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Teton Springs | In this issue of The Institutional Risk Analyst , we take a prospective look at Q2 2107 earnings for the large cap banks in the financial services sector. By way of disclosure, we don’t own any banks. Our direct exposure to financials is in fintech and in just two names – Square (NYSE:SQ) and PayPal (NASDAQ:PYPL). More on these names in a future issue of The IRA. The larger US banks experienced a mini bull rush following the most recent stress tests conducted by the Fed and other prudential regulators. The good news is that the banks have too much capital. The bad news is that, well, the largest banks have too little business to support revenue and earnings, leading to the obvious conclusion that share buybacks must go up. First, looking at the best valued of the large banks, let’s consider US Bancorp (NYSE:USB). With an “A+” bank stress index rating from Total Bank Solutions, USB is among the lowest risk large banks in the US. Trading at over 2x book value, the shares of the $440 billion total asset USB are up 2x the S&P 500 over the past year. Needless to say, with a beta of 0.93, this is one large bank stock most hedge funds don’t dare sell short. The Street estimates that USB’s revenue will be up 5% for the full year and earnings up 7% in 2017. Because USB does not depend upon Wall Street investment banking and derivatives activities to make its earnings number, this bank has among the most dependable financial performance of the top five commercial banks by assets. Next we move to Wells Fargo (NYSE:WFC), which like USB is primarily a lender with relatively little (but growing) exposure to Wall Street. Like USB, the $1.7 trillion asset WFC has an “A+” bank stress index rating from Total Bank Solutions. WFC’s equity currently trades a 1.5x book value reflecting the 12% return on equity, but WFC has just a 1% risk-adjusted return on capital (RAROC). The stock has a beta of 1.0, which means that its volatility matches that of the broad market. The Street has WFC growing revenue at less than 3% for 2017 and earnings up almost 4% for the same period, suggesting that cost-cutting and capital returns will be supporting investor expectations. We tend to discount these projections, however, because of WFC’s huge role in the residential mortgage finance sector. As we never tire of reminding our readers, the US housing finance sector is running about 30% below last year’s levels in terms of mortgage loan origination volumes. This sharp drop in new loan volumes is translating into an equal drop in issuance of agency mortgage securities. The result is a vicious scramble for collateral that is driving down profitability in the 1-4 family mortgage sector. Our sources in the mortgage channel say that WFC and JPMorganChase (NYSE:JPM) have been bidding up the price of whole loans in the secondary market in order to fill the shrinking mortgage securitization pipeline. The aggressive bid from WFC and other aggregators is killing margins for everyone in the secondary market. This makes us wonder if the resi sector won’t be the cause of an earnings miss for WFC and other large banks in Q2. Coming off a record low loan origination spread of 8bp in Q1 2017, the mortgage industry faces another difficult quarter. The ten-year average spread compiled by the Mortgage Bankers Association is 51bp, thus the continued drop in profitability has ominous implications for smaller mortgage firms that purchase production from third parties. If you’re a seller of loans, on the other hand, life is pretty good. Big lending and mortgage servicers such as WFC are desperate to buy collateral from third party originators, both to prop up agency securitization volumes and also to forestall eventual shrinkage in the servicing foot print. Also of note, Fred Small at CompassPoint reckons that this quarter banks and non-banks alike could be facing a 5% downward adjustment in the value of our favorite asset, mortgage servicing rights (MSRs). Moving right along to the next most valued mega bank, we turn to JPM. Trading at 1.4x book, JPM is fully valued to put it mildly. With lower asset and equity returns than WFC, to see the House of Morgan trading at these levels suggests to us a good bit of downside risk for the shares – regardless of how many managers want to own the stock. JPM has a beta of 1.2, indicating that the equity market valuation is more volatile than the broad market or asset peers such as WFC. While USB and WFC are predominantly lenders, JPM relies on lending for only about a third of its business. Trading, derivatives and asset management fill out the rest of the bank’s business model footprint – and contribute to earnings volatility. This results in a 0% RAROC for all of the JPM businesses combined vs the nominal 10% equity returns. JPM has an “A” bank stress index rating from Total Bank Solutions. We fully expect that JPM CEO Jamie Dimon will hit the admittedly low bar set by the Street’s estimates of 2.5% revenue growth for 2017 and 7% earnings expansion, mostly due to further cost cutting. Yet these earnings and revenue figures don’t really support the current equity market valuation for JPM – especially compared with more conservative names such as WFC or USB. Look at the Y-9 performance report for JPM and notice that the bank is consistently in the middle of the large bank peer group compared to WFC and USB which tend to be in the top quartile. Moving from the sublime to the ridiculous, we come to Bank of America (NYSE:BAC), a stock that is up 81% over the past year on the draconian cost cutting by management. And yet even with this amazing upward move, BAC currently trades at just 1x book value -- albeit with a beta of 1.6 or 60% more volatile than WFC or USB. Even though the Street has BAC growing revenue about 4.5% in 2017 and 2018, and earnings up a whopping 18% this year and 21% in 2018, the stock still does not impress managers enough to earn a premium to book. Perhaps this is because the bank’s earning rebound started from such a low base. BAC currently has an “A+” bank stress index rating from Total Bank Solutions and, like WFC, derives more than half of revenue and income from traditional banking. The presence of Merrill Lynch in the mix is neutral factor for the organization from a risk perspective, but BAC as a whole does not compare that well to its large bank peers looking at the Y-9 performance report published by federal regulators. Finally we come to the least valued US large bank, Citigroup (NYSE:C), which currently trades at 0.80x book on a beta of 1.6. C has an “A” bank stress index rating from Total Bank Solutions. Like JPM, C’s business model puts equal emphasis on lending, trading and investing activities, resulting in a lower RAROC at 1% vs a nominal equity return of a bit shy of 7%. Keep in mind that C has lower asset returns and higher credit costs than other large banks, begging the question as to whether the Fed should really be allowing the bank to increase payouts to equity investors. If you look at Page 3 of C’s Y-9 performance report , you’ll see that C’s yield on loans is 2% higher than the large bank peer group, yet the bank has a spread on earning assets half a point lower than other large banks. The Street has C’s revenue down in Q2 2017 but magically up 1.5% for the full year. Earnings are also expected to be down this quarter, but then will rise an astounding 9.5% for the full year. Despite the market bump following the release of the stress test results, which will result in returning more capital to investors than C actually earns in profits, like BAC the C common still trades at a discount to book. Unlike names like JPM, C does not have a significant asset management business and also announced an exit from residential mortgage origination and servicing earlier this year. This may turn out to be a blessing in disguise. C is up 58% over the past twelve months vs 13% for the S&P 500, so like JPM we’d say that the risk is on the downside for this much maligned stock. Will C hit its revenue and earnings numbers for Q2 2017? Probably, especially now that they’ve jettisoned the mortgage business. But the larger question is why does C still exist? In the wake of the 2008 financial crisis, C has been struggling to redefine itself in a way that makes sense to investors. But having sold the asset management business to Morgan Stanley (NYSE:MS) and the mortgage business to New Residential (NYSE:NRZ) and Cenlar FSB, there is not much left besides the consumer lending book and the payments business. As we’ve noted in previous comments, C’s board ought to consider selling the payments business for a premium price, spin the proceeds to shareholders, then dispose of the other assets for whatever they can get before turning off the lights. Bottom line is that earnings for the largest banks are likely to be a relatively disappointing exercise given the poor visibility on both earnings and revenue growth. Managers clearly want to own these large cap financials, but a combination of a slowing economy and the Fed’s manipulation of the credit markets is making sustained top line growth elusive. Longer term, the issue that investors must grapple with in 2017 and beyond is quantifying how much hidden credit risk is embedded in the portfolio of all US banks as a result of the Fed’s aggressive manipulation of the credit markets over the past five years. Corporate credit spreads remain extremely tight. Lurking beneath the currently benign credit metrics, however, lies significant potential losses for both banks and bond investors as an when we revert to the mean.

“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 July 2007 New York | Watching new era car company Tesla (NASDAQ:TSLA) getting knocked down a couple of notches last week, it occurred to us that the Fed’s program of quantitative easing or "QE" amounts to a leveraged buyout (LBO) of the US equity markets. How else can we explain TSLA, a firm whose financial performance is measured by free cash outflow , being more valuable than far larger car companies that actually earn profits? Think of it: TSLA is an LBO without any cash flow. Of course, the global equity markets are all about discounting future earnings or, in the case of TSLA, the next capital raise. With $7 billion in debt and a voracious appetite for other peoples’ money, TSLA embodies the new era notion that it is acceptable for companies to loose money until they grow large enough to be profitable -- maybe. The archetype for this style of corporate management is of course Amazon (NASDAQ:AMZN), a firm that is happily consuming whole industries as it grows into a global horizontal and vertical monopoly – and all of this without so much as a peep from the Antitrust Division at the Department of Justice . These and other questions will be considered later this week when The IRA participates in the Rocky Mountain Economic Summit in Victor, ID, just over the Teton pass from Jackson Hole. Sponsored by the Bronze Buffalo Foundation, The Hero Club and the Global Interdependence Center , the Rocky Mountain Economic Summit features speakers from all over the world considering the financial outlook from the stunning perspective of the Grand Tetons. Our discussion on Thursday in Teton Springs will focus on the financial outlook for 2017 and beyond. Given the fact that the 10-year Treasury bond has risen in yield nearly 20bp in the past week, the first order of business would seem to be the direction of interest rates. But maybe not. We should heed warnings from no less than Ray Dalio that the central banker party is over, but this does not necessarily mean that the bond markets are the first concern. Our basic view remains that this latest uptick in yields for US government debt is a pause amidst a continuing deflationary scenario. The manager of the world's largest hedge fund, Dalio says he is going to "keep dancing" with the markets even though central banks are reversing their easy money policies. Where is former Citigroup (NYSE:C) CEO Chuck Prince when we need him? Reading the pronouncements coming from the latest FOMC minutes, it looks to us like the Fed’s portfolio will not be reduced down to the $1.7 trillion target until 2024. Our friend Bob Eisenbeis, formerly director of research at the Atlanta Federal Reserve Bank now chief economist at Cumberland Advisors, notes that this fact will keep Fed policy relatively easy for the next five years. And the minutes contain no hint that the Fed regrets QE or any of its other policy moves since 2008. At present, the fact of the FOMC’s massive bond position is holding interest rates down. Ask not how long it will take for the 10-year to hit 3%, but rather the number of trading days it will take for the secular forces of deflation and growing global debt to push Treasury yields back down again towards 2% yield. Thus our fascination with Italian banks. Despite the protestations of Fed Chair Janet Yellen regarding the complexity of monetary policy, it is quite easy to borrow billions when the central bank is playing “what if” with the global financial markets. Unlike the 1930s when Irving Fisher worried about debt deflation, this time around the secular demand for investments (aka “duration”) looks to be driving yields down even as the likes of TSLA drown on debt that, today at least, clearly does not seem money good. Our friend Charley Grant gives you the basic facts in a Wall Street Journal analysis: “Yet Tesla needs to raise several billion dollars to meet its goals. Assuming a $1 billion cash balance and four quarters of similarly negative cash flow, Tesla would need to raise nearly $3 billion over the next year. At current