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"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Citigroup CEO Chuck Prince (2007) New York | Earnings have turned out to be a snoozer rather than the recession step down some gloomy souls predicted. Even if the economy is slowing, does it matter for earnings, which keep rising ever higher as net revenues stagnate? Our big takeaway from last week was the remarkable consistency in the big banks missing estimates for trading revenue, even as the Street saw higher volumes across many desks. And no surprise that securities underwriting revenue evaporated with the closure of the high-yield market in Q4 and a tedious equity pipeline. Markets seem to be moving sideways, albeit with lots of hyperventilation from the analyst community. But that does not mean there is no news. First, kudos to George Gleason at Bank OZK for turning in strong Q4 numbers. OZK remains under suspicion, though, due to its role as a benchmark for commercial real estate lending. Likewise regards to the bankers at Goldman Sachs (GS), who supplanted the traders for the first time in a decade in the only measure that matters, namely gross revenue. Of note, OZK outperformed GS last week , with the common of these two very different banks up 21% and 14% respectively -- this after OZK spiked 12% in a matter of hours after earnings were released. And, Lord be praised, both names are now trading just above book value. A year ago, OZK traded at 1.8x book value. Them were the days. Meanwhile in the automotive sector, Elon Musk and his Tesla Motors (TSLA) science project are grappling with the reality of being the most flashy, high cost member of a commodity industry. The latest TSLA announcement of layoffs took the stock down a notch and suggests evidence of liquidity stress to us, but the forgiving narrative in the financial media is that the heroic Musk wants to make money selling his mid-side Tesla 3 sedan. Never mind that consumers don’t want sedans or that the midsize slot in the global auto industry is basically a break-even proposition. Of note, TSLA is trying to squeeze every last penny out of the proverbial lithium nugget by raising the cost of ownership for Model 3 in ways beside an increase in the sticker price. For example, Tesla is officially ending any type of free Supercharging program, a surprise increase in the cost of the affordable Tesla 3. The drastic increase of Supercharging prices around the world is the latest shock for loyal TSLA owners and prospects, but also reveals the financial stress operating inside this still tiny manufacturer of electric cars. As we note in “Ford Men: From Inspiration to Enterprise” the global auto industry is a break even prospect nominally and consumes capital in terms of risk adjusted results. The advertised $35k price tag for a Model 3 is too low to be profitable in the current market. Compare the Tesla 3 with an Audi A-4 starting around $37k or an S-4 starting at $50k. Frankly the highly differentiated Tesla brand ought to be focused on a hybrid SUV that is higher in price than the premium manufacturers. Yet Musk has decided to follow the example of Henry Ford and compete on a lower price in a market that is largely consolidated and financially integrated. Good news for TSLA shareholders, of course, is that the stock is basically unchanged over the past year at about 3x sales, but what a wild ride it has been. To our astonishment, TSLA has a beta of 0.6, meaning far less volatile than the broad markets. But the credit spreads tell the tale. The TSLA 5.3s of 08/25 closed Friday at $87.75 at a weak “B” credit spread with a yield to worst of 7.71% (+500bp over 5 year Treasury debt). Compare to General Motors (GM) 5.1s of 5/25 at +260bp to the Treasury curve and Ford Motor Credit (F) 5.96s of 01/22 at +282bp to the curve. Source: US Treasury Meanwhile in mortgage land, the misery continues. Even though the spread between the benchmark 10-year Treasury note and the 30-year fixed rate mortgage has widened considerably and, indeed, is near the 2016 wide of 209 bp, profits remain elusive. We note, for example, that Ditech Holding Corporation (DHCP), which emerged from bankruptcy less than a year ago, just missed a debt payment and saw its COO depart . Read the latest DHCP 10-Q for a fascinating discussion of ties to other mortgage firms. Despite a lending profit uptick in Q2 as reported by our friends at the Mortgage Bankers Association, both bank and non-bank loan originators are still losing money on a large portion of their new residential mortgage production. The wise in the industry warn that this earnings winter could last for several more years . This raises very specific questions of survival for some industry players if the anticipated arrival of the Army of the Dead (aka rising loan defaults) occurs before lending profits recover. Source: MBA But the Creator does have a sense of humor. In December the Federal Housing Finance Agency, which regulates the three GSEs (Fannie, Freddie and the FHLBs), issued new rules for lenders regarding the use of credit scores in loan underwriting. “Chief among those rules is a provision that would prohibit the government-sponsored enterprises from using the VantageScore credit scoring model because of conflicts of interest with the company’s backers,” reports Housing Wire. Suffice to say that former agency head Mel Watt had his revenge upon the three credit repositories – Experian, TransUnion (TRU) and Equifax (EFX). See our 2017 comment, " Experian, Equifax & TransUnion want to sell you new mortgage credit scores. " This odious triopoly has poured hundreds of millions of dollars into pushing their own consumer credit measure -- Vantage Score -- in Washington. Now that FHFA has spoken, will the big three in the consumer data triopoly be forced to quietly euthanize Vantage Score? More, will the big three be forced to take a write-down of their investment in Vantage Score? Sure looks like a goose egg to us. To add insult to injury, the big three consumer data repositories must now contend with a revivified FICO, which finally realized that incorporating the non-mortgage data components pushed by the Housing Affordability mafia in Washington into the existing FICO benchmark solves the proverbial problem. Viola! Truth to tell, the key constituency in this discussion, namely global bond investors and the credit rating agencies, were never asked and did not care at all about replacing the familiar FICO credit scores. Another recent victim amidst the sideways shuttling financial market is the notion of green investing in big power. The bankruptcy of electric utility PG&E in the aftermath of the California wildfires basically suggests that providing electricity in CA may be an entirely uneconomic proposition, begging the question as to policy driven green investments. “[T]he California political class has been trying to find some way for every stakeholder group (except the shareholders) to remain intact. I would not bet on magic here.... The group's crash is becoming the failure of a model – that of private equity financed green infrastructure based upon notionally permanent fully prices contracts,” writes John Dizard in his must read column in the Financial Times . “[T]he current system of green finance has probably suffered a near-mortal blow.” So even though global equity markets are essentially moving sideways, don’t think there aren’t lots of important and even amusing things going on away from the TV cameras in the world of credit and risk. With the S&P 500 still down single digits vs a year ago, and financial bellwethers like JPMorganChase (JPM) lingering in the red by a like margin vs the exuberant valuations of last January, the global equity markets still have a long way to go before reaching solid ground. Adjusting to a world with no Fed bond market intervention and a very ambitious forward Treasury borrowing calendar will take a great deal of time. We suspect that the real test of the present market stability will come when China starts to aggressively sell dollars to prop up its sagging currency. Notice in the Treasury yield curve chart above that short-term T-bills out to 6 months are still rallying, but the rest of the complex is moving higher in yield/lower in price. Remembering that former Fed Chairs Bernanke/Yellen et al dispensed with the inverse relationship between stocks and bonds as a result of QE, the next surge for the exit may look different from December. When we see all of the yields on the Treasury curve heading higher, this under the dead weight of new issuance, then the great unwind in equities may also accelerate. Reading Martin Luther King: Notes on American Capitalism https://kinginstitute.stanford.edu/king-papers/documents/notes-american-capitalism Jim Dorn: Irving Fisher's Search for Stable Money: What We Can Learn https://www.alt-m.org/2019/01/17/irving-fishers-search-for-stable-money-what-we-can-learn/

New York | Once again it is time for earnings in the world of financials. Go back and compare the Sell Side view of financials at the end of Q2 ’18 with the narrative today. What you see is that the group basically has gone sideways for the past year. Peak gains for sector leaders like JPMorgan Chase (JPM) and U.S. Bancorp (USB) were about 5%, but both are down more than that amount since the great slide began in earnest in December. We can blame the sudden downdraft on various externalities and global trade yada yada, but the simple fact is that financials were very fully valued at the end of June. They are less so today. Is this the signal to run back into the water with the Meg? Yes and no, depending on whether you are buying quality exposures for the medium term or merely seeking a quick flip. As the recently released 2013 FOMC transcripts confirm , unwinding the great Bernanke/Yellen asset bubble means above-normal market volatility going forward. Thoughts: * There are some relative values in the financials compared with 6 months ago, but we would be cautious as the "great unwind" of the Fed balance sheet is going to continue to put pressure on valuations generally and also spreads, regardless of whether the FOMC raises interest rate targets for Fed funds. The easy days of up, up and away c/o quantitative easing are over for stocks. * To us, the sensible risk position is to stay away from complexity and "high beta" plays, but look for bargains among the low beta exemplars. The upside optionality we all thought was free a year ago now has a cost as does short-term funding. Spreads were widening as the year closed, killing HY issuance in December, but now spreads are going the other way . We believe that the real storm in terms of credit is still 12-18 months away, but equity markets are already discounting that reality. * We were a seller of PMT and NRZ going into year-end. Mortgage exposures are going to become more influenced in '19 and '20 by credit concerns. We've been a buyer of USB common and preferred because 1.7x book seems relatively cheap for the best performer of the top five banks. The USB common yields 3.25% and preferred is over 5%. LOW BETA. We like other boring, consistent names like BBT, STI and KEY for same reasons. * We are not impressed by JPM at 1.4x book or BAC at 1x. Same with Citi and Capital One (COF) at a 25% discount to par value. These last two are subprime shops and thus trade at a discount to book, period. Different business model than JPM or USB. Likewise don't like Deutsche Bank (DB) or Goldman Sachs (GS) because of the multiplicity of "known unknowns," namely continuing fears of further operational risk surprises from these investment banks. Sad to say, we still believe GS CEO David Solomon may need to fall on his sword in order to settle the 1MDB mess. Goldman Sachs is accused of facilitating fraudulent securities offerings that were ostensibly for Malaysia, but the proceeds were then stolen by various parties -- people that GS thought were clients. The Malaysians are seeking the return of the full amount of the bogus offerings plus fees, some $7 billion or thereabouts. As we noted last month, the big issue facing GS may be with US regulators and the bank's internal systems and controls. Saying that the firm was deceived by its investment bankers is not the right answer, for example, if you are speaking to the Federal Reserve Board. "I don't want to touch Goldman Sachs," analyst Dick Bove said on CNBC's "Trading Nation" last Wednesday. "People really don't understand what the issue is concerning Goldman Sachs. It's that they were involved in this huge scandal related to Malaysia. It's the fact that their compliance operations internally seem to have broken down." Ditto. The market volatility in December was good for volumes at many dealers, but not so much for clients. We could see an upside surprise from GS, Morgan Stanley (MS) and Citi as a result of the December tumult. That said, Citigroup is showing 2% sales growth for the full year 2018 and 2019 as well, but 21% plus earnings growth in Q4 ’18 and the full year. The C common is down 21% for the year vs just -11% for JPM, but if you consider the greater enterprise risk that comes with Citi that valuation differential seems about right. Consider that C has a market beta of 1.6 vs 1.1 for JPM. As