SEARCH

In an October 1925, speech in Birmingham, Michigan, Senator James Couzens , the business partner of Henry Ford, sketched out a vision of "good" businessmen, who are ethical, and "bad" businessmen, who are unscrupulous in their dealings with the public, the ultimate consumer. If you protect the markets from fraud, Couzens argued, you ultimately protect the consumer. The optimistic assumption in the 1920s was that industries could be exhorted and led to ethical behavior by the example and standard-setting of their own business leaders. Today we have given up on people doing the right thing without coercion. Instead we rely upon regulators and experts of varying flavors to moderate and oversee commercial behavior. Thus there is a bias in favor of regulated industries and a negative view of the private sector. For example, there is a constant refrain from the regulatory community when it comes to commercial banks vs. nonbanks. Simply stated, the latter are seen as acts of evil that are inferior to regulated institutions. Leonid Bershidsky, writing for Bloomberg View awhile back, embodies this perspective, chiding “shadow banks” for engaging in “regulatory arbitrage” vis-à-vis the blessed world of regulation. But nothing could be further from reality. Non-banks represent the private sector, the baseline for economic activity. Banks are government sponsored entities with implicit sovereign support. Most of the major rating agencies, for example, assume a degree of “lift” for the credit ratings of the largest US banks because of the presumption of support for the depositors of these mega depositories in times of crisis. We should remember that the regulators who supposedly make commercial banks safer than non-banks have an appalling track record. One word: Citigroup. Regulators failed to predict or avoid financial crises such as 2008 and 2001 before that, to name just two financial events. Our beloved regulators pander endlessly to consumers, but routinely ignore acts of fraud in the world of securities and institutional investors. The false narrative says that the abuse of consumers caused the 2008 financial crisis, but in fact it was widespread securities fraud by the largest banks. Nonbank lending institutions actually must play by the same rules as the banks, except they have no balance sheet and no cheap backup funding from the Federal Reserve Bank or Federal Home Loan bank. Non-bank mortgage firms, for example, are forced to affirm their credit every day because they often fund their business via short-term bank loans. Non-banks with investment grade ratings typically run at leverage ratios of 5:1 or less, but some asset classes such as aircraft, rail cars and other types of transportation assets can and do support higher leverage. Regulated banks by comparison can run at 15:1 leverage on balance sheet and more if they use off-balance sheet (OBS) financing, the core systemic risk issue behind the 2008 financial crisis. Just as large corporations use OBS transactions to hide taxable income offshore, (see The National Interest , “America Reaps Few Benefits from Trump's Tax-Cut Proposal” ), commercial banks have long used special purpose entities to hide leverage. Think about that for a minute. Even with the bank’s huge advantages over non-banks in the form of public subsidies such as the discount window and federal deposit insurance, structural subsidies that support higher leverage rates, regulated banks still feel the need to cheat in terms of disclosure of risk exposures squirrelled away in a special purpose vehicle somewhere offshore. The behavior of regulators and journalists generally towards non-bank companies illustrates the statist drift towards a largely regulated environment in the world of finance. In the fantastic world of “macroprudential” policy, regulators soar like star ship pilots who guide the economy and oversee financial institutions simultaneously. European Central Bank governor Mario Draghi typifies this “superman” syndrome. But central bankers do not see all banks as being created equal. For macro economists turned central bankers, a few large banks are preferred to a myriad of smaller banks and non-banks, which are all seen as too troublesome (to regulators) to have any economic utility. Regulators are openly contemptuous of smaller banks and non-banks alike, one reason why the research community treats non-banks firms with such slight regard. Just to illustrate the enormous skew in the thinking inside the Federal Reserve System, an April 10, 2017 blog post by The Federal Reserve Bank of New York, “Financial Crises and the Desirability of Macroprudential Policy,” actually advances an explicit justification for subsidizing large banks in times of market stress. The blog states: We use the model to consider a