prices, that amounts to roughly 6% of the total equity value. The more the shares slip, the greater the potential dilution of existing owners.” Dilution indeed. Examples like TSLA aside, the basic problem we have with the rising rate scenario narrative that emerged last week is that corporate credit spreads remain extremely tight. All during the Trump Bump, let’s recall, as the 10-Year Treasury popped up to a whole 2.6% yield, corporate bond and swap spreads generally tightened . The Fed-induced shortage of investment paper, combined with a shrinking market for equity offerings and a $300 billion drop in agency securities issuance in the mortgage market, are all combining to keep yield spreads tight as suggested by the chart from Fred below. Given the gyrations of the bond market, US mortgage origination volumes likely will barely reach $1.6 trillion in new issuance this year vs $2 trillion in 2016. When we start to see high yield corporate bond spreads as described by the good folks at the St Louis Federal Reserve Bank edging up towards 6%, then we’ll start to give credence to the rising rate trade. Over the past three years, how many investment managers have been annihilated betting on rising interest rates and widening bond spreads? Too many to count. But to us the more relevant concern for Yellen & Co is the equity markets and its recent correlation with bonds, an unnatural circumstance that seems about ready to end. Looking at spreads in terms of the Treasury market, the impact of the FOMC’s baby steps toward normalization is illustrated by the 10-year Treasury bond vs the 2-year T-note. Does this look like a market that is just dying to move higher in terms of yield? Compare the magnitude of last week’s modest move in the 10-year to the massive Trump Bump following the November 2016 election. Our best guess is that the next major leg in the 10-year Treasury bond will be down in yield and up in price until we test the 2% threshold. Corporate debt issuance tracked by SIFMA is $100 billion ahead of last year’s levels through May at $884 billion and, more important, roughly a quarter of this amount was used to fund share buybacks by public companies. Significantly, share repurchases for the S&P 500 in Q1 2017 were $133 billion, just 1.6% less than Q4 2016 and 17.5% less than Q1 2016. Source: SIFMA/S&P The debt issuance numbers from SIFMA and share repurchase figures from S&P dwarf the level of new equity offerings at just $57 billion in Q1 2017, but it is important to note that stock buybacks also peaked in 2016. Of note, Ed Yardeni’s latest report on the subject of stock buy backs is must reading. “The result of the buybacks is that net equity issuance has been negative for the last several years and bears a striking resemblance to the period leading up to the 2008 financial crisis,” David Ader wrote presciently in Barron’s last year. In this regard, consider the coincidence of the surge in corporate debt issuance in Q1 2017 and the performance of US stocks. In the chart above, note the way that total MBS issuance has cratered since Q4 2016 thanks to the election of President Trump. Sadly, even a 10-year Treasury yield well below 2% will not revive the flagging fortunes of the US mortgage finance sector with an uptick in refinancing volumes. So our message to the folks in Jackson Hole this week is that the end of the Fed’s reckless experiment in social engineering via QE and near-zero interest rates will end in tears. “Momentum” stocks like TSLA, to paraphrase our friend Dani Hughes on CNBC last week, will adjust and the mother of all rotations into bonds and defensive stocks will ensue. We must wonder aloud if Chair Yellen and her colleagues on the FOMC fully understand what they have done to the US equity markets. The notion that five years of market manipulation by the FOMC (and other central banks, to be fair) can end happily seems rather childish, especially when you consider that the other great accomplishment by the Fed during this period is a massive increase in public and private debt. Once the hopeful souls who’ve driven bellwethers such as TSLA and AMZN into the stratosphere realize that the debt driven game of stock repurchases really is over, then we’ll see a panic rotation back into fixed income and defensive stocks. The period from QE 1 in 2012 represents one of the most reckless episodes in the history of the US central bank, a period where the FOMC essentially encouraged a partial LBO of the US equity markets. The key question for the FOMC and investors seems to be this: How much new equity issuance can the markets support if public companies eventually need to reduce debt and rotate out of the LBO trade constructed by Yellen & Co? Corporate credit spreads are the key indicator to watch, both in terms of the economy and the financial markets. It’s a game of financial musical chairs. Ray Dalio, Janet Yellen and all of us are dancing. When does the music stop?

New York | News last week that European Central Bank chief Mario Draghi was considering an end to the ECB’s extraordinary purchases of securities quickly let some air out of the Great Rotation into EU stocks. Sure the euro surged against a weakening dollar, but Europe’s mountain of bad debt remains unresolved -- even after the election of Emmanuel Macron to the French presidency. Yet hope springs eternal in some quarters after Draghi’s claim of a successful “reflation.” “All the signs now point to a strengthening and broadening recovery in the euro area,” Draghi told the ECB’s annual conference. “Deflationary forces have been replaced by reflationary ones,” the former head of the Bank of Italy declared. Draghi’s bull call on inflation provides optimism for relief on excessive levels of bad debt, albeit in a context where the EU’s rules on resolving dead banks remain entirely subjective. The July 4 approval of the latest state-supported rescue for Banca Monte dei Paschi di Siena (Montepaschi) illustrates the deflationary challenges still facing Europe. As part of the overhaul, Reuters reports, Montepaschi “will transfer 26.1 billion euros to a privately funded special vehicle on market terms, with the operation partially funded by Italian bank rescue fund Atlante II.” The bank will receive 5 billion euros in new public equity funds for its third bailout in a decade. Two weeks before the EU decision on rescuing Montepaschi, the Italian government supported the sale of two profoundly insolvent Italian banks. The assets of Popolare di Vicenza and Veneto Banca were sold to Intesa SanPaolo Group at an estimated cost to the government of 10 billion euros, marking Italy’s latest breech of the EU’s rules on state support for failing financial institutions. Like Montepaschi, where retail investors were heavily subsidized, the Intesa SanPaolo transaction avoids imposing losses on senior debt and depositors, but wipes out the equity and junior debt. This outcome reflects political as well as financial constraints in Italy, but shows how far there is to go in the process of resolving bad banks in Europe. Of note, Italy is being given control over the remaining “bad bank” to wind down as the assets and deposits are conveyed to Intesa SanPaolo. This permits a bailout of senior unsecured creditors. So Italy gets what it wants – continued circumvention of EU bailout rules. If a bank disappears, notes a well-placed EU observer, “state aid rules do not apply." Compare the sale of these two insolvent Italian banks with the resolution in early June of Banco Popular Espanol, which became the first EU bank to be resolved by the EU’s Single Resolution Board (SRB). Banco Popular had a third of total assets in bad loans and real estate owned, double the 15% average for all banks in Spain. (In the US, by comparison, non-performing loans plus real estate owned equaled less than 1% of total assets for all banks at the end of Q1 2017.) “The resolution of Banco Popular, under which it was acquired by Banco Santander S.A., is consistent with the EU’s Bank Resolution and Recovery Directive (BRRD),” Moody’s notes, “which restricts the use of public funds to rescue failing banks. The route followed by the EU authorities in the case of Banco Popular contrasts with the approach taken elsewhere to other ailing banks, notably in the case of the troubled Italian lender Banca Monte dei Paschi di Siena S.p.A.” The state bailout of Montepaschi, like the sale of the two smaller banks to Intesa SanPaolo, reflects political realities in Italy. “Montepaschi’s liability structure includes large volumes of bonds purchased by retail investors before the [Bank Resolution and Recovery Directive] introduction,” Moody’s continues. “Retail investors also accounted for around 40% of Banco Popular’s share capital and also held an undisclosed share of the bank’s Tier 2 instruments.” Well-advised institutional investors fled Italian banks years ago, partly because they could not trust official disclosure. So the Rome government countenanced the sale of “deposits” to retail investors by Montepaschi and other Italian zombie banks. The process of selling the deposits and good assets of the two Italian zombie banks to Intesa SanPaolo, while retaining the toxic waste in a “bad bank”, represents the true cost of this latest example of moral hazard in Europe. Draghi deserves considerable credit for the worsening situation at Montepaschi, starting with his tenure at the Bank of Italy. When the bank merged with Antonveneta, a troubled bank it bought from Spain’s Santander, Montepaschi’s troubles accelerated. Italy's third-biggest lender, received a 4 billion euro state bailout in 2012. The negative political consequences for the current government in Rome of the latest Montepaschi bailout are still unfolding, but Draghi and his fellow technocrats are the true authors of this mess. More, EU banks still face levels of bad debts that not only indicate insolvency, but under the EU’s often ignored fiscal rules, suggest a haircut for senior debt and depositors without state aid. As with the EU today, American officials in the late 1970s and 1980s bent the rules regarding bank disclosure to enable most of the larger, internationally active US banks to avoid a painful debt restructuring. The Latin debt crisis, trouble in the oil patch, and the S&L debacle pushed some of America’s largest banks to the edge of bankruptcy, starting a process of deregulation that is still little understood by investors and analysts. The Federal Reserve Board under Chairman Paul Volcker and other regulators allowed large banks to engage in off-balance sheet financial transactions that concealed tens of billions in loan exposures. This loosening of prudential standards regarding the treatment of off-balance sheet securities deals eventually led to the 2008 financial collapse. Three decades later, when concealed structured investment vehicles came back to issuers like Citigroup (NYSE:C), the results were disastrous. Today, officials in Europe led by ECB chief Mario Draghi are playing a similar game, pretending that bad public and private debt on the books of EU banks and investment houses, and held by individuals, is somehow money good. As with the US in the 1980s, the stark reality inside the EU banking system is being concealed under a heavy dose of technocratic obfuscation. Mountains of public debt in Europe also indicate proponents of the bullish EU equity trade may be a tad exuberant. Europe just dodged a bullet in Greece, where a last-minute deal with the International Monetary Fund allowed the member nations to kick the can down the road until next year. With debt at 200% of GDP, Greece is crippled economically and requires debt reduction in order to attract new investment. Over the past few months, investors have driven yields on Greek debt to the lowest level in years. To that point, investor optimism on the EU is predicated on an eventual debt bailout for Greece. Yet investors won't see any details on a long awaited Greek debt restructuring plan before the German elections later this year. The EU trade, as it were, depends an awful lot on what happens to Angela Merkel’s coalition this September. Economic reality is slowly leading the EU down the road to the assumption of bad debt of weaker states by the stronger members of the federation led by Germany. EU economic commissioner Pierre Moscovici has called for “debt reduction” in Greece, a proposal that is met with a lukewarm response by Germans. But will Merkel ultimately go along? "In the long run, in a completely integrated euro zone, we would talk about a ‘communitization’ of new debt, but we're not going to start with that," Moscovici told reporters last week. The necessary condition for the bull case on the EU is that the Germans must eventually embrace a federated structure for Europe, this as part of a gradual approach being advanced by leaders such as Macron in France and Moscovici in Brussels. Joint and several responsibility for all EU debts is the cost of unity. Such a scenario faces significant political and practical obstacles, most notably in Germany but also in France, where Macron must somehow convince his citizens to embrace German style economic behavior. A gradualist plan for a European federation seems unworkable so long as member states are able to borrow against Europe’s collective credit without toeing the line on fiscal reforms – as in the case of Italy and its troubled banks. “The euro crisis resulted from the fallacy that a monetary union would evolve into a political union,” writes Yanis Varoufakis, a former finance minister of Greece. “Today, a new gradualist fallacy threatens Europe: the belief that a federation-lite will evolve into a viable democratic federation.”