we noted in the latest issue of The IRA Bank Book , the key issue facing banks in 2019 will be whether the rate of increase in funding costs – roughly 60% year-over-year – continues even as the FOMC shows signs of pulling up in terms of further increases in the target rate for Fed funds. The runoff of the Fed’s system open market account or SOMA is going to continue to tighten the US domestic deposit base regardless of whether the FOMC takes any further action in 2019. A pickup in capital markets volume, regardless of the reason, would be a nice surprise. More important, the debt issuance by the US Treasury will be an even greater weight on short-term funding costs – this as the 10 and 30- year Treasury bonds rally while high yield spreads are falling. Thus funding costs for banks and non-banks are rising, but the investor exodus from the equity markets is driving long-term bond yields and credit spreads lower. In normal times, such bullish bond market indicators like falling yields and credit spreads might suggest a substantial leg up awaits in the equity markets. Today, however, the market indicators are muddied by the side effects of QE, making traditional indicators less useful than ever. Then-Fed governor Jerome Powell said in the FOMC deliberations in January 2013: “Although it doesn’t show up yet in the dealer survey, some investors are saying that they sense the end of quantitative easing over the horizon, and as a result, there’s a sense of a rotation into equities and away from the safety of Treasuries, which accounts for some of the very large increase in the yield on the 10-year. And we should welcome all of that and consider whether our statements and actions reinforce or restrain the positive feelings that are out there.” As Powell predicted, the US equity markets delivered a stunning performance since 2014, with stock market valuations increasing by several orders of magnitude above the rate of US economic growth – what we lovingly refer to as the Bernanke/Yellen inflation. Now, however, with the Fed’s balance sheet shrinking and the fiscal deficits soaring, investors are seeing a sharp and somewhat contradictory pattern in the markets that was predicted by Chairman Powell in 2013. He said: “While financial conditions are a net positive, there’s also reason to be concerned about the growing market distortions created by our continuing asset purchases… Many fixed-income securities are now trading well above fundamental value, and the eventual correction could be large and dynamic. You hear that all the time now in the fixed income markets—and in the media, for that matter, which actually may suggest that it won’t happen, of course. But you hear it all the time; we all do. The leveraged finance markets are a particular concern. Rates are low; spreads are not that low yet, but they’re definitely tightening; and terms are deteriorating rapidly. There are many examples of bubble-like terms, which we can talk about at the next meeting. The Dell leveraged buyout, if it does happen, may be very prolific in that theater. I don’t think there’s an imminent crash coming. I do think that the incentives will rule in the end, and the incentive structure that we put in place with the asset purchases, is driving securities above fundamental values. So there is every reason to expect a sharp and painful correction.” Although the 2013 FOMC transcripts make clear that Chairman Powell was leading the charge against the Bernanke/Yellen tendency when it came to the scale and duration of SOMA asset purchases under QE, the markets still don’t seem to get the joke. Unwinding the Fed's asset price bubble is going to be a long and painful process. For financials in Q4 2018 and beyond into 2019, look for rising funding costs and still tough pricing for assets on the one hand, and lots of volatility on the trading book – good and bad. #BenBernanke #JanetYellen #JeromePowell #QE #SOMA

Richmond | The 10 year Treasury bond peaked in yield at just shy of 3.25% around Thanksgiving. Since then, the world’s most important interest rate benchmark has rallied, pushing yields back down to just shy of 2.55%. Most of this move is probably due to the exodus of investors from equity markets, but even with a stable dollar and relative market calm the 10 year continues to climb in price/fall in yield. QE and a lot of talk aside, deflation remains the dominant underlying tendency in US markets. So is now the time to pick up exposure to US financials? Maybe. Will refinance volumes return to the US mortgage sector? Deo volente . Bank OZK? Thinking (see below). Readers of The Institutional Risk Analyst know that credit metrics for all manner of bank real estate exposures are dramatically skewed in the too-good to be true direction. When will the proverbial pendulum swing the other way? Ralph Delguidice puts the opportunity into sharp focus in a missive this week: “The banks will present a GENERATIONAL buying opportunity in due time, when the FED has tightened financial conditions to deflate what is clearly a systemic bubble in COMMERCIAL REAL ESTATE (CRE) and, to a lesser extent, corporate loans. CRE and LL fundamentals can be debated to be sure, but the securitization bid is the CORNERSTONE of valuations in credit and it is never easy to ‘make the water fall up these ABS structures.’ Zero loss assumptions have been baked into the equity residual math for almost a decade, and there just isn’t room for ANY error. Like the equities, there is just too much asymmetry of return here. Eventually-- yes to the banks. In the meantime, the flat curve is going to make them too hard to own.” Ralph’s observations from the credit channel touch on a point we have long noted, namely that the monetary excess of the Federal Open Market Committee has made credit markets flaccid, now grown accustomed to zero or even negative net loss. As and when credit ratings for leveraged loans and related ABS start to slip below investment grade, the whole game will stop and “investment grade” assets that were liquid six months ago will be no bid. That’s what happens when you fall off the edge of the ratings table. Now if you ask former Fed Chairmen like Ben Bernanke or Janet Yellen, they will tell you that default rate expectations are low because the system is less risky. Yellen said back in 2016: “One reason that risk premiums may be low is precisely because the environment is less risky... The Fed has long focused on ensuring that banks hold adequate capital and that they carefully monitor and manage risks. As a consequence, banks are well-positioned to weather the financial turmoil.” The magical mystery tour of self-congratulation featuring Ben and Janet made an appearance last week, joining Fed Chairman Jerome Powell for a round robin session of carefully curated yet mindless nonsense on national television. For the record, Chairman Powell knows better. But their statements are important for investors because they illustrate just how far down the rabbit hole of economics are the internal discussions at the Fed and other agencies. The idiotic “capital will make us safer” view that underlies much of official thinking on the question of market risk sets the stage for a perfect systemic surprise. Ponder the views of Prerequisite Capital in Australia: “Ironically, when most investors study the top 15 global banks in the world ‘in isolation’ of the interrelationships and issues that arise when you take a broader look at the complex global system – you will hear them mistakenly talk about the improved ‘capital’ positions of these banks, thereby implying the relative ‘safety’ or strength of the banks globally. However, when you step back and ‘take into account larger and larger numbers of interactions as an issue is being studied. [...You are led to] strikingly different conclusions than those generated by traditional forms of analysis’ ... you start to realize that the banking and financial system globally is more (not less) fragile than it was in 2007.” The more capital = less risk construct that has become the intellectual foundation of prudential regulation in the US is a perfect analog to the Maginot Line of WWII. After WWI, the French built fixed fortifications along the eastern border with Germany in the hope that these extended castles would protect them from attack. It’s like the French version of China’s Great Wall. But the key failure of the Maginot Line was that it was an incomplete solution to a public problem, both physically and in a technological sense. George Ball wrote in The New York Review of Books in 1984: "Contrary to myth, the Maginot Line was, as far as it went, quite effective in blocking a German attack. France’s failing was that it had not finished the line and extended it to the sea or modernized its army units on the left flank.” We can think of capital in major global banks as a Maginot Line type of linear, static defense. But what was needed to counter the blitzkrieg warfare of the Nazi armies was a mobile, flexible defense comprised of tanks, infantry, and mobile artillery combined with close air support. The Allies did not have these tools or tactics and early on almost lost the war. In rare cases such as General George Patton, a horse cavalry soldier who became one of the fathers of modern mobile warfare, there was understanding, but not yet broad acceptance among US military leaders. Because the Maginot Line ended at the Luxembourg border, the Germans simply drove their Panzers around it via Belgium and the Ardennes Forrest. To apply the metaphor to finance, capital is fine, but regulators and officials responsible for monetary policy need to think about risk dynamically, especially when that market risk is the result of extreme forms of monetary policy. As curves flatten and funding costs soar, the possibility of contagion rises exponentially and regardless of capital – because liquidity ultimately is about confidence. Think about the fact that the 10 year T-bond has rallied three quarters of a point since November at a time when the Treasury is borrowing record amounts. The unwind of the Fed’s extraordinary policy is causing asset classes to correlate and other distortions in both demand for duration and funding. Any pretense at making rational investment decisions in such a muddled environment seems to stretch credulity to the breaking point. But life continues, in defiance of the apocalyptic. Bank OZK Let’s take a case in point, Bank OZK (formerly known as Bank of the Ozarks). Long one of the performance darlings in the US banking industry, OZK was known for being a well-run regional bank from Little Rock that had a big footprint in CRE lending nationwide. The common is off 50% over the past year, a reflection of some credit write downs that we not well handled with investors and an expensive name change and corporate name change and restructuring effort that leaves many puzzled. When you look at the available disclosure on OZK , which is greatly reduced since the bank dissolved its parent holding company and became a unitary state-chartered non-member bank, the numbers look fine. Strong capital, low credit losses. BTW, a great resource when you need to follow the growing number of publicly traded unitary banks is the TBS Bank Monitor (see below), which scored OZK an “A+” in Q3 2018. Ping Dennis Santiago at TBS for more information. Source: TBS/FDIC After cratering to down 60% YOY on Christmas Eve, OZK rebounded 10% in the past month. Do you go in and start to increase exposure to this tainted dove, this one time exemplar of the CRE syndication world that now trades at a discount to subprime players like Citigroup (C) at 0.75 x book value? Not to mention U.S. Bancorp (USB) at 1.75 x book? The answer to that question depends on your view of risk and particularly unexpected risk. We could spend a fine evening debating where that floor, that average equity market volatility rate, really ought to be for OZK given the perceived embedded risk. But looking at larger comps, the market swings of the past six weeks confirm that change is underway. The high volatility players such as Goldman Sachs (GS), Deutsche Bank (DB) and Citi all trade at a discount to book because of the potential for large operational risk events. You could argue that GS wishes for a higher beta. All of these stocks reflect a lack of visibility on future risks, something the folks at Wells Fargo (WFC) also learned about over the past several years. OZK with a beta of 1.8 is twice as volatile as GS at about 1 beta or roughly in line with market volatility. OZK at 0.89 book value is down 50% from a year ago, but since the unexpected credit write downs and the other fumbling around, the bank has lost that special bond with investors. Based on the historical performance, we want and expect to see OZK deliver solid earnings and strong credit, quarter after quarter. But once you start to lose confidence in bank management and start to think about unexpected risk events, then that premium valuation goes out the window. The fact that OZK is head-to-head in CRE lending with some of the largest banks in major metros is not exactly a cause for confidence given loan pricing. The point of the story is that consistency pays big dividends, but once you introduce the risk of uncertainty into the equation, investors quickly forget past performance and start to discount the promised outcome no matter the historical track record. Will the once premier names of WFC and OZK return to that premium pricing band above 1.5x book value? Yes, but it may take years to happen. Credit spreads have widened considerably and given the softening of collateral values in residential and commercial real estate, worry about the unknown is certainly going to dominate financials going forward. The key question for the future is when will actual default rates follow spreads and how rapidly. Further Reading: China's Stability Is at Risk The National Interest The Interview: George Gleason, Bank of the Ozarks The Institutional Risk Analyst #OZK #Capital #Maginot #RalpDeguidice #WFC