subsidy on bank equity issuance. That is, for example, for every $1.00 in equity raised, the government would contribute an additional $0.10 in equity. The goal of this regulatory scheme is to induce banks to raise more equity, thereby contributing to strengthening their balance sheets. The first thing to notice is that the folks at the FRBNY are worried about absolute levels of capital rather than bank behavior. In times of market stress, whether a bank is raising capital or not generally does not matter. The reserve of confidence with the bank’s counterparties does matter. The confidence of financial counterparties is a reflection of consistency and character, not capital. Focusing on good governance and the presence of dubious OBS financial transactions is more important for crisis avoidance than the level of capital. Only the fact that the government is the buyer of large bank equity, in the FRBNY proposal, would provide additional credit support to the issuer. Thankfully, the article does note that, above a certain level, a subsidy for large banks is “a cost to society with little or no benefit.” But the FRBNY article never asks if, as a general matter, it as a good idea to support a large, zombie banks with public funds. Like large auto manufacturers, the largest banks generally don’t even earn their nominal cost of capital. Is it really good public policy to support these regulated monopolies at any time? Maybe President Trump is right when he considers breaking up the top four money center banks. What would a mega bank break up entail? Easier than you might imagine. If we disassembled the four largest banks and ended up with 6-8 specialized consumer and wholesale banks with between $500 billion and $1 trillion in assets, the US markets would function far better. Add to that another 8-10 large non-bank broker dealers led by the likes of Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), focused on capital markets and wealth management, and you have an extremely competitive and dynamic capital finance marketplace. Hint: There are several new, emerging broker dealers that are owned by Buy Side firms. For good measure, let’s consolidate the top 20-30 non-bank mortgage seller/servicers down to about 4-5 large platforms, each with hundreds of thousands of loans in their servicing portfolio. These larger mortgage platforms will be more stable in terms of liquidity, perhaps profitable and, maybe, would actually have the money to invest in technology. We might even introduce these large non-bank mortgage firms to some large community banks. Hey, you never know. Suddenly the “risks” of non-banks may start to take on a new complexion for members of the public research, journalistic and regulatory communities. The point of this tirade is that non-banks are not “bad” banks. They just don’t have the fat subsidies that federally insured and regulated commercial banks take for granted. If we focused on important issues, namely preventing systemic crises via regulation of deceitful OBS transactions and broadly enforcing rules against securities fraud, the entire concern about capital for banks and non-banks alike would assume a far smaller part of the public narrative. You can tell a good bank or non-bank from a bad apple by whether they (or their clients) cheat on disclosure of risk and/or taxes in their off-balance sheet transactions, the ultimate source of systemic risk. For example, if a bank or non-bank has a whole department that specializes in constructing innovative tax and/or investment strategies for clients using offshore financing vehicles, then beware.

What do the US residential housing market, the stock market and the dollar all have in common? All of these markets represent bubbles created and driven by the aggressive social engineering of the Federal Open Market Committee. Will live in an age of asset bubbles rather than true economic growth. The investment world is skewed by the latest round of monetary policy experimentation by the Fed, including years of artificially low interest rates and trillions of dollars in “massive asset purchases,” to paraphrase former Fed Chairman Ben Bernanke. These bubbles are caused and magnified by supply constraints, not an abundance of credit. Whether you look at US stocks, residential homes in San Francisco or the dollar, the picture that emerges is a market that has risen sharply, far more than the underlying rate of economic growth, due to a constraint in the supply of assets and a relative torrent of cash chasing the available opportunities. Likewise with the dollar, the image of the financial markets is one of constraints rather than policy ease. Since the middle of 2014, the value of the dollar against major currencies has risen sharply, suggesting a shortage of liquidity or at least a