Grand Lake Stream | The IRA is writing today from Camp Kotok, which is held each year at Leen’s Lodge in Grand Lake Stream, Maine. We are in Washington County, which is on the border of New Brunswick, Canada, and about 200 miles north of Bangor up Rt 9. This is Down East Maine, the land of Thoreau with rolling hills and lots of beautiful rivers and lakes. The conversation this year is much the same as the narrative on Wall Street, focused on the new records for asset values and questions about what happens next with the Fed and the markets. Each day, analysts ask whether the markets can continue to climb the wall of worry to every higher (and more incredible) valuations. But at Leen’s we are concerned about more weighty matters. This week brought the latest results of the Fed’s annual stress test circus, a strange coming together of financial media and regulators in a celebration of disinformation. The stress tests don’t test the ability of banks to withstand losses, but rather the skill of bank managers at responding to the inane procedures set forth by the central bank. The real risk in banks is not what you can read in published financials or Fed stress tests, but the unknown. They key indicator of a bank’s ability to absorb loss is not capital, but income. During the 2008 financial crisis, the US banking industry diverted tens of billion of dollars from income to provisions for future losses. After a couple of years, the crisis was contained and banks regained profitability. In those cases where capital (or more specifically, confidence) was in doubt, such as Citigroup (NYSE:C) and Wachovia, the institutions failed. The Street cares about stress tests because it is believed that good results will allow banks such as Citi to return more capital to investors. The fact that the Fed’s manipulation of credit markets and spreads via QE makes higher future credit losses likely for banks is not even mentioned. Indeed, the fact that stress tests don’t explicitly include the negative impact of monetary policy on bank loan portfolios makes a mockery of “macro-prudential” policy. We should always remember that the bank stress tests were not meant to measure capital or loss absorption capacity, but rather to restore confidence. Investor confidence is a function not of capital, but of the degree to which investors believe that they understand risk. In 2008, markets disintegrated because trust was broken by acts of financial fraud contained in the “off balance sheet” liabilities of major financial institutions. Today, markets are far too trusting of the clairvoyance of the leadership at the Fed and other government agencies. We are especially amused by reports coming out of China about official concerns regarding the credit quality of heavily indebted state companies. China is a festival of bad debt and inadequate disclosure that makes the shenanigans of 2008 pale in comparison. As in 2008, what the markets don’t know is the real risk, not the amount of capital in published reports. You can be sure, however, that in the days and weeks ahead new surprises will keep emerging from China’s corrupt kleptocracy . We continue to be cautious about the outlook for financials in Q2 2017 and beyond, in part because the catalysts behind the bull trade in financials early in 2017 have largely failed. Interest rates are falling, bank earnings are flat and new lending volumes are decelerating. Credit costs for consumer and business loan portfolios are rising. Yet it is still possible to find analysts who think that financials are the next big thing. The one truth that remains unaltered is that financials are a reflection of the markets which they serve. We worry that by gunning the economy with years of unnecessary QE, the Fed has embedded significant future credit losses on the books of many banks and funds, raising questions as to whether the income and capital of today is adequate to meet the requirements of tomorrow. Loan losses and future risks are currently understated, thus investors need to exercise caution in making asset allocation decisions. But fortunately, our main concern today is catching fish and wishing the readers of The IRA tight lines and a good weekend.

“Markets go up on an escalator, they come down on an elevator. This is the most hideously overvalued market in history.” David Stockman New York | Last week’s action by the Fed was an effort to restore normalcy, but in the context of extraordinary action by the central bank. When you tell markets that the risk free rate is zero, it has profound implications for the cost of debt and equity, and resulting in different asset allocation decisions. Ending this regime also has profound implications for investors and markets. In the wake of the financial crisis, some investors found comfort in the fact that when risk free interest rates are at or near zero, the discounted future value of equity securities was theoretically infinite. Markets seem to have validated this view. But to us the real question is this: If a company or country has excessive and growing amounts of debt outstanding against existing assets, what is the value of the equity? The short answer is non-zero and declining. But hold that thought. Reading through Grant’s Interest Rate Observer over the weekend, we were struck by the item on China Evergrande Group (OTC:ERGNF), a real estate development company and industrial conglomerate that has reported negative free cash flow since 2006, but has made it up in volume so to speak. The stock is up over 200% this year, Grant’s reports. The real estate conglomerate has its hands into all manner of businesses and seems to typify the China construction craze. Grant’s recalled an earlier observation by a US Texas real estate manager in the 1980s, something to the effect that real estate is not a cash flow business, but rather an asset appreciation business – until you can no longer service the debt. We can recall hearing similar cautionary comments about the dangers of leverage from Kevork S. Hovnanian years ago, when he spoke about holding on to some of his land investments in South Jersey for decades and with no debt. Today the idea of investment without leverage draws ridicule, partly because unlevered returns in most industry sectors are down in single digits. The observation from the unknown Texas real estate man three decades ago pretty much sums up the state of the US economy. This week as The IRA heads for Leen’s Lodge in Grand Lake Stream for some Spring fishing, we see bubbles in the water just about everywhere, but little in the way of revenue growth. Empty retail locations are multiplying across Manhattan. Earnings in sectors like financials are up on cost cutting and share repurchases, but supported by little else. Asset prices for all manner of investments have risen by double digit rates or more, but income – that is cash flow – seems wanting. As in the early 2000s, the Fed has squeezed credit spreads and thereby gunned asset prices, but to little effect in terms of employment or especially income. QE did not work, notes FT Advisors. While some of our fishing partners believe that tight spreads are always a benefit to the economy, when spreads fail to differentiate relative credit risk, then eventually equity must be restored via a little old fashioned deflation – right? Consider the case of Amazon (NASDAQ:AMZN). Here’s a company with relatively little debt and fewer profits, but high revenue and equity market growth rates. The company has less than $2 billion in net working capital supporting $140 billion or so in revenue, but trades at 3x sales and 21x book value. Moody’s has AMZN at “BBB+” based upon improving debt service cover for its $20 billion in long term and lease obligations. One of the fabulous FAANG stocks – this after Facebook (NYSE:FB), Apple (NASDAQ:AAPL), Amazon, Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOG) -- AMZN last week announced the acquisition of Whole Foods Market (NASDAQ:WFM) for $13.7 billion. The consideration to be paid, in cash of note, is a rounding error compared with the $472 billion market cap of AMZN. And like AMZN, WFM is a low or no margin business as well, thus the pairing seems entirely appropriate -- but is also enormously disruptive. AMZN + WFM adds to the financial black hole created in retailing by AMZN. The combination of AMZN and WFM is seen as bringing the deflationary apocalypse for the retail food sector, one of the more vulnerable parts of the US economy. Jim Cramer of CNBC says "AMZN is a deflationary force. Fed needs to think about it." True, but the more interesting question is how the massive expansion of debt orchestrated by the Fed since 2008 and particularly with QE after 2012 has impacted equity market valuations for stocks such as AMZN, as shown in the chart below. By pulling trillions of dollars worth of duration out of the US financial markets via quantitative easing (QE), the Federal Open Market Committee has shifted risk preferences for both debt and equity. The net result is a series of debt-fueled bubbles in various asset classes, but none larger and more problematic than in large cap US equities. In order to “normalize” the credit markets, the Fed must be willing to let the equity and debt markets adjust in the short-run – by no means a given. With the toppy state of equity market valuations, the components of FAANG may be in for some significant downside. Part of the reason that the FOMC remains so clearly hesitant about reducing the size of its balance sheet is the well-informed suspicion that the Street will be unable to absorb the increase in volatility that will accompany true market normalization. Since much of the market in US Treasury debt and agency mortgage paper such as GNMAs is controlled by foreign central banks, the free float is small. Dealer inventories are minimal, thanks to the Volcker Rule. The end of portfolio reinvestment and even modest sales will increase both longer yields and market volatility. For those of us who have been critical of Fed policy since the end of QE1 in 2012, the return of more normal levels of volatility would be a positive sign that the central bank finally is willing to allow markets to once again price risk. But the downside is that the fiscal situation in the US and overseas could see yields on government debt rise dramatically once investors fully appreciate that the days of QE are ended. Having redefined “normal” based upon the extraordinary environment maintained by the FOMC since 2012, the Yellen Fed is now faced with its greatest test, namely allowing the financial markets to engage in price discovery without overt government support. We’ve been talking for years about the financial implications of the Fed’s portfolio and how trillions in duration negatively influences yields and spreads, but credit also impacts equities. At the same time, mounting levels of public and private debt call into question whether investors can really invest in equities for the longer term without an assumption of more or less continuous QE. Where would stocks like AMZN and WFM be trading in the absence of QE? Just as a zero percent risk free rate suggests an infinite valuation for equities, the end to official market manipulation by the Fed suggests an equal adjustment in market valuations as we walk back from extraordinary to normal.