Paris | In this issue of The Institutional Risk Analyst, we feature a timely comment from Robert Eiesenbeis, Vice Chairman & Chief Monetary Economist at Cumberland Advisors in Sarasota, FL . Dr. Eisenbeis was formerly Executive Vice-President and Director of Research at the Federal Reserve Bank of Atlanta. While explaining the market mechanics of the Fed's balance sheet manipulations over the past few years, he makes a key point, namely that the increase in the federal deficit is the main driver of rising interest rates and widening credit spreads. "Treasury is the driver here and all the had wringing about shrinkage in the Fed’s balance sheet is missing the gorilla in the room," he opines. Perhaps President Donald Trump should stop criticizing Federal Reserve Chairman Jerome Powell and start to focus on raising revenue and/or cutting federal spending. Meanwhile, yields on fixed income benchmarks such as the 10-Year Treasury bond and 30-year mortgage rate have been falling since mid-November. Yogi Berra, the Fed’s Balance Sheet, and Liquidity January 1, 2019 The story is that the Fed’s quantitative easing program injected large amounts of liquidity into financial markets, causing bond rates to fall and stock prices to accelerate. Consequently, the argument goes that, the shrinking of the Fed’s balance sheet through maturity runoff will cause bond rates to increase and, presumably, stock prices to retreat. But what are the essential mechanics of Federal Reserve asset purchases, and how might they affect liquidity in the market? When the Federal Reserve began its quantitative easing program, it purchased Treasury obligations in the marketplace through the primary dealer facility and paid for those securities by writing up the reserve accounts of the sellers’ banks, simultaneously increasing the sellers’ bank deposits.[1] Effectively, the Fed created money in the purchase transactions, but as far as the public’s asset position is concerned, the purchases substituted demand liabilities for Treasury obligations. The sellers received deposits; their banks’ reserves increased by the same amount; and the sellers’ Treasury holdings were reduced. From the perspective of the consolidated government balance, Treasuries were removed from the public; and on-demand Fed liabilities were substituted in their place, bearing a lower interest cost than the Treasuries they replaced.[2] One form of very liquid asset (Treasury securities) was replaced by another (reserve deposits at the Fed, with corresponding deposits held by the public in its bank). The Fed’s purchasing Treasuries bid up bond prices and put downward pressure on interest rates. One of the main effects of QE was to redistribute the ownership both of Treasuries and of bank reserves and their associated deposits. We can’t quantify or identify the sellers of securities, but we do know that a large portion of the excess reserves associated with those purchases ended up with US affiliates and subsidiaries of foreign banks. Presumably sellers were institutional investors, hedge funds, and money market mutual funds but could also include individuals.[3] Foreign banks’ share of reserves peaked at about 50% in the fall of 2014 and is presently about 35%. Those excess reserves in US and foreign subsidiaries were potentially available to generate a large increase in bank loans and the money supply. A dollar of excess reserves would support an estimated $20 increase in credit and the money supply if it were converted to required reserves as part of the bank credit creation process.[4] But this obviously didn’t happen. Indeed, the ratio of bank loans and leases to bank reserves in Oct 2008 was 26.0, whereas that same ratio as of October 31, 2018, was only 5.6; so bank credit did not expand nearly to the same degree that bank reserves expanded. Interestingly, despite the series of QE experiments, in September 2014 a dollar of reserves was associated with only 2.9 dollars of bank loans and leases right before the Fed stopped adding to its portfolio in October 2014.[5] In short, the degree of stimulus, as far as bank lending was concerned, was muted. In fairness, business investment demand for credit was not great. The NFIB (National Federation of Independent Businesses) reported in March 2014 that 53% of its respondents indicated no need for a loan. Only 2% reported that financing was a major problem; and only 30% reported borrowing on a regular basis, a near-record low. One of the reasons was pessimism about investment and expansion prospects. The report stated that “The small business sector remains in maintenance mode, no expansion beyond a few firm starts in response to regional population growth.”[6] In December 2016 the Fed began a series of 25 bp increases in its target rate for federal funds, and in October of 2017 it began the process of shrinking its balance sheet by letting assets mature and run off naturally. As of December 19, 2018, the Fed’s balance sheet stood at $4.084 trillion, down from its peak of $4.5 trillion on October 14, 2015. Critics have complained that the balance sheet shrinkage process has contributed to a liquidity shortage; but they have not defined exactly what the nature of liquidity problem is, who is or is not constrained, and how that constraint is manifested. The size of the Fed’s balance sheet is determined by the outstanding reserve balances (both required and excess reserves), the volume of currency in circulation (which is of course the most liquid of assets), the volume of funds in the Treasury’s account with the Fed, the volume of reverse repo transactions outstanding, deposits in foreign official accounts, and of course capital. The only way the Fed’s balance sheet can shrink in size is if outstanding currency declines, bank loans shrink, Treasury or other official balances decline, or assets are allowed to mature, in which case the Fed’s liability to the Treasury declines, offsetting the maturing assets. Several factors have actually put upward pressure on the size of the Fed’s balance sheet since October 2014, including an increase of $330 billion in Treasury balances, an increase of $314 billion in added currency outstanding, and an increase of $82 million in foreign official and other deposits. This increase was offset by a decline of $1.07 trillion in bank reserves. How can we explain the drop in reserves if other factors seem to be pointing to an increase in the balance sheet? The source of Treasury balances is tax revenues that are deposited in Treasury tax and loan accounts at commercial banks. When the Treasury transfers funds from those accounts, the reserve accounts at the affected commercial banks are drawn down. So, in fact, the increase in the Fed’s liability to the Treasury is offset by a decrease in the reserves of the tax and loan account banks. Similarly, when bank customers withdraw funds in the form of currency, currency demand increases. That currency is obtained from the Fed in exchange for a reduction in banks’ reserve accounts. So again, rather than actually increasing the size of the Fed’s balance sheet, the composition of its liabilities is changed – currency outstanding is increased, and bank reserves are decreased. Of the $1.07 trillion decline in bank reserves, there was a corresponding increase in Federal Reserve liabilities to the Treasury and the increase in currency outstanding together accounted for $653 billion of the decline. The remainder is largely associated with the runoff and shrinkage of the Fed’s asset holdings.[7] It is important to note that when the Fed engages in what it calls reverse repo transactions, the securities sold remain on the Fed’s balance sheet. Bank reserves are temporarily reduced, but corresponding liabilities to banks under the account “reverse repurchase agreements” are increased. The composition of Fed liabilities changes but the volume does not. When the repo transaction is reversed, bank reserves go up and “reverse repurchase agreements” are reduced. The bottom line is that the apparent decline in bank reserves, far in excess of the change in the decline of the Federal Reserve’s balance sheet, is offset by changes in the other factors absorbing reserve funds, which simply represent a reallocation of the ownership of Federal Reserve liabilities. In the case of the Treasury, it accumulates funds to spend on entitlements, purchases, salaries, etc., which when paid reduce Treasury balances but reappear as an offsetting increase in bank reserves when the funds are deposited with the banking system. As for the notion that the Fed’s reducing its balance sheet holdings of Treasuries contributes to a so-called liquidity problem, again the mechanics are not clear, especially when we consider what has happened to Treasury debt issuance. To be sure, the Fed’s portfolio of Treasuries fell by $213 billion since the decision to let maturing issues run off, while MBS holdings declined by $132 billion.[8] Treasury debt held by the public increased by $956 billion through the end of the third quarter of 2018 as the Fed’s portfolio began to run off. But the actual net issuance of Treasury debt is even greater than that because the Fed’s portfolio is treated from an accounting perspective as part of the public’s ownership of the debt. Since the Fed’s ownership declined by $213 billion, the Treasury securities owned by the public, not including the Fed, increased by $1.169 trillion. This issuance dwarfs the rundown in the Fed’s portfolio and its potential impacts on securities markets. The decrease in the Fed’s marginal demand for Treasuries is far offset by the increase in supply. That supply, depending upon the maturity structure of the Treasury’s refunding, puts downward pressure on rates across the Treasury curve relative to the impact that the FOMC’s rate increases have had on short-term rates. This issuance pattern probably is the major explanation for the overall upward shift in the yield curve that we have experienced since the Fed began letting its portfolio run off. In the meanwhile, more liquid assets are now in the marketplace as a result of the increase in currency outstanding and the increased supply of outstanding Treasuries, and banks still have a huge volume of liquid reserves. Note that, like cash and bank reserves, Treasuries satisfy the banking regulatory agencies’ liquidity requirements, so it isn’t clear what the nature of the claimed liquidity problem is or who is experiencing problems.[9] Liquid assets are supposedly those that can be sold with little or no impact on their price. But we must be mindful that in order for an asset other than cash or deposits at the Fed to be liquid, there must be a buyer on the other side. If there is no buyer, then assets that were thought to be liquid suddenly are not. Indeed, the Fed in essence became the buyer-of-last-resort during the financial crisis. If Yogi Berra were asked to define liquidity, he might have said the following: “Liquidity is what you have when you don’t need it; but when you need it, you don’t have it.” [1] The following discussion of asset purchases and sales omits much of the institutional detail and mechanics behind the transactions and focuses instead on the key results. [2] We have noted before that the Treasury pays the Fed interest on its Treasury holdings, and the Fed pays interest on reserves out of those proceeds (as well as covering its other operating costs) and remits the remainder back to the Treasury. The effect is that the Treasury’s financing cost on the Fed’s Treasury portfolio is the cost of interest on reserves and not the interest payments on the Treasuries themselves. [3] Foreigners and foreign institutions own about 50% of the outstanding debt held by the public. [4] Author’s estimates [5] Source: FRED FRB St Louis [6] See http://www.nfib.com/Portals/0/PDF/sbet/sbet201403.pdf. [7] It is important to note that when the Fed engages in what it calls its reverse repo transactions, the securities sold remain on the Fed’s balance sheet, and bank reserves are temporarily reduced, but liabilities to banks under reverse repos are increased. The composition of Fed liabilities changes, but the volume does not. When the repo transaction is reversed, bank reserves go up. [8] Data from Oct 2017 through December 19, 2018 [9] If Secretary Mnuchin understood banking, the last institutions he would have called to inquire about liquidity problems would have been the nation’s largest banks, which hold the bulk of the excess reserves and have ample liquidity.