relative preference for dollars vs other fiat currencies. The vast flow of foreign direct investment drawn into the US and then into asset classes like residential and commercial real estate illustrates the abundance of global dollar liquidity and relatively scarcity of assets. Even with the supposedly accommodative policy by the FOMC, key measures of market liquidity continue to suggest either price and/or structural constraints, both in the US and overseas. Looking at the effective cost of dollar credit, for example, illustrated by the notorious London Interbank Offered Rate or LIBOR, the cost of borrowing dollars in Europe has risen steadily risen since the Middle of 2015. Again, the chart below makes us wonder if the good folks on the FOMC appreciate the degree of fundamental demand for dollar credit. With the end of the Mortgage Bankers Secondary Market Conference in New York, American lenders face a market with new origination volumes down 25-30%. Meanwhile, the reinvestment of prepayments on $1.7 trillion worth of mortgage backed securities (MBS) held by the FOMC is essentially taking up new bond issuance by Fannie, Freddie and Ginnie combined. We have been on the record saying that the FOMC should adjust its portfolio now to accommodate private market demand for yield. And there is no need for actual sales. Simply ending the Fed’s reinvestment of mortgage bond prepayments would allow the interest rate markets to find a natural level and, to us, give the Fed a more accurate picture of demand upon which to adjust supply. "I think they're aiming for something in the vicinity of $2.3 to $2.8 trillion, something like that," former Fed Chair Ben Bernanke said Monday on CNBC's "Squawk Box." Ending reinvestment of the Fed’s MBS portfolio would lead to a net monthly runoff rate in high double digit billions of dollars. Or to put it another way, it is time for the FOMC to get out of the way of the private market. Shrink the Fed’s bond portfolio and credit the reserve accounts of the banks. It seems that many market indicators such as the dollar and LIBOR suggest a market that is either schizophrenic or dysfunctional. Our guess is the latter, in part due to excessive prescription-based regulation of traditional banking and finance, particularly low-margin money market businesses which are being abandoned by the big depositories like JPMorgan (NYSE:JPM) and The Bank of New York Mellon (NYSE:BK). There are seismic changes going on in the world of trading cash securities and collateral lending, changes that see a host of non-banking firms returning to this traditional nonbank space. Staring at these charts for the dollar and LIBOR, we wonder how much of the upward price movement is caused by legal and regulatory changes occurring over the same periods. The clear question from all of this: What happens when this latest dollar super cycle ends? Given that zero or negative rates elsewhere are driving much of the emigration into American assets, why should the dollar ever selloff, right? Regards the prospect of a dollar drop, Megan Greene tells us on Twitter that “Only way I see it in the short-run is if everyone else gets in trouble and the Fed opens swap lines w other CBs to supply QE #unlikely We hear all of that, but can’t help but ask the question. All things do come to an end, including the seeming ability of the FOMC to painlessly levitate the fortunes of heavily indebted nations on a sea of easy dollar credit. This works really well when the dollar is strong, otherwise not so much. #JPM #Bernanke #dollar

Last week The IRA’s Chris Whalen participated in the Executive Roundtable in San Francisco, hosted by the Morrison Foerster Law firm. We got to hear from a lot of different representatives of the mortgage and fintech sectors. The big worry at the table is that production of new mortgages in 2017 is down about 30% compared with last year due to the rise in interest rates following the November election of Donald Trump. Trump politics drives interest rates higher and mortgage production falls. Just as the Executive Roundtable meeting was ending, news crossed the screen that the Consumer Financial Protection Bureau (CFPB) and a number of states were imposing new sanctions on mortgage servicer Ocwen Financial ( NYSE:OCN ). CFPB head Richard Cordray (pictured above) was formerly attorney general in OH, where he used his legal power to extract millions in settlements from private mortgage companies. A key political ally of Senator Elizabeth Warren (D-MA), Cordray represents a new generation of liberal politicians who use the power of regulation to impose legal settlements and fines as a means to achieve political power. Trial lawyers and event driven hedge funds follow Warren and Cordray like crows. White House economic czar Gary Cohn reportedly