Below are some thoughts for the discussion at Cato Institute in Washington, D.C., today, “Financial Crisis and Reform: Have We Done Enough to Fix the Government-Sponsored Enterprises?” The title for today’s discussion is a question “Have We Done Enough to Fix the Government-Sponsored Enterprises?” The short answer is “Yes.” A decade and a half before the US government took over the GSEs in 2008, Harold Ramis came out with a film called “Groundhog Day” starring Bill Murray, Andie MacDowell, and Chris Elliott. Murray’s character, an arrogant TV newsman from Pittsburgh named Phil Connors, is caught in a time loop, repeating the same day over and over again. Talking about GSE reform has taken on a similar quality. There is a crisis in the world of mortgage finance, but it has nothing to do with the debate of government-sponsored enterprises such as Fannie Mae and Freddie Mac. The situation with the GSEs is a Washington story that deals mostly with issues of equity and public policy, but gets virtually all of the attention from the financial media. To the bond market, though, the only validation needed to support the “AAA” rating of the GSEs is the credit support of the United States, period. The “sale” of the GSEs 50 years ago was a financial fraud perpetrated by members of Congress and a number of Presidents going back to Lyndon Johnson. The US government never “loosed dominion” over the GSEs, to paraphrase Supreme Court Justice Louis Brandeis, who ruled in 1925 that an incomplete sale “imputes fraud conclusively.” The erstwhile shareholders of the GSEs, seen through that prism, are really creditors rather than owners. Meanwhile, the business of making and servicing loans is being slowly decimated by over-regulation, soaring operating costs and uneven interest rate markets. Over-regulation of the mortgage industry hurts banks and non-bank financial institutions, and their customers and shareholders. More the any other change to the Dodd-Frank law, the standard for regulation of lenders needs to be revisited. A bizarre line of thinking prevalent in the academic world says that increased regulation of commercial banks since 2008 has somehow made non-banks more competitive that depositories, which are after all GSEs just like Fannie Mae and Freddie Mac. Banks have access to the Discount Window, federal deposit insurance and other subsidies, and are protected from hostile takeovers by the Fed. But of course, we all know that Feinberg’s First Law states that no private entity can compete with a GSE. In fact, the increased regulation of home mortgage finance has made it virtually impossible for many smaller non-bank firms and community banks to operate profitably in the residential mortgage market. There is a steady exodus of both banks and non-banks out of residential lending and servicing, particularly from the government guaranteed market overseen by the Federal Housing Administration (FHA). The growing dominance of the remaining non-banks in the FHA market raises both liquidity and credit concerns. Non-banks have the least ability to fund FHA lending, servicing and loss mitigation tasks, yet they are now well more than half of the total market. And the FHA is taking share away overall from the GSEs through insuring below-prime loans, paper the commercial banks won’t touch. In 2014, JPMorgan (NYSE:JPM) Chairman Jamie Dimon very publicly moved his bank out of the FHA market, a trend that has been followed by many other commercial banks. Dimon is especially critical of the FHA’s use of the False Claims Act, Civil War era legislation that was intended to protect the government from fraud by suppliers. Many industry participants say that the False Claims Act has been used abusively by the Department of Justice to extort fines and settlements from banks and non-banks alike. Many of the supposed “violations” of law alleged by the DOJ did not happen at all, but the mere threat of criminal prosecution of a bank’s officers and directors has been enough to compel most private lenders to settle and pay. Not only have these unwarranted fines been costly for shareholders, but the withdrawal of banks from the FHA market has, according to Dimon, reduced mortgage lending by banks to the tune of about $300 billion annually. Likewise, the undefined “abusive practices” standard contained in the Dodd-Frank law has been used to extract billions in fines from banks as well as non-banks. Only in rare instances such as Quicken’s litigation with the DOJ and PHH Corp’s (NYSE:PHH) now famous Constitutional challenge of the Consumer Finance Protection Bureau (CFPB) have private lenders been willing to fight back against this abuse of power by the CFPB and DOJ. Most of us are familiar with the travails of Ocwen Financial (NYSE:OCN), but literally dozens of other non-bank mortgage firms have been unjustly penalized by the CFPB and state agencies. Most recently, the CFPB issued a sensational statement, saying it was fining Fay Servicing, a high-touch distressed mortgage servicer in Chicago, more than $1 million for “illegal foreclosure practices.” According to the CFPB, an “investigation” found that Fay Servicing was “keeping borrowers in the dark” about their foreclosure prevention options. Like many mortgages firms that have settled with the agency, Fay founder and CEO Ed Fay took issue with the characterizations in the CFPB’s remarkable press release. He notes that his firm was not asked to pay a fine, otherwise known as a civil penalty payment. Rather, Fay was asked to pay $1.15 million in redress to borrowers; to offer borrowers opportunities to pursue foreclosure relief; and comply with mortgage servicing rules. This action against Fay, PHH, Ocwen and many, many other firms follows the familiar pattern of the National Mortgage Settlement and the CFPB’s rule making authority, both of which essentially allow aspiring politicians to tax private mortgage firms for “abusive practices” or “violations of law” without any due process or transparency. And at the top of the political food chain, the US Attorney and the CFPB act as judge and jury in a modern day Star Chamber in issuing enforcement actions and fines. The cost of regulation is seen in the expense required to make or service a home loan. According to the Mortgage Bankers Association, the average cost of servicing a performing loan rose to $181 in 2015, three times higher than in 2008 when the cost per loan was $59. The average cost of servicing a non-performing loan grew to $2,386 in 2015, almost five times higher than in 2008 when the cost per loan was $482. This increase in cost was driven by one public policy priority enshrined in Dodd-Frank, namely protecting American consumers from abuse of process when they failed to repay their home mortgages. Defaulting on your mortgage has become a new American entitlement. With the election of Donald Trump, both banks and non-banks believed that salvation was at hand. Stock prices soared on the promise of deregulation of the financial services industry, both via reform legislation and more simply by putting agencies such as the DOJ and CFPB back into business friendly hands after eight years of bleeding under the Obama Administration. The Trump Administration has proposed that the CFPB be substantially stripped of its powers, but events in the bond market have created even bigger headaches. Yet despite a lot of positive talk coming from Washington, the situation facing the mortgage industry is dire as Q2 2017 comes to an end. First and foremost, the talk early on regarding infrastructure spending and lowering taxes took Treasury bond yields up half a percentage point in the three months after the election. The sharp rise in rates right after November 2016 put the kibosh on mortgage refinancing, driving industry volumes down sharply. As shown in the chart below, the Mortgage Bankers Association (MBA) has future refi volumes flat lined at $100 billion per quarter into 2019 vs $250 billion per quarter in Q2-Q4 2016. Because of the upward move in interest rates in the three months following the election of Donald Trump, today the mortgage industry is running light on home lending volumes to the tune of $300-400 billion this year. When you hear us suggest that the Federal Open Market Committee could easily sell $50-100 billion per month in mortgage bonds from its hoard, this decline in agency issuance is partly the reason. The chart below shows the 10-year Treasury bond and 30-year mortgage rate. If you understand the concept of option adjusted duration, then you’ll perceive that by maintaining a position of over $2.2 trillion in mortgage securities, the Federal Open Market Committee has created a downward bias on long-term interest rates. The resulting compression in bond yields (and credit spreads) now visible in the mortgage and forward rate/TBA markets is in direct opposition to the policy objectives of the FOMC, of note. This is why we believe that Chair Yellen and the FOMC err in putting increases in benchmark rates ahead of portfolio sales. The operating results for the industry reflect the political and financial confusion that the two above charts illustrate. MBA Vice President of Industry Analysis Marina Walsh and her colleagues have dutifully assembled statistics for the US mortgage industry in Q1 2017 and the results are truly dreadful. "The drop in overall production volume in the first quarter of 2017 resulted in the highest per-loan production expenses reported since inception of our study in the third quarter of 2008," said Walsh. "While higher production revenues mitigated a portion of the cost increase, production profitability nonetheless declined by more than half the previous quarter. For those mortgage bankers holding mortgage servicing rights, an increase in mortgage interest rates resulted in MSR valuation gains and helped overall profitability." Other key MBA findings: Average production volume fell to $455 million per company in the first quarter, down from $690 million per company in the fourth quarter. Volume by count per company averaged 1,944 loans in the first quarter, down from 2,811 loans in the fourth quarter. Average pre-tax production profit fell to 10 basis points in the first quarter, down from an average net production profit of 24 bps in the fourth quarter. Since inception of the Performance Report in third quarter 2008, net production income has averaged 51 bps. Purchase share of total originations, by dollar volume, rose to 68 percent in the first quarter, compared to 58 percent in the fourth quarter. For the mortgage industry as a whole, MBA estimated purchase share at 59 percent in the first quarter. When our friends in the regulatory community ask us why the mortgage industry does not make more investments in expensive new technology to improve the servicing process, we gently remind them that half of the industry is not profitable. Most of the rest have equity returns in mid-single digits at best, paltry results that consign these businesses to mostly debt financing, with full collateral of course. A cynic might say that no sane investor would allocate capital to this business -- unless there is serious scale involved, say at least $100 billion in unpaid principal balance (UPB) of loans serviced. Go big a la Nationstar (NYSE:NSM), Quicken, Flagstar (NYSE:FBC) or Lonestar’s Caliber, or go home. Since for most non-bank mortgage firms the intangible MSR is the only real capital asset, innovative financing for loan servicing assets is currently the holy grail. For regulators and researchers to compare non-banks with heavily subsidized and regulated banks is fanciful, but it also reflects an indifference on the part of the policy community regarding the real world impact of regulation on people and markets. The changes in regulatory incentives in the banking world since 2008 have made residential loans among the least attractive loan types for any financial institution. Regulators have actively discouraged banks from engaging in either lending or servicing below-prime loans. With some notable exceptions, most banks have decided to avoid residential lending. Why? Because the risk-adjusted returns are relatively low once high operating expenses and regulatory/reputation risk is factored into the equation. The goal of any regulatory change in the mortgage world should be to preserve the protections for consumers that were codified in the National Mortgage Settlement and also contained in Dodd-Frank, but make the regulatory process less adversarial and, frankly, more fair. The current regulatory environment for consumer lending in the US is entirely counter-productive for both consumers and investors. Former Solicitor General Ted Olson said of the Dodd-Frank consumer agency in arguments for PHH: “The CFPB’s structure is the product of aggregating some of the most democratically unaccountable and power-centralizing features of the federal government’s administrative state.” Nothing better proves Olson's point than the treatment of the mortgage industry by the CFPB over the past five years. The employees, customers and investors of mortgage companies enjoy the same Constitutional protections as all Americans. They should be treated with respect and fairness, rather than disdain and indifference. No other industry in America faces the level of punitive hostility that the mortgage community endures at the hands of the CFPB and other agencies. If regulators work with the industry to balance fairness with regulation, mortgage industry profitability will improve and with it the possibility of operational improvements that best serve consumers and investors as well.