Paris | Those of us who anticipated a quiet holiday break have been greatly disappointed. It is tempting to blame the electronic flatulence of the POTUS for the market selloff of the past few weeks, but in fact the credit for the great unwind must go to the members of the Federal Open Market Committee. First, the FOMC embraced unconventional policy after 2008, greatly expanding the liquidity in the US financial markets and thereby boosting valuations for stocks, bonds and real estate to astronomical levels. Second and most important, the FOMC lied to the American public about these policies. Specifically, by adopting a largely conventional policy narrative that ignores the real world impact of unconventional policy, the FOMC has misled the public and confused the markets. In simple terms, the FOMC refuses to accurately describe its policy for what it is – namely a reckless embrace of asset price inflation. Recall that after the 2008 liquidity crisis, when Fed Chairman Ben Bernanke wanted to call quantitative easing (QE) “large scale asset purchases,” the Fed’s Washington staff instead came up with the absurd and largely inaccurate euphemism of “quantitative easing.” QE, properly understood, was a direct violation of the legal mandate from Congress that instructed the central bank to seek “price stability.” During the period of radical FOMC policy measures like QE and Operation Twist, the US equity markets rationalized the extraordinary. Economists and Sell Side market analysts told investors that everything was fine, when in fact the FOMC was engaged in a vast and largely speculative experiment that distorted all manner of asset prices in the US and globally. Asset prices rose and investors cheered -- even as Washington's red ink became a torrent of new debt. From 2014 through the middle of 2018, the S&P 500 and DJIA rose by nearly 60% while the US economy was growing at barely 2%. Say what you want about central bank independence, at some point we need to hold members of the FOMC responsible for their policy actions. If the price of achieving full employment is to set the US economy on a course toward another asset bubble and financial crisis, then it is time for Congress to repeal the Humphrey-Hawkins Full Employment Act of 1978. Part of the reason why the FOMC finds it impossible to accurately describe its policy actions is that the second part of the mandate, namely “price stability,” has largely been discarded. Humphrey-Hawkins, let us recall, mandated zero inflation given full employment, a goal that was probably never possible. The political pressure from both national parties makes it problematic for any Fed Chairman to repeat the anti-inflation policies of former Chairman Paul Volcker in the 1970s. The demographic patterns of fifty years ago rightly put the emphasis on wage and consumer prices, this at a time when offshore capital inflows did not figure significantly in the economic equation. Today, however, the vast growth in the global use of the dollar as a means of exchange and store of value has changed the calculus for assessing “inflation” in profound ways. In the 2000s, vast capital inflows financed the US economy with the appearance of low inflation, but now the tide is going out. Of course, economists point to the heavily adjusted statistical measures of wage and price inflation as evidence that the FOMC is largely fulfilling the dual mandate. But how can any reasonable person watch annual double digit gains in stock market valuations or real estate prices and conclude that inflation is under control? We note in the most recent edition of The IRA Bank Book that inflation in real estate prices finally has skewed the net-loss given default for $2.5 trillion in bank owned 1-4 family mortgages negative in Q3 2018 (see chart below). Source: FDIC The same skew in the credit loss characteristics of 1-4 family mortgages is also visible in multi-family and commercial real estate, thus begging the question to the FOMC: Is the same volatility and price deflation now visible in US stocks eventually going to be seen in real estate as quantitative tightening (QT) proceeds with the shrinkage of the Fed’s balance sheet? Real estate markets move far more slowly than stocks, but is the same dynamic that has taken away almost half of the stock market gains since 2014 also pushing property valuations inevitably lower? A: Yes Our contributor Ralph Delguidice (" Are Leveraged Loans a Problem? Yes, and No. And YES ") reminds us that noted economist Zoltan Pozsar has long argued that QE-created bank reserves are not --and have never been --“excess.” In fact, he notes, they remain the ONLY settlement medium that can be used to meet the now binding (intra-day) liquidity requirements and all the other regulatory constraints on bank capital and assets. Pozsar wrote in his paper “ A Macro View of Shadow Banking ” (2015): “The swapping of excess reserves for reverse repos and boosting the supply of Treasury bills (whether in a reserve neutral or reserve draining fashion)… would both lead to shrinking bank balance sheets (as reserves are swapped into RRPs deposits flow out of banks to fund RRP counterparties such as money funds) as well as shrinking dealer balance sheets as more Treasury bills and RRPs offer alternatives for money funds that are safer than dealer repos. And on the flipside, reduced matched-book repo volumes mean less funding for levered bond portfolios and fewer opportunities for lending low intrinsic value securities, both of which will reduce opportunities to deliver excess returns via levered betas for pension funds and other real money accounts that struggle with structural asset-liability mismatches.” The obvious points to take from Pozsar’s work are two: First, the FOMC cannot withdraw the liquidity provided to the US financial system via QE without causing the system to implode. Chairman Jerome Powell needs to publicly state that the Bernanke-Yellen inflation in asset prices will entirely reverse as the FOMC tries to reduce “excess reserves” to pre-crisis levels. Regardless of whether the FOMC raises the Fed funds target rate or not, continuing to shrink bank reserves via QT implies a significant reduction in prices for stocks and real estate. Second and more important, Powell needs to inform Congress that so long as the Treasury intends to run trillion dollar plus annual deficits, the Fed’s balance sheet must grow rather than shrink . To have the FOMC try to follow a narrative set in place half a century ago when fiscal deficits were minuscule is obviously impossible given the Treasury’s borrowing needs. This implies that the FOMC must embrace an explicit policy of inflation that is at odds with the legal mandate enshrined in Humphrey-Hawkins. As we’ve noted previously, the POTUS is right to criticize the Fed’s policy actions, but for the wrong reasons. The fixation of markets and the financial media on whether the FOMC raises the target rate for Fed funds or not is misplaced, part of an time worn policy narrative that is completely antiquated. Since 2017, the only important trend in credit markets has been whether the Fed’s balance sheet is shrinking and at what rate. The move in credit spreads that started in August signaled that there is a growing problem with liquidity, yet the FOMC ignored the warning. Trapped in a policy path that is at odds with actual fiscal and economic realities, the FOMC is now the destabilizing factor in the markets. And remember that credit leads, equities follow. Our prediction for 2019 is that the FOMC will be forced to resume QE and again grow the System Open Market Account (SOMA) portfolio to maintain a ratio (yet to be determined) between the SOMA and the rapidly growing stock of outstanding Treasury debt. This is a pattern familiar to observers of other heavily indebted developing nations. Welcome to Brazil. #ZoltanPozsar #RalphDeguidice #FOMC #HumphreyHawkins

In this issue of The Institutional Risk Analyst, we feature a comment from our friend Ralph Delguidice, a veteran fixed income markets observer based in San Francisco. He provides important detail and context to the evolving credit dynamics of leveraged loans and collateralized loan obligations (CLOs) . San Francisco | December has been a cruel month for investors in “Leveraged Loans” as winter came in like a lion, early and cold. Primary and CLO spreads have exploded wider suddenly and loan prices have fallen below par going into the year end, stranding dozens of deals in bank warehouse lines and postponing the pricing on hundreds of other deals. This has drawn considerable media and market attention of late, as the asset class has grown to $1.1 trillion and now eclipses the high yield (HY) bond market it used to shadow. The Fed has been outspoken in their concerns as ETF and mutual fund buying has fed an insatiable demand for yield that naturally followed a decade of QE, and now with accommodation in process of being withdrawn the questions on possible systemic vulnerabilities are back front and center. The question of where and how fast this market might be going is complex to say the least, and there is room to disagree to be sure. That said, a couple of things are important to keep in mind from a MACRO and structural point of view that may hold the answers: The current correction is a natural and inevitable consequence of the widening in IG (investment grade), as the CLO markets are dispositive with respect to loan pricing and the quality of the CLO arbitrage—and expected loss adjusted returns—is a straight line-function of IG liability costs at the top of the “stack” (AAA, AA, A) that trade with corporate IG markets and FX swap costs It is not an exaggeration to point out that AAA tranches are now priced entirely in Japan by a small handful of buyers—most notably Norinchukin (a huge deposit funded agricultural co-op) many of whom were big buyers the last time around in 2008. They forgive easily. But should FX swap costs and/or alternative sovereign yields offer a more attractive option the CLO bid could close altogether. From a more MACRO point of view, the Fed hostility to leveraged loans (LLs) is actually ironic, especially given what is a clear and present intent on the part of the central bank to use the Non-banks (CLOs, hedge funds) as a loss absorbing “buffer” to protect the systemically critical GSIBs from the fallout as rates rise. This is perhaps the most important distinction of all for the asset class—as the Fed will not be quick to cut rates this time around in the face of non-continuous price discovery. It has become evident that the dramatic easing of LIBOR in 2008 and 2016 was Central Bank driven and was critical to the “out-performance” of LL’s (vis-a-vis HY) in the past. Remember, cutting LIBOR rates offers IMMEDIATE relief to FRN’s that makes refianacings unnecessary. But this time around the Fed has neither the room nor the desire to bail out the LL markets. Either way, the Fed is comfortable with credit vol. contained in the non-banks that they view as expendable (at best), and that is a BIG RED FLAG. Away from CLO’s--where volatility in the BB tranches was 8X the vol of the similarly rated loan collaterals-- the loan market has been saturated with demand from so-called SMAs (separately managed accounts). These are pension fund and family office investors who were attracted by the decade of flip-chart “out-performance” and who have joined HUNDREDS of brand-new—and totally untested—managers of hedge “credit funds” in what seemed to be an easy- Alpha trade. The question of how well (and stably) funded these SMAs and hedge funds will turn out to be--and how serious is their intent --we will see in time. But retail fund flows are already suggesting significant outflows from the ETFs and loan funds, and this is not going to be lost on those institutions, especially those who may not have fully understood what it was they were buying into. It is vital to remember that CLO deals that are half ramped (many of them) and that all own many of the same names already--are not going too be cash flowing fully to the residual (equity) tranche until they can manage to get fully loaned up. What this says about incentives (and other people’s money) as the market becomes volatile may be open to some debate, but transparency is in VERY short supply here, lags are long and management fees are, still, what they are. The FED has 2 REAL questions where systemic risk and the potential for contagion are concerned that need to be watched carefully. The first is the question of liquidity transformation where the ETFs are concerned. Loan settlements can literally take MONTHS and ETF/Fund liquidity is minute to minute. Should the BKLN or SRLN ETF see outflows that test the integrity of sponsors and force-clear pricing the rest of the credit ETF/mutual fund market—8T$ AT LEAST— will certainly be impacted. The second, and perhaps more important question (given the FED resolve in re the non-banks), is the degree to which so-called “collateral upgrades” have been done with CLO debt and LL’s themselves. In a nutshell, the now near total mandate to clear ALL interest rate and most credit swaps has created a pressing need for cash collateral to be posted at CCPs as initial margin. The BIS has estimated that swaps re-novated to CCPs have resulted in margin shortfalls are in the 4T$ range, and the primary users of swaps (insurance, hedge funds) are short of the acceptable sovereigns and cash to nearly this amount. Over the past several years the custody banks and prime brokers have quietly managed to offer the users of derivatives the ability to swap corporate securities OF ALL KINDS WITH ALL RATINGS for UST collateral that can be REPOed for cash. Of course it is hugely profitable. The problems are equally obvious, and; ironically, are a repeat of what went wrong in 2008 as REPO funding market runs suddenly become, as Vince Lombardi once said: "not just everything, but the only thing.” The above are some of the known-unknowns that LL and credit investors and will be dealing with in coming quarters. It is important to remember ALWAYS that these are specific issues that will be playing out against an economic backdrop that has become clearly hostile to credit of all kinds; and when all is said and done LL’s, CLOs and ETFs are all just different ways of packaging what is essentially raw credit risk—with few covenants and even fewer supporting market makers—into “securities” that are designed to appeal to retail investors that have been yield starved for more than a decade. If ever there was a text book smart money/stupid money trade, it is probably this market right now. Several of the MOST experienced mangers—those FEW who actually were doing the trade just 2 years ago—have started CLO funds that will offer a designed predatory flexibility to buy busted debt and collaterals from the less fortunate and prepared. Ellington and Highbridge know the risks, and they are getting ready for a GOT-style Red Wedding. My advice is don’t go -- more later. #LeveragedLoans #AAA

