheffect #housing