“Stock prices have reached what looks like a permanently high plateau." Irving Fisher October 1929 This Thursday The IRA’s Christopher Whalen will be in Washington to participate in an event at Cato Institute, “Financial Crisis and Reform," We'll talk with Cato's Ike Brannon about whether enough has been done to “fix” the problem, real or imagined, with Fannie Mae and Freddie Mac. The question posed by the title of the Cato Institute panel suggests that Washington has the slightest idea about the “problem” in the mortgage business much less a solution. You can be sure that nobody actually working in the US mortgage market is losing any sleep over the fate of these troublesome government sponsored enterprises. Whether you’re lending, servicing loans or managing interest rate risk, you’ve got bigger issues than the fate of the GSEs. Excessive regulation and fickle benchmark interest rates top the list. More on Mortgage Finance in the Age of Trump in our next comment. And that same evening also at Cato, we’ll be speaking to The Prosperity Caucus about the new book “Ford Men: From Inspiration to Enterprise” and talk about the brave new world of “mobility.” And we’ll have some good stories to tell about John Carbaugh, Robert Novak and other former members of the Prosperity Caucus. The past eight months since the election of Donald Trump has been anything but stable, either for investors, lenders or consumers. Coming off of the Brexit vote in the United Kingdom last summer, the events that followed the Eighth of November have seen markets soar on waves of optimism, only to be thrown down in bitter disappointment. And the economic indicators are no more clear than they were before the US election. Wall Street desperately wants to believe that interest rates are headed higher, part of a larger need to confirm that the current market and economic situation is returning to normal. Yet fact is, after eight years of monetary experimentation by Bernanke, Yellen & Co, interest rates are falling, debt markets are at record levels of issuance and the new-issue equity markets are largely barren of value. It is notable that despite the downward movement in Treasury yields, there are still analysts willing to make public arguments about the benefit to banks of rising interest rates. While net interest margins for all US banks did rise about 10bp in 2017, this was largely due to the upward move in rates after the surprise electoral win by President Trump, as shown in the chart below. Since the end of the year, however, the twin pillars of the bull trade in financials – rising interest rates and deregulation – have been eroded to the point of disappearing entirely. We spoke about the prospects for legislation helping the banks with our friends on CNBC’s “Squawk Box” on Friday . The fact that there are still analysts willing to tout the positive aspects of rising interest rates when the 10-year T-bond is sinking towards 2% yield illustrates the indomitable optimism of Wall Street – and the degree to which forward risk indicators are diverging. We called for a 2% yield on the ten year T-bond at the end of last year, a viewpoint that is confirmed by the mounting evidence of credit problems in asset classes from credit-cards to commercial real estate to auto paper. By embracing the modern equivalent of “trickle down” economics via asset price manipulation, the Federal Open Market Committee has succeeded only in adding a new layer of speculative debt atop the financial carcass as it stood around 2010. As this latest vintage of debt issuance ripens, we may be surprised at the rate of change in terms of credit losses at banks and inside ABS. "Although card standards were extremely tight in the years following the financial crisis, if underwriting then loosened materially, as the rise in charge-offs suggests, asset quality could continue to deteriorate rapidly going forward, especially in the event of a recession," notes our colleague Warren Kornfeld at Moody's . As we opined in earlier missives, the key relationship to watch when it comes to bank earnings is not interest rates or even net interest margin, but provisions for credit losses vs operating income. This is an especially important topic because the folks at the FASB are currently negotiating with the banking industry about changes in estimated future loss rates on loans that could add 10% or so to the cost of bank provisions for credit losses. Our friends in the bank credit channel say that the impact of the rule change by FASB will be for banks to over-report likely loan losses, which will then lead to larger recoveries after the defaulted loan is fully resolved. The standard is expected to take effect in 2020, although FASB has indicated that it may revise the rule to address industry concerns. It is more than a little amusing to see the FASB advocating a change in presentation to bank loan loss provisions that will effectively result in over-reserving for credit losses. This was traditionally the position taken by prudential regulators, while the SEC always tended to want to see loan loss provisions kept to a minimum so as not to artificially understate earnings. Shareholders will, eventually, see the cash returned to the bottom line via recoveries, but seeing this reversal of roles is a rather delicious irony. Changes in accounting rules, however, will not change the underlying economic reality of excessive debt. We worry about the fact that the latest period of exuberance engineered by the FOMC has embedded significant future losses in the financial system. While the US may be a good bit healthier than the EU or China when it comes to absolute debt levels and credit quality, the fact remains that the predominant tendency in the US credit markets remains deflation. The 20th Century US economist Irving Fisher worried about the decline of income in the event of a debt deflation , yet today we face a different problem. A combination of technology, innovation and the aging demographics of the key industrial economies is limiting income growth even as asset prices are goosed ever higher by monetary policy and structural constraints. One reason we expect that the widely anticipated rate hike by the Fed this week will be the last is that members of the FOMC seem to at least understand that the US economy is slowing. Rising credit losses in a variety of asset classes will force the central bank to pause on the road to normalization and prepare to battle another bout of old fashioned debt deflation. Irving Fisher noted in 1933 “that great depressions are curable and preventable through reflation and stabilization,” but it remains questionable whether the FOMC has in fact achieved either of these blissful ends over the past eight years. Fisher worried that “when over-indebtedness is so great as to depress prices faster than liquidation, the mass effort to get out of debt sinks us more deeply into debt,” but in 2017 the problem is different. In the 1930s, the debt markets were allowed to clear without government manipulation or support, resulting in catastrophic debt deflation. Today the Fed artificially supports elevated asset prices in the vain hope that a “wealth effect” of some sort will “trickle down” and boost incomes. Memo to Chair Yellen: There is no wealth effect, there is no wealth effect. What is clear is that the Fed has added to the collective credit bubble, begging the question as to when asset prices will readjust downward again to match flat income levels. Not only has US public debt almost doubled since 2008, but private debt has likewise risen by mid-double digit rates. The slowly rising cost of credit visible in banks and the bond market may herald the start of a new type of debt deflation cycle. Thus we expect June to be the last rate hike by the Fed in 2017 and perhaps for years to come. As with January/February 2016, our friend Nouriel Rubini writes , concerns about faltering US growth could put further rate hikes on hold. Just imagine how Wall Street will greet that happy news. The real question for investors is when will the Fed be forced to publicly reverse course on rate increases, then cut rates and maybe even resume asset purchases to keep debt deflation at bay for a while longer. #Bernanke #yellen #Cato #Banks #CNBC #GSEs

In this issue of The Institutional Risk Analyst, we speak to John A. Kanas, Chairman of BankUnited (NYSE:BKU). Kanas rose to prominence in the banking world first by building North Fork Bank into a leading northeast community lender, then selling it in 2006 to CapitalOne Financial (NYSE:COF) for $14 billion in cash and stock . In 2009, he led an investor group, which included Blackstone, Carlyle Group, Centerbridge Partners and WL Ross & Co, that acquired a failed Florida thrift called BankUnited. Kanas and his veteran team rebuilt the bank and doubled the institution’s assets over the past seven years. He stepped down as CEO of BankUnited in January, handing the reins over to COO Rajinder P. Singh . We spoke to him last week from Florida. RCW: John, thanks for taking time to speak with us. When you look back over building North Fork and BankUnited, two very different banks, how do you think about these two institutions? JK: Building North Fork really was about the banking market of the 1990s and 2000s. BankUnited was a failed bank that we acquired from the FDIC in 2009. Both banks were similar in that they served a local community of businesses and consumers, classic relationship banking. You had to understand the local landscape and give your customers white glove service. As today, the competition for deposits and loans in those days was intense. RCW: Is there more competition today in the industry among smaller banks than the larger institutions? JK: Competition among smaller institutions has always been intense. The larger banks have very different funding models. The smaller banks are going head-to-head for the best customers in the markets they serve. The larger banks really don’t focus on those types of customers, small to mid-size businesses, for example. RCW: And the larger banks tend to be half market funded as opposed to core deposits. It sounds like the smaller banks need the deposits. Is that good? JK: Yes, there is clearly an ongoing need for deposit growth at banks. Mid-cap and smaller banks tend to be fully loaned out with ratios of loans to deposits in the 90 percent range vs. the 70s years ago. RCW: The data from the FDIC suggests that, over the past 30 to 40 years, banks have seen the average return on earning assets fall from over 1% to just 75bp today. Has this shrinkage in asset returns forced banks to increase their leverage by making more loans? JK: In part that is definitely true. Remember that we have been operating in a period of declining interest rates for decades, so banks have been forced to adjust their business models to support returns. RCW: Your peers among the better run community banks tend to have loan to deposit rations in the 90 percent range, yet the old models used by bank regulators and rating agencies penalized banks for being fully loaned out. Does the credit sector need to rethink how they assess loan to deposit ratios and bank business models? JK: That is correct. In today’s market, a well-run institution has to be fully loaned out to make the asset and equity returns work. RCW: Does the question of success or failure for a bank ultimately come down to credit management? Look at Bank of the Ozarks (NASDAQ:OZRK). We get calls constantly from investors looking to short that stock because of the focus on C&I lending and commercial real estate. Our response is “be careful what you wish for.” Bank of the Ozarks has a very strong credit culture and went through the financial crisis pretty much unscathed. In fact, our friends at Kroll Bond Ratings just put OZRK on watch for a ratings upgrade ! JK: A lot of people have lost a great deal of money trying to short OZRK over the past several years. The bank has performed extremely well despite their focus on real estate lending. RCW: At BankUnited, you tended to stay away from areas such as residential mortgages and auto loans, preferring to focus on commercial lending. Has this included lending on construction and development in your footprints in New York and Florida? The banking industry’s portfolio numbers on C&D lending are literally half of where they were before 2008, largely because the loans were charged off and restructured. A number of banks failed because of C&D. How do you view the C&D sector given your focus on FL and NY? JK: The regulators have been very direct with their guidance to the industry regarding C&D lending because of the experience that you mentioned. It has been very tough to expand that asset class. The message from regulators is that C&D lending must be done very carefully. RCW: The number of home builders have been cut by a third since 2008. It is not hard to understand the concerns of regulators given the number of bank failures. How does the US grow the amount of credit available to support new construction of single family homes? The asset prices for residential properties in your footprint have been soaring and the credit metrics for defaulted construction loans are extremely good. JK: C&D loans today tend to be 30-40 percent loan to cost as most, meaning that there is a lot of equity in these deals. The regulators have a very cautious posture toward construction lending and this is reflected in LTV ratios. Yet if I were running my own bank today, without being accountable to other shareholders or regulators, I would do nothing but construction lending because there is such a great need. RCW: And better returns than residential mortgages or prime auto loans. Let’s go back to BankUnited transaction for a moment. When you acquired that bank from the FDIC, what was different about that experience vs building North Fork? JK: When we bought BankUnited in May of 2009, we were one of less than five bids for the bank. I was working with Wilbur Ross at the time to identify opportunities in the banking sector. The situation in the markets was very uncertain. Nobody in the financial world had a clear vision about what to do next. The prices for failed bank assets reflected this uncertainty. North Fork was a much more conventional story having been forged out of 18 acquisitions over 30 years. RCW: When then-FDIC Chairman Sheila Bair and her colleagues at the FDIC sold Indymac in January 2009, the literally room was empty. The FDIC put loss-sharing on the table and got the party started, but it sounds like not much changed in several months between that transaction and the acquisition of BankUnited. JK: The pricing did not change immediately. Our original plan going into the BankUnited transaction was to buy a number of failed banks in Florida but once we closed the acquisition, the pricing in the market improved dramatically for the FDIC. That ultimately drove our decision not to continue with a more aggressive acquisition plan. RCW: So how about today? The whole industry was taken up by 20-30% following the election of Donald Trump. What do you tell your shareholders about the movement in banks stocks over the past six months? JK: There was a lot of enthusiasm after the election given the prospect for tax cuts and deregulation, but this promise has faded. It is not clear what will actually be changed in terms of the regulatory environment this year. RCW: It looks like the regulatory relief for small banks will be the easiest thing to get through the Congress. Do you agree with that? JK: Yes, there is clearly support for regulatory changes to help small banks. The support for rest of the agenda is far less clear, including tax cuts and other changes outside of the regulatory sphere. The community bank sector is very competitive right now when it comes to deposits particularly. There is a case to be made that smaller banks need relief so that they can continue to provide credit to local customers. RCW: So talk about the community banking sector going forward. There is a flood of opinion coming from the investment bankers and consultants that says that community banks are doomed and the industry will consolidate down to 1,000 banks. Is that your view? JK: I can remember first hearing those arguments about the demise of community banking back in the 1970s. Community banks are more relevant today than ever. So long as you have small communities with local businesses that need to be financed, community banks will be the only option to support this part of the American economy. RCW: Former Fed Chairman Paul Volcker reportedly once said that the only innovation in banking has been the ATM machine. Is that true? Is the industry changing of its own volition or is change being imposed? JK: Technology is clearly changing the industry in a number of ways, but there are also cases where the local demand for services actually goes the other way. We had looked at closing some branches in FL, for example, but when some of our competition shuttered branches, we found that our business grew at our facilities. The fact is that when people enter into a significant transaction like a business loan or home purchase, they want to talk to someone face-to-face. RCW: There is a lot of talk about how technology is pushing the industry towards branchless banking, yet the statistics seem to suggest that while consumer like to shop online, they also like to sit across the table from a banker when they enter into a major transaction like buying a home. And bankers often like to have a look at a prospective customer before committing on a loan. JK: Correct. When consumers or small business people enter into a significant commitment, they frequently want to do it in person. Going back to my earlier comment about “white glove” service, community banking is about individual service above all else. In the competitive environment in the industry today, you must be as aware of your customers’ needs as you are about new technology. RCW: We are part of a debate in the financial economics community about whether the fact of the Fed paying interest on excess reserves negatively impacts lending. Given the competitive environment you described, do you think that the fact of the Fed offering 1% risk free on excess reserves impacts your calculus as a lender, either in terms of price or the actual decision to lend? Net of FDIC deposit premiums, you’re making 85 to 90bps. JK: Any time risk-free investments are available to banks they present competition to building loan assets. Interest on reserves at the 1% level is no exception. RCW: We hear periodic rumors about you possibly going to Washington. The Wall Street Journal had a comment earlier this year. Is there any truth to these reports? JK: I have had some discussions with the Administration about a number of possibilities. There are some very capable people being considered for positions in the bank regulatory world but the process is ongoing. There are something like 150 individuals being considered for the positions that require confirmation alone. I don’t have any specific plans at the moment. I have a two year commitment as Chairman of BankUnited and look forward to being helpful to the industry as opportunities arise. RCW: Thanks for your time John.