New York | First a safe and happy holiday to all. In this issue of The Institutional Risk Analyst , we ponder past prognostications and future risks in 2019. And we are happy to announce the publication of The IRA Bank Book for Q4 2018. For those of you who were furiously buying copies of the Q3 edition last week, for which we are most grateful, hit the download link again to get the Q4 edition. You’ll want to read about why US bank earnings growth is now 100% correlated to interest rates. FYI, new editions of The IRA Bank Book are published about two weeks after the FDIC and other regulators release their institution level and aggregate data (roughly day 60 after the quarter end) for US banks. The popular IRA Top Ten Banks usually appears after quarterly earnings are complete. And yes, to your questions, we only sell the most recent edition of each report. So what is our top concerns in 2019? First comes liquidity. For the past several weeks, US equities have fallen as the great unwind gathers speed. The same pressures that are causing the Federal Open Market Committee to consider pausing on rate hikes in 2019 are forcing stocks lower. Never mind the parade of mindless reasons for the stock market reset – trade, China or even a weak US economy – the key factor pushing markets lower is the radical tightening of credit by the FOMC. Even without a single rate hike in 2019, the tightening caused by the runoff of the Fed’s bond portfolio will continue to suck liquidity out of the financial system. And lowering the target rate for Fed funds really won’t help if markets lock up. Just as quantitative easing expanded the US liquidity base, quantitative tightening or "QT" represents a structural decrease in liquidity. As the Fed’s balance sheet contracts, there is a dollar-for-dollar decrease in liquidity because the Treasury is running a deficit. A bank deposit becomes a Treasury bill on the national balance sheet, illustrating why the Fed and Treasury are two faces of the same agency. But the key point is that QT is beginning to impact markets and credit spreads. The destruction of trillions in equity market valuation is creating a level of panic in the US markets not seen since 2016, when China fears caused the capital markets to seize up. We may be replaying that scenario again. With high yield spreads headed to the danger zone of 500bp over Treasury yields, that tells you that the policy message coming from Washington is off key. But it also means that the market for subprime debt, including leveraged loans and CLOs, is grinding to a halt. That sound you hear is Wall Street choking on conduits full of loans that cannot be sold. Feldkamp’s First Law states that when spreads widen too much, debt markets stop functioning and equity markets lose value. We talked about this in “ Financial Stability: Fraud, Confidence and the Wealth of Nations .” When the mix of policy and personalities is toxic, spreads blow out, debt markets freeze and wealth as measured by the equity markets falls. Sadly there are only a handful of people on the Street who get the joke. The majority is captive of a narrative where trade tensions are responsible for market weakness. Next on the string of worry beads is Europe. The European Central Bank just announced the end of its version of “quantitative easing” or QE, but unlike the US the ECB intends to reinvest its bond portfolio indefinitely. There will be no “quantitative tightening” in Europe by actually allowing the portfolio to run off as in the case of the US Federal Reserve. We reported this to readers after our trip to Paris last March. This past week, ECB Governor Mario Draghi confirmed our belief that EU banks cannot withstand a significant increase in rates. The list of banks in Europe that are effectively insolvent is long and growing, in part because the EU banking system is not particularly profitable. Again, as we noted in previous comments, strong banks are profitable banks. Profits allow you to build capital and deposits, and fund credit losses. For the banks of Europe and particularly nations like Italy, far too often there is little or no real profitability. This leads banks to hide credit losses and asset quality problems. We were amused to read that Qatar is considering increasing its stake in Deutsche Bank, as the newspaper Handelsblatt reported Sunday. This brings back memories of a decade ago when Korea Development Bank was touted to be looking to acquire Lehman Brothers. Then as now, the reports are not particularly helpful. What DB needs is to be recapitalized or acquired, but so far no credible investors has been willing to put new capital into this troubled bank. Merge Deutsche Bank with Citigroup (12/04/18) As we have discussed previously, the fact that insolvent Chinese aviation conglomerate HNA is selling its stake in DB means that the bank badly needs a new shareholder. And keep in mind that HNA was not a cash buyer of DB shares, but instead used leverage to fund its position. Presumably the Qataris have cash. We see the failure or restructuring of DB as a very real possibility in 2019, an event of default that will force the larger issue of bank solvency in Europe. With the bank trading below one quarter of book value, the stock of DB is not suitable as an investment. When will the EU authorities accept the fact that DB is crippled and requires state aid in order to stabilize? In the event, the mirage of German economic power in Europe will evaporate. Last comes China, both because of the growing potential for violent change and because western audiences are completely unprepared for this eventuality. Credulous western observers talk about the “long term” perspective of the Chinese Communist Party (CCP), but in fact this gang of “running dogs” to borrow the Maoist terminology is no different than western politicians. The make it up as they go. The CCP is no more able to manage a economy than is President Donald Trump. The key difference in China is mountains of debt, no real equity leverage in the economy, and a payments system that is entirely focused through the Bank of China. But the most troubling development in our view are the growing signs that the CCP and paramount leader Xi Jinping feel compelled to take more and more authoritarian measures to retain political control. The brutal rise of Xi Jinping to sole power in China is nothing if not a display of massive insecurity, starting with the elimination of all rivals and ending with the dissolution of collective leadership. Revelations that Beijing feels the need to imprison over a million Muslim Uighurs in work camps, a mere 10% of the 11 million population of Xinjiang, also suggests a very direct fear of instability. Mao Tse-Tung wrote in World Marxist Review in 1961: “A potential revolutionary situation exists in any country where the government consistently fails in its obligation to ensure a least a minimally decent standard of life for the great majority of its citizens. If there also exists even the nucleus of a revolutionary party able to supply doctrine and organization, only one ingredient is needed: the instrument for revolutionary action.” The revolutionary party is radical Islam, spilling across China’s western and southern borders. The CCP well recognizes the parallels with Chinese history. And it has happened before. Just as the Chinese nationalists and communist forces defeated the Japanese in WWII after decades of brutal occupation of China by Tokyo's fascist rulers, the CCP is now in the position of the oppressor and the Islamist “terrorists” are the liberators. No member of the CCP who understands China’s history could fail to be impressed by this parallel. Watching the liquidation of the HNA Group, a process which we now learn from Reuters is being administered by China Development Bank, you begin to appreciate just how fragile is Beijing’s control of the economy. CDB, of course, is HNA’s biggest creditor, and it in turn is an appendage of the Bank of China. When Wang Jian, the co-chairman and a co-founder of HNA Group, “accidentally” fell off a wall in Provence, France, he was atoning for creating a scheme so gigantically absurd and so heavily leveraged that it threatened the CCP. The CCP is happy to tolerate or even encourage wealth creation, but only so long as it does not become a problem. HNA’s $50 billion debt fueled shopping spree was and is still a problem for China in 2019, but only illustrates a larger issue of national economic solidity and cohesion. Westerners may need to consider the possibility of political change in China, a process that historically has come from the periphery and moved to the center in Beijing. Offshore investors who have become enamored of the illusion of political stability in China may want to recalibrate the reality gauge in 2019. #MaoTseTung #DeutscheBank #HNA #XiJinping

Charleston | In this issue of The Institutional Risk Analyst, we feature an important comment by Robert Eisenbeis, PhD., Vice Chairman & Chief Monetary Economist at Cumberland Advisors . Eisenbeis raises a key question at the end of his commentary, namely whether the Federal Open Market Committee is going to run down the level of excess reserves back to pre-crisis levels. Should the FOMC refuse to allow the extraordinary levels of excess reserves to run off, then it implies the permanent nationalization of the short-term credit markets in the US by the Federal Reserve Board. In another week the FOMC will have its final meeting of 2018 and its last with the current mix of policy makers. Already, the discussion has turned to what the Committee will do at that and subsequent meetings: Will it proceed with further 25bp increases in the target range for the federal funds rate, or will it pause? Markets appear to have priced in another rate increase in December, at least as signaled by what has happened to the short end of the Treasury curve, shown in the chart below. Chairman Powell afforded this view credibility in a speech he gave on November 28 in New York. Although the purpose of the speech was to highlight the release of the Fed’s first-ever financial stability report, he did touch on monetary policy. After noting the delicate balance between moving policy rates too fast or too slow to achieve the Fed’s dual mandate and the need to consider information contained in incoming data, he stated that, as far as current policy is concerned, “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy….” What Powell is clearly saying is that he would be comfortable with at least one more rate increase, and this sets the stage for the FOMC’s next move in December. There are two important reasons why the FOMC will move at its next meeting. First, it has provided justification of where rates should be to be “neutral”- that is, neither too tight nor too loose with regards to slowing down or speeding up growth. Second, that justification blunts any perception that the FOMC may be bowing to political pressure from the White House when it comes to setting rates. By saying it is “almost there” and stating that further moves are data-dependent, the FOMC is setting the stage for a possible pause. And the rationale for such a pause will be contained in the Summary of Economic Projections, if the Committee does indeed decide that it has achieved a neutral policy stance. Clearly, world growth is slowing and should the slowing continue that may be sufficient to justify a pause by the Committee. The minutes of the November FOMC meeting, released November 29, reinforce the “almost there” view articulated by Chairman Powell in his speech. The minutes reveal some concern on the part of FOMC participants about the risks to inflation posed by uncertainty concerning the fiscal situation and trade policies. The Committee laid those concerns aside, however, in commenting on the path for policy, and there was agreement that “another increase in the target range for the federal funds rate was likely to be warranted fairly soon if incoming information on labor market and inflation was in line with or stronger than their current expectations.” However, some expressed uncertainty over the timing of further increases, while at least two participants expressed the view that the neutral policy stance had been achieved. The bottom line is that the minutes, combined with Chairman Powell’s “almost there” hint in his NY speech, perfectly position the FOMC for another rate increase at its December meeting, while preserving flexibility to pause at future meetings and putting some distance between the FOMC and the White House. The minutes are interesting for another reason as well, because they indicate the nature of the current state of the discussions about how future policy might be conducted once the Fed has normalized its balance sheet. That decision is shown to hinge critically on whether the FOMC decides to return to the pre-crisis regime of a balance sheet determined primarily by currency demand and a low level of excess reserves or favors instead a large balance sheet with a large volume of excess reserves. The former would imply policy exercised by small changes in the volume of excess reserves achieved through manipulation of the federal funds rate in the overnight market. The latter would imply continuing the reverse repo approach and dealing with a larger number of potential non-bank counterparties, such as money market mutual funds. It is clear from the discussion that no decision on these alternatives has been made, and the decision process is complicated by changes in how financial markets have functioned in the wake of the financial crisis. The clear message in the minutes is that this discussion is “to be continued.”