gave Cordray an ultimatum over dinner a few weeks ago to resign from the CFPB. Cordray declined President Trump's invitation to leave public life and instead launched a new assault on subprime mortgage servicer Ocwen Financial, which was accused last week of operational deficiencies by the CFPB and a number of states. Regulators have been bleeding Ocwen dry with fines and monitoring costs for years, but this latest move by Cordray amounts to a not-too subtle “Foxtrot Yankee” to the Trump Administration. Just by coincidence, as the CFPB and states announced their action against Ocwen, the stock was simultaneously hit by waves of short-selling from hedge funds and several new class action lawsuits, all this in less that 24 hours. This week, subscribers to Whalen’s Financial-Technology Investor can read my assessment of the Ocwen situation. Click this link for information about the special offer for readers of The Institutional Risk Analyst. There was much discussion in SF last week about efforts to expand the mortgage credit box. The good news is that interest rates are falling, with the 10-year Treasury now down to 2.2% from the peak of 2.6% several months ago. The tentative bad news, however, is that mortgage volumes are only slowly starting to recover at all from the Trump Bump. The first quarter of 2017 was for single-family mortgages what Q1 2016 was for commercial real estate asset-backed securities (ABS) – that is, dreadful. Down a lot more than 30% to put it mildly. Mortgage origination pipelines seem to be better in April, however, and mortgage banks are now delivering loans into agency securitizations with 3% coupons instead of the 3.5% coupons seen at the start of 2016. Our friend and TBA market watcher Adam Quinones at Reuters writes: “The range is no longer the range and while breakout energy has been largely contained thus far, the rally is impacting pipeline hedging strategies. Naked C30 pricing now pays a premium on 3.75 and 3.875 notes. That puts FNCL 3s back in the delivery mix. Once lenders start showing these levels to LOs [loan officers] in size, late 2016/early 2017 borrowers will see their option jump in the money. Swapping coverage down-in-coupon is an aggressive decision at this point but everyone should be preparing for a sudden shock in pull-through volatility. One or two major aggregators flipping to BestEx [best execution] the buyup is all it takes to trigger a mini-churn event here. Don't think originators are that responsive to a small dip in rates? Think again. It was a rough Winter.” In other words, the attractiveness of selling residential mortgage loans into agency markets is growing as rates fall. More, residential mortgage refinance volumes may come back later in 20017 -- assuming that Washington does not cause another "bump" in interest rates. But watch that interest rate and spread volatility. Another topic that came up at the Executive Roundtable during discussions of the Trump Bump was whether the major banks and especially JPMorgan Chase (NYSE:JPM) and Bank of America (NYSE:BAC) would re-enter the market for Federal Housing Administration (FHA) loans. The short answer is not yet, both because of concerns about punitive action by the Department of Justice and other, operational factors. JPM chief Jamie Dimon has been very clear on his views of the Washington situation and the financial and reputational risk that comes from originating FHA loans in his shareholder letters. One suspects that this issue is on a list somewhere in Washington, but the recent actions by the Consumer Financial Protection Bureau (CFPB) against Ocwen Financial hardly inspire confidence in this regard. And the Department of Justice litigations with both PHH Corp (NYSE:PHH) and Quicken Mortgage continue unabated. But some banks like the FHA market. Mortgage industry Maven Rob Chrisman notes that WFC is already changing pricing on FVA loans to become more competitive: “Regarding FHA loans, did you see Wells Fargo's price changes for low balance FHA loans this week? (Starting May 1, see how the pricing works for a low-FICO borrower, and you're calculating in a 3, 4, or 5-point hit.) It is generally believed that JPMorgan Chase would return to offering that program on a competitive basis IF the regulatory, and penalty, environment changed. And if they do, the market share will be taken from smaller independent mortgage banks who have been enjoying the profits.” Chrisman further notes that mortgage banking earnings for JPM, WFC, and PNC Financial (NYSE:PNC) were down in the first quarter but largely in line with expectations. The decrease in Q1 2017 earnings was driven by lower origination volumes, he notes, while gain-on-sale (GOS) margins were mostly flat. “JPM's mortgage origination volume of $22.4 billion was down 23% Q/Q from $29.1 billion while WFC's origination volume was down 39%. WFC's application pipeline was down 21%, which was slightly worse than expected. Both companies reported flat gain on sale margins,” Chrisman reports. The bottom line with the big banks and the FHA market is that when the risk-adjusted returns make sense and the threat of government litigation subsides, then the banks will return. So much of banking today is a function of risk-adjusted returns, both operationally and from a regulatory perspective. If the numbers don’t meet the economic and regulatory hurdles, then the banks will shed market share or even get out of the asset class entirely. Single family home finance has been a chief victim of the emigration of banks out of residential mortgage originations, but the same risk adjusted returns calculus is also pushing many banks out of prime auto lending and ABS. The numbers in prime auto simply do not work when you consider the rising cost of loan origination and servicing, the indirect regulatory risks, and the poor execution into ABS. The decision by Citigroup (NYSE:C) to sell its mortgage servicing business illustrates this trend. But also recall that WFC got out of residential mortgage lending entirely in the early 1990s. Mortgage lending is a negative cash flow business and servicing too has historically been a cost center at most banks. Legacy banks and non-banks, as a result, both suffer from profound operational inefficiency. Historically banks could subsidize the lending and servicing businesses, but less efficient non-banks cannot, especially the monoline servicers will no significant lending business. One reason that shops like Flagstar (NYSE:FBC), PennyMac (NYSE:PMT) and new entrant Amerihome, which is owned by insurer Athene (NYSE:ATH), are able to be successful is the fact of being both a lender and servicer. Operating efficiency and capital markets sophistication, however, are other key advantages enjoyed by these relatively new, large and growing platforms. Another fascinating aspect of the conversation in SF was fintech and how different players were disrupting the established order. We heard presentation from SoFi, who has figured out a way to use restricted stock units (RSUs) from millennials working at tech companies as part of the income calculation for a jumbo mortgage. The logic goes that an RSU counts as income on your taxes, so why not include as part of the assessment of ability to pay and DTI. Is this a great country or what?? We also heard from Donald Lampe, Partner at Morrison Foerster, on the outlook for regulatory reform. “Not clear where Dodd-Frank reform fits into the Trump agenda, but evidently not in top three,” notes Lampe, who is based in Washington and is an astute observer of the political process. “Dodd-Frank statutory reform is not easy in Congress, especially in the Senate – it’s still gathering steam in the House. And even the Courts (D.C. Circuit) will have a say in any reforms,” he cautions. Doug Duncan of Fannie Mae and Mike Fratantoni of the Mortgage Bankers Association held forth on the outlook for the economy and the housing sector. Suffice to say that MBA has GDP growth at 2% this year, declining to 1.9% in 2018 and 1.7% in 2019 – even with Trump factored into the equation. They see total loan originations down 25% at $1.6 trillion in ’17 and ’18, then rising back to $2 trillion in 2019. Not good news for originators focused on loan refinancing. So the basic prognosis for the mortgage industry is that volumes will remain depressed by substantial shrinkage in refinancing volumes, but look for some purchase volume growth as the proverbial credit box widens accordingly. The sudden buzz around new products such as fractional interest mortgages in going to be sustained and grow louder as originators and aggregators look for new and innovative ways to fill the purchase loan pipeline to drive ABS issuance. In this regard, note the new blog created by Weiss Analytics focused on the US housing sector. The latest blog posting from Weiss notes that “US Housing Crosses the Great Divide” as the number of homes rising in heretofore red hot markets is starting to fall, even as the number of homes falling in value is increasing. Unlike other measures of home price appreciation, Weiss actually values tens of millions of individual homes. Could the secular bull market in single family homes going back to 2012 finally be ended? Don’t look for home prices to fall very much, but the continuous rise in home price appreciation at multiples of income and GDP growth may have finally outrun consumers’ ability to borrow and pay. But like public stocks, the residential home market faces a persistent shortage of supply, which will likely keep valuations from falling too much in the most desirable locations.