"[F]rom early spring throughout 2009 and until mid-year 2010, the Fed engaged in the first major quantitative easing program of purchases of government agency debt and agency-guaranteed mortgage-backed securities. The Fed’s purchases reached a cumulative total of $1.285 trillion, and excess reserves reached nearly $1 trillion. Essentially, the new reserves provided by the purchases program enabled the banking system to fund the repayment of about $1 trillion of various forms of advances to financial institutions under the [Fed’s] emergency lending program. The emergency lending program ended, but quantitative easing replaced it." Walker F. Todd "The Problem of Excess Reserves, Then and Now" American Institute for Economic Research May 2013 Is the neo-Keynesian era over at the Federal Reserve Board? Press reports indicate that the Trump Administration finally has decided upon at least two new appointees for new Federal Reserve Board governors. President Trump is expected to nominate investment banker Randal Quarles and economist Marvin Goodfriend to two of three vacancies at the central bank. Despite the media attention to these new appointments, Wall Street does not yet seem to appreciate how the eventual selection of three new Republican governors could change the policies and personal chemistry at the central bank. At a minimum, the arrival of two and eventually three GOP appointees on the Fed board may have a significant impact on how Fed policies impact the credit markets. Since the appointment of Janet Yellen in February 2014 for a four-year term ending February 2018, the Federal Open Market Committee has followed a predictably neo-Keynesian path, at least in rhetorical terms. The Fed’s use of “quantitative easing” or QE was an attempt to synthetically create the economic impact of deficit spending by the federal government. Yet as the above quote from our friend Walker Todd suggests, the central bank has pretended to focus on stimulating growth and employment, when in fact it has been bailing out the big banks once again. This symbiosis between the Fed and the largest banks, who are the chief beneficiaries of QE, has seen the central bank create trillions of dollars worth of risk-free assets for the biggest banks in the form of $4 trillion plus in excess reserves. The massive overhang of liquidity created by the Yellen Fed has swelled the monetary base of the US economy, but has had little or no impact on employment, consumption or inflation – at least not yet. To quote from Todd’s important talk at Levy Institute last year: “The Fed should have learned from the experience of the earlier quantitative easing programs that its purchases of securities do little or nothing to increase the quantity of bank credit actually supplied to the general economy. Purchase programs might make sense in some circumstances if they helped make real interest rates positive, but generally real rates have been negative since 1Q 2009. The Fed’s methodology is not necessarily entirely irrational, but the evidence is that it simply has not worked.” Once there are three new Republican governors on the FOMC, however, Chair Yellen may find herself being challenged on some of the most basic assumption that underlie current Fed monetary policy. The incredible description of QE as a form of economic stimulus, for example, may be questioned given the paltry success of the policy so far. Both Quarles and Goodfriend are reliable conservatives who are unlikely to acquiesce in this view of current Fed policy. For example, Goodfriend’s current position as the “Friends of Allan Meltzer Professor of Economics” at Carnegie Mellon’s Tepper School of Business and his published research makes it seem improbable that he would support the FOMC’s direction under Yellen. His 2014 essay, “Why Monetary and Credit Policies Need Rules and Boundaries,” illustrates how he differs from the radical monetary policy regime under Yellen. But as one reader of The IRA does note, Goodfriend did advocate NIRP in his remarks at Jackson Hole. It is important to recognize that the Yellen Fed has diligently worked to weed out any dissenting voices among the regional Reserve Bank presidents, thus dissonant views among the governors will represent a new challenge for Chair Yellen, a change that could see her step down before the end of her term. Fed Chair's have traditionally resigned when they are on the losing end of policy votes by the FOMC. The unfortunate departure of Richmond Federal Reserve President Jeffrey Lacker, who announced his resignation in April after admitting that he indirectly discussed sensitive information with an analyst regarding the Fed's plans for economic stimulus, conveniently eliminated an important dissident on the FOMC who had consistently questioned the efficacy of QE. "I wouldn't have gone down this asset-purchase path. I'm in the camp that we should taper and stop right now," Lacker told CNBC’s Squawk Box in a 2013 interview. "I think a reasonable case can be made that path of unemployment wasn't affected much by quantitative easing we've seen over the past few years." The big change facing the Yellen Fed is that the chair actually may start to hear questions from the Republican governors asking what the FOMC is doing in terms of monetary policy and why. The fact that the Fed did not immediately start to shrink its balance sheet following QE 2-4 speaks volumes about the intellectual orientation of the FOMC, which has been entirely willing to accept the neo-Keynesian, Paul Krugman worldview that additional open market intervention was required even after the abortive 2009 fiscal stimulus. But the true irony is that the supposed stimulus of QE was in fact a sop for the banking industry, especially the largest banks. As Todd notes, the start of QE 1 was not meant to help the economy, but instead a move by the FOMC to liquefy the US banking system in the immediate aftermath of the 2008 financial crisis. Without QE1, the major US banks could never have raised sufficient liquidity to repay the emergency loans made by the Fed in 2009. In addition to the immediate subsidy for the largest banks, the Fed’s open market purchases of securities since 2009 have compressed credit spreads but done little to help boost employment or consumption. As we noted in previous issues of The IRA , the cost of credit in bank loans and bonds has been suppressed by the Fed's actions, suggesting that above-average credit losses await banks and bond investors down the road. The chart below shows relative corporate and government credit spreads going back a decade. Source: FRED With the significant exception of the China market hiccup at the start of 2016, high yield spreads have been consistently below the long-term average during Yellen’s tenure. The current FOMC frets about the potential dangers of unwinding the Fed’s bond portfolio, but the reality is that today the duration-starved capital markets could easily absorb the entire amount over a period of a couple of years. Keep in mind that new issuance of mortgage backed securities by the GSEs is running several hundred billion dollars below last year’s levels. With this significant decrease in bond issuance by the GSEs, it is unlikely that the Fed can raise interest rates until the central bank’s portfolio has been significantly reduced. The prospect of Quarles joining the Fed raises an interesting historical question. The last Mormon banker to sit as a Fed governor was Marriner Eccles, who became associated with the term “pushing on a string” after his testimony to Congress in 1935. Then as today, Eccles knew that monetary expansion such as QE did not work because consumers were unwilling to spend. But the Eccles was not doctrinaire in his economic views and actually became a strong advocate of fiscal stimulus to offset a deficit in investment spending, a situation very similar to that existing today. As Allan Meltzer noted in his classic book, “A History of the Federal Reserve: 1913-1951,” Eccles went further than any of his colleagues on the Fed and attributed the excess of savings to inequitable income distribution. “Eccles differed from his predecessors in his belief that government had to take responsibility for the economy,” wrote Meltzer. “He devoted much of his time to advocating fiscal measures, especially increased spending on investment financed by government borrowing to expand demand.” Like Donald Trump and the Republican majority in Congress, both FDR and Henry Morgenthau believed in the 1930s that a balanced budget and cuts in government spending were the surest path to economic recovery. Yet Marriner Eccles believed just the opposite and became a leading advocate for deficit spending to address the lack of investment and consumption during the Great Depression. As noted in our 2010 book “Inflated: How Money & Debt Built the American Dream,” John Kenneth Galbraith would later describe the Fed under Eccles as “the center of Keynesian evangelism in Washington.” It seems pretty clear that confirmation of Randall Quarels and Marvin Goodfriend will mark a significant and welcome change at the Fed, but observers of the central bank should remember the case of Marriner Eccles when it comes to predicting the behavior of Fed governors. That said, the transition from Democratic to Republican control on the FOMC may finally signal the return of a bear market in the world of fixed income after decades of manipulation by the US central bank.