New York | Last week Federal Reserve Board Chairman Jay Powell blinked and thereby changed the monetary narrative. We suspect that this is just the start of a tactical retreat by the Fed in the face of mounting evidence of financial stress. Like the sailors who traveled to the New World with Columbus, Powell said something about nearing the “neutral rate” and promptly trimmed his sails for fear of encountering a reef. That reef, dear readers, is the sudden move in credit spreads. Equities rallied and, more important, corporate bond spreads narrowed a bit last week, slowing a worrisome trend towards the repricing of credit that almost certainly implies bad times ahead. The fact of a mountain of mis-priced corporate debt has become an almost commonplace topic in the financial media. We know that bond covenants have been weakened to an absurd degree, stripping investors of assets or any legal right to the supposed security. We also know that the Fed’s manipulation of interest rates and the term structure of same has likewise distorted the pricing of risk. Yet default rates remain extremely low, begging two questions: First, how much of the downward skew in current defaults is due to the Federal Open Market Committee? Second, how quickly will credit spreads reprice, especially with a market that is tightening by the day as the Fed’s bond purchases slowly run off. Even were Powell and his colleagues on the FOMC to do one more rate hike this year and then pause in 2019, the runoff from the FOMC System Portfolio would continue to shrink the US deposit base and thereby tighten liquidity. Thus the term “quantitative tightening.” Unknown to most Fed analysts, Chairman Powell actually has a great deal of leeway in terms of the Fed’s “data driven” policy. Even with no further rate hikes, the liquidity in the US markets will continue to tighten apace. Every dollar of Treasury debt that runs off from the Fed’s books means a dollar’s worth of bank deposits disappears (HT to Lee Alder at The Wall Street Examiner ). While many economists inside and outside of the central bank continue to waffle about the need to raise rates to enhance future “policy flexibility,” a truly bizarre construct, in fact the only decision that matters today is whether the FOMC is a net buyer of Treasury debt. Ponder that. Next week we’ll be releasing the Q4 edition of The IRA Bank Book , which will delve into this phenomenon of domestic bank deposit shrinkage more deeply. Suffice to say that the Fed and Treasury are alter egos, two faces of the same fiscal ledger, so that what one manifestation of America gives in terms of market liquidity the other takes away. Thus in our day job we see core bank deposits trading at a healthy mid-single digit premium again after years of no premium or even discounts. And yes, non-interest bearing bank balances at US banks fell again in Q3 2018. With non-interest bearing deposits falling, offset of note by growing foreign inflows into US banks, the bias for US deposits overall is flat to down, as shown in the chart below. Source: FDIC Ralph on the left coast notes that the fund community is already gearing up for the opportunity to purchase busted corporate bond deals, especially the collateralized loan obligations or “CLOs” that first became famous in the financial crisis. These deals typically have a weighted average rating factor or “WARF” in single digits for “B” rated debt, meaning that if too much of the collateral in the deal is downgraded below that rating, then the covenants kick in to protect the senior debt. Ralph sees several new funds with WARFs of 50% “CCC” being created to clean up the impending mess in corporate debt. “In nutshell, the new deals are designed to allow for up to 50% CCC with no WARF test, so they will be in perfect position to be buyers of the newly downgraded CCCs that will be puked up across the whole CLO surface,” opines Ralph. Yummy. It needs to be said that out of every market contagion, great fortunes are created. But the fact of these large opportunities to profit also attracts swarms of politicians, regulators and members of the trial bar. Just as there is a great concentration of public companies around the “BBB” investment grade band, there also is a large pile of “B” rated crap inside CLOs that is just perfectly situated to slide down into “CCC” nowhere land at the right moment. Again, ponder the velocity of the transition from apparent credit ratings visible today to where they ought to be in a world without the Fed. Sound like 2008? The value of QE and "Operation Twist" in terms of option adjusted duration is an important question in this regard. The gradual repricing of risk will not only bust more than a few CLOs, but may also provide some surprises in the world of investment grade credit. Consider a home owner in CT or CA or NY who has a FICO score north of 800, seven figure income and a home that in theory is worth $5 million. At the moment, however, there is no bid near that valuation. The home has a 50% mortgage on an appraised value of $4.5 million and is being rented for less than half of the monthly carrying costs. Q: How long will the affluent home owner fund the negative carry asset? A: We’ll find out. It's called "strategic default" by the way. Q: What is the true loan-to-value ratio of this mortgage? A: Higher than 50%. Just as there is an awful lot of toxic corporate exposures inside the world of CLOs, there is also a fair amount of apparently prime credit that are, in fact, susceptible to a forced reset due to the prospect of a buyers market in residential or commercial real estate. Indeed, the current vapor lock in high end residential property reminds us an awful lot of 2005, when the real estate market began the long slide that did not end until 2012. When the loan sales volumes at WaMu and Countrywide started to fall, you could tell that the party was over. And loan volumes have been falling for years. The toggle that starts the repricing process is not merely the absolute level of interest rates but rather spreads. We know that Chairman Powell and his colleagues watch many types of market indicators, but the most important and fast moving over the past month has been the rate of change in high-yield (HY) credit spreads. The folks at the Fed may want to increase interest rates to provide increased flexibility, but they are also trying to avoid a repeat of 2016, when worries about China drove high-yield spreads through the roof. Notice that even the modest uptick in spreads at the far right side of the chart was enough to almost destabilize the US equity markets. Owing to the China syndrome in the first part of 2016, when high yield spreads rose to more than 800 bp over Treasury yields, the bond and ABS markets were basically dead for six months. Nobody on the FOMC wants to repeat that experience. In plain English, when high-yield spreads jump 20 percent in a 30-day period, you can be pretty sure that the spaceship is approaching the neutral rate. Thankfully Chairman Jay Powell noticed. Yet even his soothing words last week are unlikely to slow the exodus of investors from CLOs and corporate debt more generally. Of note, the Fed is considering big change in how it sets US interest rates, possibly targeting the OBFR instead of the fed funds rate. But what is the OBFR? The Fed tells us that, "The overnight bank funding rate is calculated using federal funds transactions and certain Eurodollar transactions." All we can say is that Europe is short dollars and always has been. When the next idiosyncratic event strikes – Italy, Deutsche Bank, BREXIT, a New Hanseatic League – look for the dollar cost of credit in Europe to spike large. #WARF #Ralph #Powell #CLOs

New York | Reading the financial press over long holidays in essential. In the days immediately before or after a holiday, there are inevitably important news items that will be missed. Exhibit 1 is the festering situation in the world of non-bank mortgage finance, where a combination of excessive regulation and interest rate manipulation by the Federal Open Market Committee has set the industry on a collision course with reality in 2019. Eddie Small at The Real Deal in New York summarized the situation: “Lenders are trying to navigate the new landscape using tactics like selling their mortgage-servicing rights or lending to borrowers they would have previously overlooked. Dan Gilbert, chairman of the largest nonbank lender Quicken, told the Journal that purchase mortgages are becoming more central to the company’s business.” Let’s set the stage. Back in 2008, the FOMC opened the proverbial floodgates, pushing interest rates down to near zero and ushering in a bull market in both commercial and residential real estate starting in 2012. To give you a sense of just how far up the FOMC has manipulated home prices, the chart below shows loss given default (LGD) for the $2.5 trillion in bank-owned 1-4 family mortgages. Source: FDIC In Q3 ’18, the LGD for bank owned 1-4s was negative 15%, meaning that recoveries on foreclosed homes actually exceeded the gross amount of defaulted loans. The long-term average loss rate for bank-owned 1-4s is 65% going back to 1984. And the level of both recoveries and defaults for the portfolio is very low, below $1 billion. But both the negative level of credit loss and the low default rates are outliers that will be reversed. By engineering an artificial sellers market in real estate after 2012, the FOMC also created a huge opportunity for adept mortgage firms to make piles of money, both on mortgage refinance transactions and also by managing the vast flow of defaulted mortgages coming out of the crisis. At the start of 2012, by comparison, the LGD on bank owned 1-4 family mortgages was 94%, meaning that banks were loosing $0.94 per dollar of face amount of loan every time a mortgage defaulted. Today, with home prices now above 2008 levels, mortgage servicers are actually making $0.15 profit per dollar of the original loan amount in those rare cases where a mortgage actually goes through foreclosure. With interest rates rising and the accumulated backlog of defaulted mortgages largely (but not entirely) resolved, mortgage firms are now facing the worst of all possible worlds. On the one hand, mortgage servicing is no longer profitable for many non-banks because of the Dodd-Frank, the regulations imposed by the Bureau of Consumer Financial Protection and the 50 states. While mortgage firms are able to generate decent margins on mortgage refinancing, the cost of originating new purchase loans is over $8,000. Kroll Bond Ratings put the market into context in a recent report: “[N]on-bank lenders are experiencing [gain on sale] GoS margin compression and falling origination volumes as the industry transitions to a higher rate, purchase-focused market. For large banks, 3Q18 mortgage banking results largely mirrored industry trends with slightly better GoS margins and declining origination volumes. While linked quarter margins improved for some (JPM, WFC, HTH), margins compressed further for Flagstar (FBC), HomeStreet (HMST) and PennyMac (PFSI). More notably, GoS margins year-over-year (sometimes a better proxy given seasonality associated with the market) for all companies in KBRA’s FI Mortgage Panel were down an average of 33 bps (24%).” According to the Mortgage Bankers Association, the average pre-tax production profit for non-bank mortgage lenders was 21 basis points (bps) in the second quarter of 2018, up from an average net production loss of eight bps in the first quarter of 2018, but down 24 bps from the second quarter of 2017. Keep in mind that residential loan officers typically make 1% or more in commissions on new loans, thus the industry is still operating deep in the red on every loan originated. As lending volumes have slowed over the past several years and purchase mortgages have become the dominant loan type, the profitability of many non-bank lenders has disappeared. Unlike banks which are able to earn money from the custodial deposits related to mortgage payments, non-banks must survive on gain-on-sale of new loans and servicing fees. With the cost of servicing loans up 200-300% since 2008, however, many independent mortgage banks no longer can count on a profitable servicing book to see them through periods of a sellers market in housing, when new home purchase mortgage lending is typically unprofitable. The same market manipulation by the FOMC that has caused interest rates to fall and real estate prices to soar has also encouraged non-bank mortgage firms, which are already struggling with profitability, to sell a portion of future loan servicing fees at premium prices. New production mortgage servicing rights (MSRs) for conventional Fannie Mae and Freddie Mac loans are currently going at between 5.5 and 6x annual cash flow, record price multiples for MSRs that again illustrate the huge distortions introduced into the world of housing finance by the FOMC. Which brings us to that little pre-holiday data point. On November 15, 2018, the Government National Mortgage Association (aka “GNMA”) published a bulletin to issuers operating in that market that makes a number of