This week provides an interesting comparison between two “financials,” Bank of America (NYSE: BAC) and Goldman Sachs (NYSE:GS). The former is the best performing large bank stock in the US over the past six months, while the latter just disappointed on both revenue and earnings. Before we get into that, the link below announces the launch of my new venture with the folks at Agora Financial, Chris Whalen’s Financial Technology Investor . There is a special limited time offer for readers of The Institutional Risk Analyst . Please take a moment to read this exciting announcement. Become a Charter Member of Christopher Whalen’s Financial Technology Investor Now let’s consider GS, one of Wall Street’s leading investment houses and also one of the most political banks in the world. There are two kind of Goldman partners – deal guys and politicos. The latter category include the likes of Robert Rubin, Hank Paulson, Jon Corzine and now Gary Cohn. Quite a list, yes? In fact, there are about a dozen or so former Goldman Sachs bankers working in the Trump Administration. This either means that the financial world is headed for a crisis or the Mother Ship on Broad Street is in some serious kimchi. Looking at the latest financial results, our informed guess is the latter. As Goldman’s CFO Martin Chavez put it: “We did underperform.” Jim Cramer at CNBC put it better: “Talk about not executing.” GS fell to a five month low yesterday after missing on both earnings and revenue. Normally the Street analysts set the bar on forward estimates pretty low, so a miss is pretty bad – especially when you are Goldman Sachs. The other issue is that the chief financial officers of large cap financials usually have a couple of cents worth of earnings in their pockets to help meet or beat, so when you miss large that is even more disturbing to investors. So what happened? Investment banking was actually up 15%, but the other business lines missed and by a wide margin. Most notable was the 22% drop in fixed income and commodities trading in institutional client services. Investment management results also fell, driven down by a 46% decline in incentive fees. Q: Was there a loss that caused the big move in results in fixed income and commodities trading in institutional client services? GS says no. Awfully big move for a failure in execution. But with all that said, the net revenue line was down just 2% sequentially and actually up 27% year-over-year, but the GS stock got hammered anyway. Remember that Q1 2016 was awful for the Street, so the YOY comparisons require a lot of seasoning. The sizable increase in operating expenses then put the kibosh on a happy ending, leaving GS with flat net income sequentially but up 80% YOY. Indeed, leaving aside the sharp rise in expenses, the YOY comparisons for all of the GS business lines were not bad, yet investors turned their backs on Goldman. Maybe more than the numbers, the damage to the aura of invincibility of the House of Goldman may be the real story in this quarter’s financial results. Meanwhile, BAC managed a significant beat in terms of both earnings and revenue. Keep in mind that going into this week, BAC had Street estimates for earnings and revenue growth that are normally associated with tech companies. In particular, BAC has taken operating expenses down more than 30% over the past five years. Operating income has stayed remarkably steady in the low $80 billion range, leading to an 1,110% improvement in net income over the past five years. What is remarkable is that CEO Brian Moynihan did not get much credit for his expense reductions until the election of Donald Trump last November. BAC then sprinted, leading the large cap financials higher, outdoing JPMorgan (NYSE:JPM) by a 2:1 margin. Total income for BAC was up 10% YOY to $22 billion, but expenses rose as well and yet were flat YOY. All of this cost cutting led to earnings up small vs Q4 2016 and $1.3 billion YOY. Fully diluted earnings were 41 cents vs 28 cents a year earlier. Hoo Rah! All of the progress made by BAC is of course splendid, but Wall Street has a notoriously short memory. Just ask the folks at Goldman Sachs. So if BAC is really going to hit the 16% earnings growth estimate for 2017 and the 21% estimate for next year, Brian Moynihan is going to need to pull multiple bunnies out of the proverbial top hat. To be specific, that means getting quarterly net income up to $5 billion by the end of 2017 and $6 billion by the end of 2018. This implies a significant increase in the assets and revenue of BAC that we simply cannot see happening in this environment. We give kudos to BAC for the great performance over the past five years, but fade the forward Street estimates on earnings and revenue growth please. Of course, nothing is impossible, as proven by the remarkable job of cost cutting and expense containment achieved by BAC so far. But if BAC can get run rate quarterly net income up to $5 billion plus by year end, then maybe this long neglected stock will manage to stay above book value. Then JPM will need to start running faster.