Financials swooned this week as investors now seem to accept that much of the Trump program is in doubt – at least for 2017. No surprise then that yesterday large-cap financials actually closed down for the year. In our last edition of The Institutional Risk Analyst , " Macro-Prudential Delusions: Bank Credit Outlook 2H 2017 ," we referred to how in April the forward guidance from Capital One Financial (NYSE:COF) caused financials to begin their swoon six weeks ago. The bank’s comments to analysts during Q1 earnings concerned prospective loss rates’ on the bank’s consumer loan book through '17. COF is off its high of $96 per share in February and closed yesterday at $76, largely due to concerns about eroding credit quality and a failure to deliver in Washington. What gives? Short answer is that the period of artificially low loss rates c/o the FOMC is ending and investors are squirming. The first thing to notice when starting your analysis of COF is that the majority of the bank’s loan book is in consumer loans. While the larger peers of COF tend to view credit cards and consumer lending as an important adjunct to a broader business, this bank is just the opposite. There are two bank subsidiaries of COF, Capital One, National Association in MacLean, VA and Capital One Bank (USA), National Association, Glen Allen, VA. The risk profiles of the two banks are very different. The former earns a “A” bank stress rating from the Total Bank Solutions Bank Monitor, while the latter earns a “C” due to the high default rate on the credit card business. Capital One Bank is about one quarter of COF’s assets and reported 721bp (7.21%) of default in Q1 ’17. Loss given default last quarter was 80%, but COF’s credit card bank boasted 1,500bp of gross spread on its loans -- not including fees. The whole company reported 300bp of default in Q1 ‘17, illustrating that COF has a far riskier portfolio than most commercial banks, large or small. The average default rate for all US banks was only about 60bp in Q1. COF’s loan loss rate is several standard deviations above the industry average, but it is not nearly the most risky member of the credit card specialization group defined by the FDIC. Consumer lending was a traditionally hard-money, nonbank business. But COF has turned itself into one of the largest subprime consumer lending businesses after Citigroup (NYSE:C). There are smaller niche providers of subprime credit that have loss rates and gross loan yields far above those of COF and the larger banks. But among the top 50 banks, COF is clearly an outlier in terms of business model and internal default rate targets. By comparison, Citi’s credit card portfolio showed 125bp of default in Q1 ’17, the highest among the top four banks by assets. But then again, what COF’s team calls “commercial lending” at Capital One Bank was throwing off over 300bp of default last quarter. The industry average default rate for C&I loans is about 44bp. Back in 2009, COF peaked at 740bp of default for the whole bank vs one third that figure for all banks. COF’s default rate for the credit card book touched 1,100bp (11%) of total loans in 2009. Obviously funding costs, which in the case of COF include core deposits as well as brokered money, are a crucial part of the model. The chart below shows COF’s gross default rate vs the large bank peer group. The red circle shows Q1 '17. Source: FDIC To make this subprime model work, COF and consumer lenders must make more money per dollar of assets than typical commercial banks. Adjusted operating income as a percentage of earning assets is 7.5% vs less than half that rate for the large banks in Peer Group 1. The gross yield on COF’s loans and leases is over 9% vs 4.3% for other large banks. So, for example, COF generates a net interest margin over 6% vs below 3% for most large banks. The high yields on credit cards and consumer loans enable the bank to absorb oversize losses. COF’s provisions for loan losses are 10x the industry average, but earnings coverage of losses is far lower than for average banks, just 2x vs almost 20x for Peer Group 1. This may explain the sharp stock selloff last month following COF’s earnings warning and 50bp uptick in defaults. That said, C with a beta of 1.55 is technically a more volatile stock than COF as of yesterday’s close. Behind the profitability, COF has a significant backstop with 13% equity to total assets. The almost $400 billion asset bank is also significantly more efficient than its larger peers. And the low double leverage at the parent level allows for accessing the capital markets to fund growth opportunities. But the fact remains that COF is an outlier among large banks because of the high-risk nature of its loan portfolio. If you convert the 329bp (3.29%) of COF defaults into a bond rating, it comes out to a “B” rating. The implied “B” bond rating of COF’s portfolio illustrates the deliberate business model decision that COF has made by focusing on credit cards and consumer credit. The scale below shows the approximate credit ratings breakpoints for actual credit default levels that my friend Dennis Santiago included in the original IRA Bank Monitor in the early 2000s. Target Debt Rating/ Loan Default Rate (Basis points) AAA: 1 bp AA: 4 bp A: 12 bp BBB: 50 bp BB: 300 bp B: 1,100 bp CCC: 2,800 bp Default: 10,000 bp Think about it: On a good day, the average American consumer is maybe a “B” credit in terms of a default probability, one out of 8-10. The good news is that the bank’s emphasis on consumer exposures gives COF a very short duration loan book – less than three years average life – but also more exposure at default with 150% unused lines vs credit already utilized by customers. Even when COF has acquired other banks, the management team has tended to focus on growing the credit card book while running off other categories such as residential mortgages. The chart below shows the major components of COF’s loan book since 2011. Source: FDIC And even with all of the income from the below-prime loan book, COF barely manages to earn positive risk-adjusted returns in the TBS Bank Monitor, not due to the loan book but because of market exposure from the bank’s securities investments. The big factor for investors to ponder with COF is that this 1.2 beta stock may move lower, faster than other large cap banks when default rates start to rise. Think of it as a measure of equity beta linked to loan credit quality. If COF has 10x the default rate of other large banks now, after years of credit market manipulation by the Fed and other central banks, the downside for the stock could be considerable if our thesis about the Fed suppressing the cost of credit turns out to be correct. Only time and the FOMC can tell. #COF #CapitalOneFinancial #creditcards #FOMC

In the mid 2000s, just before the financial crisis began, US banks were reporting credit metrics for all asset classes in loan portfolios that were quite literally too good to be true. And they were. The cost of bad credit decisions was hidden, for a time, by rising asset prices. The same aggressive, low-rate environment used by the Fed to artificially stoke growth in the early 2000s has been repeated in the aftermath of the 2008 crisis, only to a greater extreme. Today US banks report credit metrics in many loan categories that are not merely too good, but are entirely anomalous. Negative default rates, for example, are a red flag. A decade ago, the more aggressive lenders such as Wachovia, Countrywide and Washington Mutual were actually reporting negative net default rates, suggesting that extending credit had no cost – in large part because the value of the collateral behind the loans was rising. In those heady days of comfortable collective delusions, non-current rates for 1-4 family loans were below 1%, the lowest levels of delinquency since the early 1990s. This situation changed rather dramatically by 2007, when several large west-coast non-bank mortgage lenders collapsed. By the start of 2008, funding for banks, non-banks and even the GSEs was drying up and default rates were rising rapidly. The cost of credit reappeared. Net-charge off rates for 1-4 family loans in particular went from 0.06% early in 2005 to 1.5% by the end of 2008 and peaked at 2.5% by the end of 2009. Today the irrational exuberance of the Federal Open Market Committee has created huge asset price bubbles in sectors such as residential and commercial real estate. A combination of low rates, a dearth of home builders (down 40% from ~ 550k firms in 2008 to ~ 330k firms today) and even less construction & development (C&D) lending (down ~ 30-40%) has constrained the supply of homes. But low rates sent prices for existing homes soaring multiples of annual GDP growth – both for single-family and multifamily properties. Keep in mind that the folks on the Federal Reserve Board think that asset price inflation is helpful – thus the “wealth effect.” Specifically, the FOMC believes that manipulating risk preferences, credit spreads and therefore asset prices helps the economy to generate more income and employment. Many analysts have debunked the notion of a “wealth effect,” but the FOMC persists in this thinking even today. Mohamed E-Erian writing in Bloomberg has it right: “Forced to use the 'asset channel' as the main vehicle for pursuing its macroeconomic growth and inflation objectives – that is, boosting asset prices to make consumers feel wealthier and spend more, and also to increase corporate investments by fueling animal spirits – the Fed has ended up providing exceptional multiyear support to financial markets using an experimental array of unconventional tools and forward policy guidance. Indeed, most investors and traders are now conditioned to expect soothing words from central bankers – and, if needed, policy actions – the minute markets hit a rough patch, virtually regardless of the reason.” In an economic sense, the Federal Open Market Committee is the heart of the Administrative State. The use of the “asset channel” to pretend to boost economic activity is part of the larger delusion at the Fed known as “macro-prudential” policy. The macro-prudential worldview sees the Fed as an all knowing, all-seeing global managerial agency that can somehow balance goosing economic growth using asset bubbles with preventing the associated systemic risks. Note that regulating whole industries and constraining growth is, in fact, a key part of the Fed’s macropru model. Having maintained low interest rates and used trillions of dollars of bank reserves to fund open market purchases of Treasury bonds and agency mortgage paper, the FOMC now faces an asset market that has understated the cost of credit for over a decade. From 2001 through 2007, and then 2009 through today, the FOMC has boosted asset prices – but without a commensurate and necessary increase in income. The Fed has, to paraphrase El-Erian, decoupled prices from fundamentals and distorted asset allocation in markets and the economy. SO the question that concerns The IRA is when will the credit cycle turn and how much of the apparently benign credit picture we see today is a function of the Fed’s social engineering? If this latest round of Fed “ease” is more radical than that seen in the early 2000s, will we see an even sharper uptick in bank loan loss rates than we saw in 2007-2009? Total Loans Let’s start with the big picture perspectives of all US banks using our favorite chart, which juxtaposes pre-tax income with provisions for credit losses in the chart below. Note that quarterly pre-tax income for all US banks has slowly crawled back over $60 billion, resulting in net income in the low $40 billion range. The industry’s average tax rate was just below 30% on the $18.8 billion in taxes paid in Q1 2017. Source: FDIC Looking next at the $9.3 trillion in total loans for all US banks, the picture in the chart below is relatively calm. Note that the rate of non-current loans at 1.3% is still elevated above pre-crisis levels as are net loan charge-offs. Also, particularly note that in 2009 all non-current loans spiked to over 5%, yet net-losses after recoveries (loss given default or “LGD”) peaked at just 3%. Source: FDIC Loss given default at 75% is near the historic lows seen in 2006 and previously in the early 1990s. Think of LGD as the inverse measure of recoveries since the quality of the collateral behind the bank’s loan is the key determinant. Industry LGD for all bank loans fell to a low of 70% in 2014 when the bubble in residential and commercial real estate was roaring. Rising LGD for all bank loans today suggests that the bloom is off the rose in bank loan portfolios. Source: FDIC 1-4 Family Loans The $2.4 trillion in loans secured by 1-4 family residential properties is actually smaller in absolute terms and as a percentage of the bank balance sheet than it was a decade ago. In Q1 2000, loans secured by 1-4 family homes were 32% of total bank loans, but today that same metric is just 25% of total loans. Keep in mind that bank balance sheets have more than doubled since 2000 from $4.3 trillion in total loans to $9.3 trillion today. How’s that for an inflation indicator? Sales of residential mortgages in the agency and government market are also down sharply for all US banks, reflecting a secular migration by banks away from 1-4 family mortgage loans as the asset class of choice for American banks. Compliance risks and high operating expenses make the residential mortgage sector among the lowest return on equity asset classes. With non-current rates still at 3% vs 1% for the decade before the 2008 crisis, the credit quality of bank portfolio loans does not seem to have improved looking at the numbers. Net charge-offs at 0.4% are back down at pre-crisis levels. Looking at the chart below, loan losses seem to have been suppressed for almost two decades starting in the early 1990s. Source: FDIC More interesting, however, is the sharp, falling off the cliff movement of LGD for 1-4 family mortgages. Since the 2008-2010 period when LGDs were near 100% of the total unpaid principal balance, today loss given default for the average bank portfolio home loan is just 40% and lower than at any time since 1990. The chart below really shows the effect on credit performance of the Fed-engineered increase in asset prices since the financial crisis. But when do we revert to the mean? Source: FDIC So while the percentage of 1-4 family mortgage loans past due remains high, LGD is at all time lows. Go figure. Again, the principal driver of low loss rates seems to be the double digit home price appreciation since 2012. Credit Cards Another asset class that has been very popular with investors and the financial press of late is bank credit cards. The industry’s $750 billion in total portfolio credit card loans has seen non-current and default rates rising. The chart below shows noncurrent loans vs. charge-offs. Unlike other loan categories, notice that charge-offs of bad credit card debts are above the rate for noncurrent loans. Source: FDIC Capital One (NYSE:COF) warned last quarter on future defaults. COF saw net charge-off rates rise 42 bps year over year to 2.50% compared to the industry average of 3.6%, a statistic that suggests there are some far riskier books in the industry besides just-below-prime operations such as COF. Further, COF reported that provision for credit losses surged 30% from the year-ago quarter to $1.99 billion. Sadly the FDIC does not release publicly the data on provisions for future losses by loan type, an important piece of information that would enrich the public record. The chart below shows LGD for the credit card portfolio of all US banks. Notice this is a pretty stable metric for loss net of recoveries that fluctuates between 80-90% of the loan amount. Source: FDIC “During the first quarter, banks charged-off $11.5 billion in loans, an increase of $1.4 billion (13.4 percent) over the total for first quarter 2016,” notes the FDIC’s Quarterly Banking Profile. “This is the sixth consecutive quarter that charge-offs have posted a year-over-year increase. Most of the increase consisted of higher losses on loans to individuals. Net charge-offs of credit card balances were up $1.3 billion (22.1 percent), while auto loan charge-offs increased $199 million (27.7 percent), and charge-offs of other loans to individuals rose by $474 million (66.4 percent).” C&D Loans Today the world of real estate construction lending is very different than before the 2008 financial crisis. A decade ago, much of the C&D book was focused on single-family homes. Today banks focus on commercial and multifamily properties. The latter category has tended to be rock solid in the major metro areas, even through the 2008 crisis. From 2008 to 2010, about 1/3 of the ~ $600 billion C&D portfolio for all US banks was charged off, restructured or repaid. New lending dried up. This left a lasting caution on the part of regulators and the industry when it comes to lending on dirt. In the beginning of 2008, the total bank C&D portfolio in the US was $631 billion, but today it is just $390 billion. In 2008, there was $180 billion in 1-4 family residential construction loans held by all FDIC insured banks, but today there is just $70 billion. When you consider the factors behind the lack of supply in single family homes in the US, start with the sharp reduction in credit for the construction sector. And recall that bank balance sheets have grown 20% since 2008, so the proportion of bank portfolios allocated to financing housing construction has also dropped sharply relative to other loan types. Source: FDIC But to really see the handiwork of the FOMC, you need only look at the loss given default for C&D loans. During the early 1990s and the 2008-2012 periods, note that LGD was nearly 100% of the loan amount. Banks in the Southeast and Southwest failed in droves as development loans were taken to the curb and then written off entirely. But since 2012, the market manipulation of the Fed has caused LGDs on construction and development loans to go sharply negative, suggesting that this credit exposure has no risk or cost. In mathematical terms, recoveries on defaults are exceeding charge-offs by a wide margin, suggesting that asset prices for land and improvements are rising very rapidly. There may also be some resolutions of past defaults in the data -- going back five years or more. Source: FDIC So how does this all end? In the short term, look for default rates on consumer exposures to continue rising. But in asset classes like commercial real estate, residential homes and C&D lending, we suspect that the party may continue, at least in statistical terms, through at least the end of the year. After that, however, we full expect to see loss rates and LGDs start to snap back to the middle of the proverbial distribution. As one well-placed bank CEO told The IRA over breakfast, “there are lots of sweaty palms” in the New York commercial real estate market. Read this little missive in The New York Times about the Park Lane Hotel to get a sense of the level of exuberance in the commercial real estate market in Gotham. Without a rather robust confirmation of asset prices with rising incomes, as El-Erian and many others have observed, current levels of assets prices are unlikely to be maintained. In the event, look for bank default and recovery rates to normalize, with a sharp increase in credit costs for lenders and bond investors alike. Trees do not grow to the sky, credit costs are never really negative, and last we looked, Fed chairs cannot fly through the air or spin straw into gold. But they can manipulate asset prices and cause other mischief that, we suspect, represents a net cost to consumers and investors alike. But this is hardly a novel state of affairs. In that regard, we appreciate your comments about our earlier missive, “Buy Britain, Sell Europe.” Many of you challenged our idea that Britain is an enduring nation state, while the EU is merely a bad idea whose sell by date has passed. To address these comments, we refer to one of our favorite reads of late, “Playing Catch Up,” by Wolfgang Streeck. The emeritus director of the Max Planck Institute for the Study of Societies in Cologne, Streeck writes regularly for the London Review of Books . He is ready to suspend democratic processes to support “willing governments” that advance German-style reforms, but Streeck has a cogent view of the European political economy: “Here, as so often in her long career, Merkel is anything but dogmatic, and certainly isn’t beholden to ordoliberal orthodoxy since what is at stake is Germany’s most precious historical achievement, secure access to foreign markets at a low and stable exchange rate. For several years now, Berlin has allowed the European Central Bank under Draghi and the European Commission under Juncker to invent ever new ways of circumventing the Maastricht treaties, from financing government deficits to subsidising ailing banks. None of this has done anything to resolve the fundamental structural problems of the Eurozone. What it has done is what it was intended to do: buy time, from election to election, for European governments to carry out neoliberal reforms, and for Germany to enjoy yet another year of prosperity.” Sound familiar? In the US as well as Europe, what passes for fiscal and monetary policy are merely a series of short-term expedients meant to get us from one day to the next. The nonsense of macro-prudential policy represents the apex of such thinking. As we look out to credit conditions in the US banking sector in 2H 2017 and beyond, the one sure bet is that the cost of credit will not remain suppressed forever. #bank #credit #COF #macroprudential #macropru #FOMC #assetbubble

“Europe is now a continent of widespread economic misery, of financial collapse, of disappearing faith in ‘mainstream’ political parties and rising support for ‘extremist” parties, of a loss of sovereignty and thus of legitimacy and democratic control, and of the destruction of law, both domestic and international, by the judicially larcenous European Court of Justice (sic).” Bernard Connally Rotten Heart of Europe: The Dirty War for Europe's Money 1997/2012 With the elections in France safely recorded as a win for the pro-EU forces, the bull migration back into European equities has begun. Our usually sensible friends at Barron’s declare the raging bull buy signal on this week’s cover: “Buy Europe.” And by Europe, they mean excluding the United Kingdom. “Given attractive valuations, diminished political risk, low interest rates, and a pickup in global growth, international markets, and Europe in particular, could finally start to outperform,” declares none other than Vito J. Racanelli. The driver of the EU bull trade? Emmanuel Macron’s ambitious plans to rebuild the eurozone. His plan has been backed by Germany’s Finance Minister Wolfgang Schäuble, who wants to push deeper European Union (EU) integration. Go deeper or go home pretty much sums up the situation facing the Europeans. Most analysts have been focusing on the downside for the UK in a BREXIT scenario, but we wonder whether the EU is really viable – with or especially without the UK. Even as the cheering for the victory of Macron is dying down in Paris, officials of the International Monetary Fund are preparing for a new debt bailout for Greece. And then comes Italy. The IRA also notes that the “experts” have consistently underestimated the prospects of the UK post BREXIT, all the while waxing effusive about Europe. The dire predictions regarding the future of the UK economy, for example, have been largely wrong. The experts seem to miss the basic fact that the UK is a key player in global finance and will continue to be after it leaves the EU. United Europe, on the other hand remains a badly flawed work in progress that, for our money, has a better than 50/50 chance of outright failure. Everything written two decades ago by former EU economist Bernand Connolly in his classic book “Rotten Heart of Europe” has been proven correct and then some. Last week we got to catch up with Brian Barnier of ValueBridge Advisors LLC, who we first met while fishing up at Leen’s Lodge in Maine. He confirmed our suspicions that the EU project is in far more fragile condition than its departing member. More, Barnier says that most models of the long-term impact of BREXIT on the UK are fatally flawed and often rely only on aggregate averages for inputs, ignoring extensive details from statistical agencies in Europe. Barnier is an economist who asks questions. Rather than just accepting the output from a given model or data source, he likes to ask what is in the model. Like fully understanding what is in the chopped salad at the Greek diner. And he delights in asking model-building economists uncomfortable questions like “are you using the correlation factors from the SAS package or are you calculating them yourself?” For example, Barnier wonders why so many analysts projects a ponderous EU process for negotiating trade agreements with the UK – especially when the UK already has a dozen trade agreements ready to go and others in process. Good question. When he is not consulting for institutional investors, Brian is the proprietor of Fed Dashboard & Fundamentals , a portal dedicated to spreading economic enlightenment by highlighting errors and discrepancies in official data and how it is used to guide official policy around the globe. In a recent FDF comment, he noted that “BREXIT will unnecessarily hurt shoppers in the UK and EU unless governments recognize that prices of different products don’t necessarily move together and that inflation doesn’t necessarily cause growth.” “In the Euro area, consumers have enjoyed low average price increases over the past few years; often buying more as prices fell. This defied the European Central Bank’s (ECB) expectations that rising prices over time are needed if purchases are to grow. Thus, the ECB reacted to the perceived danger with aggressive monetary medicine,” Barnier continues. Of course, the whole point of “quantitative easing” in Europe has not been to promote growth but instead as a palliative form of hospice care for insolvent sovereign debtors such as Greece and Italy. The decline of inflation from 5% peak in 2009 to half that rate today certainly is a problem when it comes to monetizing sovereign debt. As Moritz Kraemer, S&P's head of sovereign ratings, told Tom Keene of Bloomberg News this week, the credit standing of EU nations is “going sideways” rather than improving. He also notes that unemployment in the EU is almost 10%, far higher than before the financial crisis. But Kraemer, like most observers, persists in thinking that the UK is the big loser in BREXIT. Thus we sat up in our chairs when Barnier next advanced the view that the EU and not the UK is most threatened by BREXIT. The whole bull thesis about Europe is that the French elections open the door to new prosperity in Europe while the UK must carefully negotiate an exit with Brussels. Barnier, on the other hand, declares that the negotiations are over and that the UK government led by Theresa May basically told the EU to sod off when it comes to large alimony payments. A “disastrous” meeting at the end of April between British Prime Minister Theresa May and European Commission President Jean-Claude Juncker apparently marks the end of any idea of a large British payment to essentially buy a smooth exit. As Juncker said of May: “I have noted that she is a tough lady.” Right. Wolfgang Münchau, writing in the Financial Times , thinks the EU miscalculated the mood of the British people when it offered David Cameron "a rum deal" before the Brexit campaign began in earnest. He adds that Brussels should learn from that error and be sure not to repeat it. And the mood of PM Theresa May is particularly noteworthy. We recall the excellent essay last Fall in The London Review of Books , “ Home Office Rules ,” by William Davies. He explained that: “[May’s] long tenure (six years) and apparent comfort at the Home Office suggests that the mindset may have deepened in her case or meshed better with her pre-existing worldview. This includes a powerful resentment towards the Treasury, George Osborne in particular (whom she allegedly sacked with the words ‘Go away and learn some emotional intelligence’), and the ‘Balliol men’ who have traditionally worked there. In making sense of May’s extraordinary speech at this year’s Conservative Party Conference, the first thing to do is to put it back in the context of her political experience. For her, the first duty of the state is to protect, as Hobbes argued in 1651, and this comes before questions of ‘left’ and ‘right’.” He continued: “Home secretaries see the world in Hobbesian terms, as a dangerous and frightening place, in which vulnerable people are robbed, murdered and blown up, and these things happen because the state has failed them. What’s worse, lawyers and Guardian readers – who are rarely the victims of these crimes – then criticise the state for trying harder to protect the public through surveillance and policing.” Indeed, May could be as much of an outsider as Donald Trump, albeit one that grew inside the state from a career as a professional politician instead of from outside as a business mogul. And she leads Britain combining a decidedly domestic political perspective with a deep knowledge of the workings of that country’s administrative state. The best advice for President Juncker seems to be don’t mess with this lady. With the EU itself predicting flat GDP growth below 2% through 2019, it is hard to get behind some of the enthusiasm of our colleagues for the European trade. The fact that the Germans and French are falling in love again does little to cheer the nations of Eastern Europe, which are among the most dynamic and fastest growing parts of the EU. In fact, the rush into Europe looks an awful lot like the bull market stampede last October that took US financials up 20 and even 30% and more by the end of March. There are increasingly hyperbolic comments coming from Sell Side analysts about European valuations relative to opportunities in the US and Asia. But when we consider the underlying economy, it seem hard to reconcile the exuberance with the appalling data. Meanwhile we note that Greek Prime Minister Alexis Tsipras seems to be running out of political support and Greece is running out of cash, again (despite the current account surplus). Say what you might about the promise of Europe, the UK made the right decision to keep a foot outside of this experiment in statecraft. And say what you will about the new “unity” in Europe after the Macron victory, the UK has ‘first-leaver” advantage. We are far more bullish than the consensus on the prospects for the UK economy separate from the eurozone and far more cautious on the European project. To us, the UK is going to evolve into the Singapore of Europe as what remains of the EU must decide if they will pay the price of unity. So far, the EU’s response to that question has been QE care of Mario Draghi and the European Central Bank. But the only way that the EU can survive is to take a more aggressive and authoritarian approach towards weaker members. Thus we see Wolfgang Schäuble tightening his grip on Greece even as political tensions in that country continue to grow. The Daily Express notes that Greek protesters took to the streets in recent days to react to more demands that the country cut pensions by up to 18 per cent. Rather than new unity in Europe, we see a continued process of the Huns bullying the weaker nations, first up being Greece and then likely followed by Italy. This is hardly a formula for economic recovery and growth.