changes to how MSRs are financed and sold. A few members of the industry press commented on the rule before T-Day, but by and large the mortgage bankers still don't get the joke. The memo from GNMA COO Michael Bright states: “Effective immediately, Ginnie Mae is implementing new notification requirements for Issuers engaged in certain subservicer advance or servicing income agreements, which do not require prior Ginnie Mae approval, but can impact an Issuer’s ongoing liquidity position and financial obligations. While Ginnie Mae currently permits subservicers to advance funds on behalf of an Issuer to pay security holders under the MBS Program, subservicers will now be required, upon request, to notify Ginnie Mae about such advances, including details about the frequency, amount, and purpose. Similarly, Issuers that enter into pledges of servicing income, or other transactions that encumber an Issuer’s Servicing Income, that are not subject to an Acknowledgment Agreement, must notify their Account Executive via email no later than 15 business days after the date that the transaction agreement is executed. Upon notification, Ginnie Mae may require the Issuer to provide the specific terms of the transaction, relevant documentation, or updated financial information.” The new GNMA regulations require all banks and non-banks operating in that market to disclose all past financings, sales and participations of MSRs. Why is this important? Because the ability of an issuer in the $2 trillion GNMA market to 1) pay bond holders and 2) purchase bad loans and conduct loss mitigation is crucially dependent upon the solvency of the issuer/servicer. When an independent mortgage bank “sells” part of their future servicing income to help offset current losses on lending, for example, we create a scenario where the mortgage bank is more likely to fail when 1) interest rates rise and/or 2) default rates increase. The Economics of Servicing Let’s quickly dive into the economics of loan servicing in the Ginnie Mae market, which we addressed in depth last summer in a working paper entitled “ Increasing Capital & Liquidity for GNMA Mortgage Servicing Rights ” last summer. Let’s assume that we have a hypothetical mortgage with an unpaid principal balance of $300,000 and a loan coupon of 5%. The typical GNMA issuer gets a net servicing fee of 32bp annually. Take 32 bps on $300k and you get $960 per year in gross servicing. Most servicers can administer a performing mortgage for $7 per month, so again 12 x $7 or $84 per year. This means that, in theory, the non-bank could “sell” the other $880 or so of the servicing income or "strip" to a financial investor like Black Rock or Apollo. But this works only if there are no problems with the loan, no need to speak to the obligor, call them or send them mail, etc. Sending out a piece of first class mail costs at least $1, for example, vs an electronic mortgage statement. The moment a GNMA loan goes delinquent, the cost of servicing skyrockets, 10x the normal cost or more, as do the fees the servicer eventually receives for fixing the loan. But all of the excess fees for servicing a distressed loan are on the back end and must be financed by the non-bank, along with advances of interest, principal, taxes and insurance required to protect the value of the home. The only cash the GNMA issuer/servicer receives each month is the 32 bps servicing fee. Thus the reason why GNMA wants to know how much of a non-bank’s 32 bps of servicing has been sold away. Remember that the full 32 bp strip is capital meant to finance operations during periods of peak defaults. Under the current practice in the mortgage industry, many non-banks have sold away more than half of their gross spread from their MSR. We hear in the channel that GNMA is considering in the near future imposing a 25bp minimum for retention of income from the MSR. Note that the annual float on the mortgage example above is in excess of $30,000 per year in a high tax state. This float can generate twice the fees that a servicer receives for actually administering the loan, but only a bank can fully capture this benefit. Note too that larger loans generate bigger servicing fees, one reason that big banks like Wells Fargo and Bank American will pay up for jumbo loans, which they often hold in portfolio. The trouble for investors in MSRs arises from the optionality regarding termination of servicing rights by GNMA, an issue that is fundamentally connected to the solvency of the issuer/servicer. Thus the new GNMA regulations provide a stark warning and also a roadmap to future contagion in the non-bank sector. Keep in mind well more than half of the non-banks in the US residential space have probably blown through their bank credit covenants due to impaired capital, poor profitability or both. The other issue for investors in non-bank mortgage firms and MSRs is participations. When a non-bank sells or finances part of their 32 bp GNMA servicing strip to a financial investor, this is most often done via a participation agreement. There is no “sale” and the mortgage bank remains the owner of record of the MSR. In the event of default, a bankruptcy trustee for a non-bank or the FDIC acting as receiver for a failed bank will likely try to reject the participation agreements that have not been fully isolated. As we noted in American Banker , some lawyers like to pretend that the current practice on Wall Street regarding loan participations is safe and sound, but in fact unless the asset is legally isolated from the failed bank or non-bank, the purchaser of participations in loans or MSRs stand at risk of total loss. It happened before in a little mess called Penn Square Bank. The FDIC repudiated all of the dead bank’s loan participations, gutting five large banks in the process and causing four (Chase Manhattan, Continental Illinois, Seafirst and Michigan National) to subsequently fail and be sold. Of the five banks most impacted, today only Northern Trust Co (NTRS) survives that default event as an independent bank. The Road to Contagion The first step toward contagion in the world of non-bank finance, as we’ve noted before, will be a liquidity squeeze that is ongoing and forcing many smaller non-bank firms out of business. Even were the FOMC to do just one more rate hike in 2018 and then wait awhile for the System Portfolio to unwind, it is unlikely that loan spreads in residential loans or other asset classes are likely to recover in the near term. In fact, so great is the concern about profitability that GNMA is meeting with the largest issuers, industry maven Rob Chrisman wrote just before the holiday: “Ginnie Mae sent a "liquidity letter" to its 14 largest issuer/servicers in late October, telling them to come up with contingency plans as the profitability picture worsens. The management teams of these 14 shops will be sitting down with Ginnie officials in early January to discuss the matter further. Ginnie also issued an all-participants memo, dictating new standards for firms seeking to become issuers, including the stipulation that applicants submit to a corporate credit evaluation similar to what the rating agencies put them through.” The industry currently has capacity to do at least $2 trillion in new mortgages annually, but volumes in 2018 will be closer to $1.4 trillion and declining – and with little profitability. We easily could see a 10% reduction in the number of non-bank mortgage firms this year and a larger downward headcount adjustment in 2019, a grim figure that suggests thousands of job losses in the world of residential mortgage finance. Step two in the Merry-go-Round of non-bank risk will be credit. The real fun is some two to three years out. This is when years of low-interest rate lending starts to mature and throw off supra-normal loss rates. We suspect that some of the REITs and Buy Side shops that have been hungrily acquiring MSRs at single digit returns may become sellers when the true cost of credit is revealed. As Mike Lau told us a few weeks back in The Institutional Risk Analyst (" The Interview: Michael Lau on the State of Mortgage Finance " ) , MSRs are a mid-single digit internal rate of return asset (IRR) through the credit cycle and w/o leverage. Just as credit spreads have galloped 20% in the past 30 days, we suspect that indicators such as LGDs and loan default rates for bank owned loans will also start to move pretty quickly as and when movement occurs. Whether or not home prices start to soften as quickly as credit turns across the US is really the big question. If we see loss rates for residential and commercial assets start to rise in a sustained way, then we’ll know that overheated home prices are headed for a correction. Watch those LGDs over the next year. We’ll be addressing this point in the next edition of The IRA Bank Book . Further Reading Goldman Chairman Met Privately With Fugitive Accused in Malaysian Fraud The New York Times By Emily Flitter, Matthew Goldstein and Kate Kelly A Cautionary Tale from the '80s for Today's Loan Participations American Banker By R.C. Whalen #GNMA #MSR #MichaelBright #loanparticipation

New York | Last week in The Institutional Risk Analyst we mentioned the transition from that carefully managed reality, that “new abnormal” of the past decade, to something very unfamiliar to most investors. Over the past two months, wildfires have swept over numerous industry sectors, leaving a lot of previously expected investment returns in ashes. The real human tragedy in CA will certainly hurt economic growth, but the carnage on Wall Street also is immense and growing. Financials have taken a hit over the past 12 months, even as the benchmark S&P 500 has managed to stay positive single digits. Exemplars among financials like US Bancorp (USB) have actually stayed even with the S&P at plus single digits, but the KBW Bank ETF is basically flat for the year. In the latest edition of The IRA Top Ten Banks , we talk about why USB is the best performing money center bank in the US. And we also tell you who we believe is the weakest CEO among the top ten US depository institutions. Most of the market’s attention currently is focused on two related risk hot spots: Asia and Technology. In the case of the former the great deflation in China is gathering speed thanks to Beijing's spending and President Donald Trump’s asymmetrical trade war. As illustrated by the massive liquidation of HNA , the implosion of Uncle Xi’s paper tiger continues apace. When we say “paper” of course we are not only referring to mystical papier-mâché creatures that can be used in parades, but rather our suspicion that China’s mountain of bad debt may be imploding under its own weight. When global investor Kyle Bass says China needs a reset, he knows not how right he is this time around. Savings obsessed Japan is very different from crazy rich China under the early years of Xi Jinping. The use of leverage in China over the past decade dwarfs even American levels of fiscal profligacy. China’s banking system, for example, is twice the size of the US if you believe the statistics. “It’s insane how levered this market has become,” Bass told Reuters . “You’re starting to see bankruptcies across the board in China that are hard to hide, if you look at the corporate default rate, the bankruptcy rate, M1 and M2 (money supply), the slowest money growth in over four decades.” When you combine decades of economic mismanagement with the natural tendency of members of the Chinese Communist Party (CCP) to steal everything in sight, the obvious conclusion in that there is no equity underlying China’s economy or financial markets. Add the random factor of President Trump and the CCP is left in disarray. The “Belt and Road” initiative is alienating many important overseas relationships for China and leaves behind a huge cost in terms of bad debt, but economics is not the point. As one close observer of China joked during dinner in New York: “Think of Chinese infrastructure spending as a giant pension plan. It is literally a way to occupy people and get them out of the cities or even out of the country entirely. Profit is secondary.” Goldman Sachs: Chasing Growth Much of the risk coming out of Asia has to do not just with economic slowdown but also plain vanilla fraud. Consider the 1 Malaysia Development Berhad (1MDB) scandal involving Goldman Sachs (GS), which has seen its common shares drop double digits for the year and now trades comfortably below book value. Vampyroteuthis infernalis The 1MDB scandal features Malaysia's former Prime Minister Najib Razak and "financier” Jho Low and is Exhibit A for the Age of Credulity scrapbook. As with highly leveraged conglomerate HNA, nobody had any idea as to the origins of Low or where the money came from or was going. Somehow GS raised another $6 billion from investors to support this apparent act of fraud against the Malaysian state. We can’t help but wonder if GS, the organization famously dubbed the “vampire squid” by Rolling Stone’s Matt Taibbi, knew about the assistance one of its partners gave to Mr. Low, contrary to what former Goldman Sachs CEO Lloyd Blankfein suggests. Or maybe they did