“Anyone taken as an individual is tolerably sensible and reasonable – as a member of a crowd, he at once becomes a blockhead.” Friederich von Schiller, Quoted by Bernard Baruch The term "magical thinking" refers to how children believe that their thoughts have a direct effect on the rest of the world. So last week we learned that the Trump Bump is not real. Lower taxes, increased spending, these were never really serious goals, but merely political talking points. Charles Gasparino and Brian Schwartz of FoxBusiness also suggested that the proposed cut in corporate taxes would instead mutate into a repatriation scheme a la Argentina and Italy. Corporate tax cuts are dead, but "a percentage of the money returning to the U.S. would be used to finance an infrastructure fund to build the roads and bridges that President Trump has recently been touting,” they report. This is bad news for Wall Street, where lower corporate taxes have been a key underpinning for the recent exuberance. As the Don mutates before our very eyes, his promise of big things and thus the outsized impact of same on financial markets will also change – and dramatically. President Trump’s change of mind on corporate tax cuts certainly goes against the happy consensus view. The move in the stock market from the latter part of last October to the beginning of March 2017 can only be described as a speculative episode, to paraphrase John Kenneth Galbraith. As he wrote in A Short History of Financial Euphoria : “Regulation and more orthodox economic knowledge are not what protect the individual and the financial institution when euphoria drives up prices, and to the eventual crash and its sullen and painful aftermath. There is protection only in a clear perception of the characteristics common to these flights of what must conservatively be described as mass insanity. Only then is the investor warned and saved. There are, however, few matters on which such a warning is less welcomed.” Indeed, while the raging bulls raised up Bank of America (NYSE:BAC) nearly 60% in four months and pushed the yield on the S&P 500 below 2%, the reality of the Trump Administration and its truly conventional nature was becoming apparent. The big statements and big ideas are abandoned without remorse as the President seeks leverage, to paraphrase our friend Jim Rickards. A key takeaway from earnings so far is that we have confirmation of a slow-down in lending and a related slowing of the economy. Retail is also in a downward phase, although the stalwart optimists in the crowd believe that the numbers will improve later in the year. And Chinese GDP beats expectations. The other obvious takeaway from earnings is that we’re pretty deep into the current credit cycle. If anything, the Fed should be thinking about mild easing. But instead Janet Yellen & Co are trying to “normalize” rates as the economy slows. The chart below shows yield on the 10-year Treasury bond less the yield on the 2-year Treasury note. Not only are interest rates falling rather than going up, but the yield curve is also flattening as the difference between long and short interest rates is squeezed. This is not a bullish chart needless to say. But even less encouraging is the juxtaposition of real GDP and the federal funds rate, an important chart that reorients your thinking about just where we are in relative economic terms and in particular the definition of “normal.” The chart below shows these two relationships and suggests to us that getting short-term rates to 3% is going to be a near impossible task. We are waiting to hear from BAC this week to see just how our favorite zombie girl justifies those impressive forward estimates for revenue and earnings growth. More than any of the top banks, BAC has reduced operating costs and positioned the bank for growth – this after years of bloody, slow-motion restructuring. But rising interest rates will not help bank earnings, especially when interest rates are going down. Readers of The IRA will recall that we took the view after 2008 that BAC should have put the parent holding company through a Ch 11 bankruptcy to accelerate the restructuring process. But today, fact is, the bank’s selling, general and administrative expenses start with a “5” as in $54 billion rather than a “7” as in $72 billion in 2014. With a 16% estimate for 2017 earnings and 21% for 2018, its does not take a lot of imagination to see why BAC moved as far and as fast as it did, but that’s all over now as the song says. The promises by Donald Trump during the 2016 election have been replaced by conventional thinking and even more conventional people to think them. Witness reports from Politico that President Trump is expected to nominate former Treasury undersecretary Randy Quarles as the Federal Reserve's top bank regulator. Quarles is a big time member of the establishment, a veteran of the George W. Bush administration and managing partner at equity investment firm The Cynosure Group. “I don't think the folks who voted for Trump thought they were voting for Randy Quarles, although I like the Dickensian name,” notes one DC insider. “Quarles is a Bushie and could be weaker than Tarullo.” CompassPointLLC opines politely that “Our sense is that Mr. Quarles will be viewed as a pragmatic deregulatory force.” But Washington’s premier investment bank avers that “tax reform expectations in D.C. continue to temper. Our view remains that political and policy realities will slowly grind broad tax reform efforts into a narrower tax relief package with corporate rates of 25-28%.” So the good news and the bad news rolled up together is that the Trump Revolution is over. All of the talk of change, tax cuts and new policies is rapidly giving way to a very conventional Republican Administration populated by bankers from Goldman Sachs. To get a good bearing on President Trump, think of the first term of President William McKinley combined with the latter years of Ulysses Grant. For Wall Street, the end of the Trump Revolution portends a return to the October 2016 status quo ante, with all of the attendant difficulties and discomfiture. We can’t say for sure that BAC will go all the way back to $16 per share, where it started its remarkable journey last October. But even at the $22 close on Thursday, BAC was still trading below book value, a remarkable, even magical commentary in these increasingly conventional times.