not want to know. And here's our question: Did Blankfein step down as Goldman CEO in anticipation of the 1MDB blow-back? Like Citigroup (C), which suffers periodic breakdowns in its internal controls related to the offshore venues where it does business, Goldman is also known for regular operational risk events. And chasing growth in Asia, to paraphrase Blankfein, is an ideal way to get into big trouble. That noise factor, the near certainty that both Citi and Goldman will trip up when it comes to operational risk events such as fraud and money laundering, seems to keep these names trading at a discount to less exciting peers like USB. We could tell you a story about John Reed, Citibank Private Banking and Raul Salinas de Gortari in Mexico, but we digress. Ben Walsh at Barron’s writes: “[T]he bank has warned that the investigation could result “in the imposition of significant fines, penalties, and other sanctions. Whether or not Goldman is penalized, the 1MDB scandal is a huge setback to its campaign to repair its public image after the financial crisis.” Agreed. But we wonder, regarding Q4 earnings, whether GS will be forced to take a reserve for the cost of cleaning up this mess, including the return of $600 million in ill-gotten investment banking fees? To us the bigger question is whether the new CEO David Solomon, who headed the GS investment bank, will survive the 1MDB scandal. No matter how you cut it, the answer to the key question to Goldman Sachs of why didn’t you know about the relationship between Goldman Asia banking head Tim Leissner and Jho Low is unsatisfactory. Whether the answer is (1) a breakdown in systems and controls or (2) a failure to supervise, Solomon must ultimately shoulder the blame for failure to supervise one of his key managers and direct reports. Goldman Chairman Blankfein says that Goldman investment bankers “evaded our safeguards, and lied—stuff like that’s going to happen.” Really? Bank holding companies and broker dealers subject to Fed and FINRA supervision, respectively, are supposed to have systems and controls in place that prevent employees from evading safeguards. Blankfein telling us “that’s going to happen” is an absurd response. The risk facing Goldman is very similar to the situation at Wells Fargo & Co (WFC), where the board of directors failed to take action for more than a year in the face of clear acts of fraud. Given that Solomon was the manager of Tim Leissner, it seems difficult to envision a pathway for the GS board that does not involve Solomon stepping down. At the very least, the SEC, Fed and other regulators will need to extract a pound of flesh from Goldman Sachs a la Wells Fargo to atone for what seems like a truly ugly example of management failure. Spreads Widen, Deals Slow Meanwhile in the world of emerging technology and high yield debt, the great deflation being led by the Federal Open Market Committee is starting to show a modest upward impact on credit spreads. Some names are doing better than others. Deal flow is starting to suffer as a result. Members of the financial punditry will fashion endlessly ingenious explanations for why tech stocks are cheap – and getting cheaper -- yet the simple fact is that rising rates will sink many speculative stories in the debt and equity markets. For example, even with all the "good" news of the past several weeks, Tesla Motors (TSLA) 5.3s of 2025 trade + 475 bp to the 10-year Treasury bond. This puts TSLA on the wrong side of “B” in terms of ratings breakpoints even after a remarkable rebound for the stock since October 8th when it was down 20% for the year. Of note, the FOMC seems perfectly content to crater the market for leveraged loans and collateralized loan obligations or “CLOs,” an acronym you unfortunately want to remember. A key indicator of rising investor caution, namely credit spreads, are starting to widen, as shown in the chart from FRED below. From a low of 316 bp back in early October, the ICE BAML high yield index has widened more than 20% to 400 bp over the Treasury yield curve. That is a very rapid change. As and when this indicator gets to 450 bp or higher, that is a danger signal for both market contagion and economic recession. Deal flow stops when spreads widen too much too fast. When high yield debt spreads get near 500 bp over the Treasury curve, financing activity for speculative firms essentially stops and related bank lending will follow that example. Of all of the time series and indicators that the FOMC can watch, high yield and corporate credit spreads are the most relevant. Rising high yield spreads will accelerate the reckoning in leveraged loans and CLOs. The temporary redemption of Elon Musk’s little science project at TSLA, however, cannot reverse the overall market gloom due to the fall of Facebook (FB) one of the big tech beneficiaries of the irrational easing of the FOMC. Going back to 2012, FB is still up more that 330% vs last week’s close – this at a time when the economy was barely growing. But over the past quarter, the stock has moved sharply lower, from up 20% in the first week in July to down a like amount last week. Idiosyncratic Risks The negative factor weighing down GS, FB and TSLA, however, is idiosyncratic risk coming from the CSUITE. In the case of FB and TSLA, these two publicly owned organizations have founder risk. Both have reached the point in their development where a transition to a more stable and competent management team could benefit shareholders. But an exit by either Musk or Zuckerberg could crater each stock. Goldman Sachs, on the other hand, may be in serious jeopardy because of its big dependence upon risky investment banking revenue. GS is a compliance violation disguised as a going concern. Bankers always evade. Or as Richie Metrick, COO of the investment bank at Bear, Stearns & Co was famously known to say about bankers: “If their lips are moving, they’re lying.” JP Morgan & Co (JPM) was known a century ago as “The Octopus.” Goldman Sachs is merely a squid. That is, fish bait. JPM has trillions of dollars in core deposits, while Goldman has yet to bank the first $100 billion in stable cash funding. GS is too small to be credible as a commercial bank and ranks just behind the largest universal bank, JPM, in the overall global league tables for deals. In the world of deals, GS is pursued by Barclays, Merrill Lynch, Morgan Stanley (MS) and Credit Suisse (CS), among others. But in the next few weeks and months, Goldman’s fate may rest on how it extricates itself from the 1MDB mess, a when not if proposition that we think could be visible in Q4 earning for GS. The eventual cost of salvation may include disgorgement of the $600 million in fees, appropriate fines and penalties, and perhaps the departure of both Blankfein and Solomon. But atonement in the world of investment banking is, as the Economist wrote in 2002 about the WorldCom scandal, “a worrying process whose end still seems a long way off.” #GoldmanSachs #VampireSquid

Washington | Last week in response to popular demand we published our first Top Ten List for the largest US lenders . We noted that credit performance for the top institutions is pristine, but we also noted that spreads on loans and securities remain extremely tight, discouraging lenders in high-cost markets in such sectors as residential mortgages and even multifamily lending. This seems to be the paradox of the post 2008 markets: credit underwriting standards are better, but the profitability of originating assets is minimal and cash flow coverage is stretched, suggesting serious problems ahead that will cause loan and bond default rates to rise. The present situation in the financial markets reminds us of our favorite quotation from “A Tale of Two Cities": This week we got to hear FDIC Chairman Jelena McWilliams talk about current market conditions at a bank conference sponsored by Kroll Bond Rating Agency. Taking a page from “A Tale of Two Cities,” McWilliams said it is “the best of times” but noted that regulators need to work with banks to make the cost of compliance balance with the size and resources of the bank. Chairman McWilliams then made a comment on credit conditions that could easily be applied to the equity markets as well: “There has not yet been a single bank failure this year but as you all know that is not normal. We are in abnormally good times. Usually we have three or four bank failures per year. That happens and it is a normal part of the business cycle. We have been in what I like to call the best of times this year. This is the new abnormal. At some point we will get back to normal.” What is most striking about Chairman McWilliam’s comments is that they could apply to many sectors of the debt and also equity markets. The premium pricing seen for many assets and, as one reader put it so well, the “velocity of collateral” moving through the financial system, makes us wonder if the target for the next crisis has moved from asset quality to the operating and market stress caused by excessive competition on price. The impact of an abnormal market on many normal businesses is profoundly negative. We note from the banking channel that while there may not have been any bank failures this year, there are certainly a lot of smaller banks for sale at the present time because these businesses simply do not make money. The rising cost of regulation and compliance has likewise raised the bar in terms of the minimum size of a bank that can be economically viable. To give you some idea of the scale of cost increases for the industry, the direct cost of servicing a performing mortgage loan in the US is about 15 basis points (bp), according to The Mortgage Bankers Association, or half of the income from the gross servicing strip. A decade ago the cost to service a performing residential mortgage was closer to 5 bp. With rising operating costs and horrible execution on the loan origination and secondary market sale, many banks have decided to flee residential lending. Meanwhile in the market for multifamily and commercial construction and finance, there are growing signs of stress due to years of abnormal markets c/o the Federal Open Market Committee (“FOMC”). We heard Eric Thompson, Senior Managing Director of the Real Estate group at KBRA, remark at the same conference that “interest only” mortgages are now all the rage in the market for commercial mortgage backed securities or CMBS. In the brave new world of Dodd-Frank, lower loan to value (“LTV”) ratios are supposed to protect lenders and investors from shoddy underwriting, right? But nature finds a way. A case in point regarding the new abnormal is New York City multifamily. Andrew Dansker, a first vice president of finance at Marcus & Millichap, writes in The Commercial Observer about the combination of historically low capitalization or “cap” rates and low interest rates: “Because of these underwriting constraints, and the low loan-to-value ratios that they imply for low capitalization rate deals, almost every acquisition made in New York City in the past five to 10 years has a loan which was underwritten to a maximum size based on the ratio of available cash flow to the cost of the debt. The low leverage points make these deals appear to be conservative, but they are actually very aggressive on current cash-flow underwriting standards.” The moral of the story is that asset prices are high, abnormally so, but so is the cost of acquisition and construction. As interest rates rise, deals that seemed “normal” three or four years ago based upon cash flow coverage of debt may no longer work at higher interest rates. And the same logic that suggests that there is trouble brewing in the commercial real estate sector also applies to leveraged loans and collateralized loan obligations or “CLOs.” One of the most interesting and frightening aspects of the great normalization is the way in which the earlier machinations of the FOMC, which were supposed to help the economy, have now become a gale force headwind in terms of both liquidity and credit. Rising interest rates, for example, are pushing many obligors over their debt covenants with lenders. Meanwhile, regulators are downgrading these cash flow stressed exposures, making lenders far less inclined to roll the credit. And tenants are pushing back on sky high rents, further hurting the cash flow and ultimate viability of new projects. The collective effect is a reduction in liquidity that will result in higher defaults in commercial real estate. As the market for luxury multifamily properties in New York and other major metros around the US rolls over, look for sponsors to seek renegotiated terms on loans, a dangerous strategy that can get the credit flagged by auditors and regulators. But a more likely outcome is that lenders will refuse to renew these credits, notes Dansker, “forcing the issue into the arms of borrowers.” He concludes: “Whatever course of action is chosen, it seems we are poised to see a rise in transaction volume in the coming year. Investors should be ready to transact either with banks or with owners opting to sell instead of recapitalizing their holdings.” #FDIC #KBRA #JelenaMcWilliams #CMBS