Since the November 2016 election, large cap financials have moved sharply higher, in the case of Bank of America (NYSE:BAC) up almost 60%. This spasmodic upward movement in reaction to the election of Donald Trump reflected both the collective desire of professional managers to increase allocation to financials but also the shared frustration of investors with the chronic under-performance of large banks. Let’s face it; there’s a whole generation of managers on Wall Street who made their careers buying big banks. These torpid zombies may not have very good financial metrics, but the roar of the Buy Side crowd managed to push financials to more than a quarter of the market cap of the S&P 500 during the 2000s. Today financials as a group are not quite half that portion of the broad market and for a reason: large banks are horrible financial performers. Flat revenues, strained earnings and buckets of headline risk do not make for peaceful slumbers in the world of Buy Side managers. Just look at the self inflicted wounds at Wells Fargo (NYSE:WFC). And ask yourself if anybody, anywhere would have predicted three years ago that Warren Buffett’s favorite big bank would be clawing back CEO comp and, yes, effectively cutting off fingers and toes for public giggles. Yeah? Can’t make this stuff up. Since BAC peaked a bit shy of up 60% on March 1st at a whole $25 and change per share, our favorite zombie girl has been giving back those hard won gains. The House that Brian Moynihan kinda, sorta owns, by default, closed at below $23 yesterday and our guess is that the best performing large bank of the past six months will give up more in coming weeks. Consider the fact that in the upward whoosh of the Trump Bump our friends at BAC actually outperformed the other large zombie banks and by a wide margin. BAC is still up 40% since the election of Donald Trump, while JPMorgan is up a mere 25%, WFC under 19% and Citigroup (NYSE:C) right on 20%. There are so many managers that have waited so long for Brian and BAC to take flight that they simply could not help themselves. As we told Jeff Cox and our pals at CNBC the other day , our guess is that nothing in earnings this week or next is going to prevent these large cap financials from giving up more ground in coming weeks. The fact that the Street has BAC with a up 9% revenue estimate for Q1 ‘17 can only be interpreted as an act of extraordinary generosity, especially when you consider that the full year estimate is just half that number. But even if we assume 9% up revenue for the full year, admittedly an amazing suggestion, does the current market value of equity of BAC make sense on any planet in the solar system? Then there is Citi, the laggard in the large bank peer group and for a reason. The Street has Citi up 2% on revenue in Q1 ’17 and, wait, a whole 2.1% top line growth for the full year. That is just 1/10th of the move in the stock since October. But somehow the house that Bob Rubin almost destroyed single handedly in the 2008 will do plus 4% revenue growth in 2018? You really have to respect Street analysts for their ability to see the bright side of the picture no matter what the actual numbers may suggest. The Street has WFC up a whole 0.5% on revenue this quarter and 4.3% for the full year 2017, another act of selfless generosity based upon the bank’s shaky state of governance and the sharp decline in mortgage origination volumes. We are still getting over the fact that WFC publicly got ripped a new orifice over hedging its mortgage book last quarter. Like, really?? If the biggest mortgage bank in the world cannot hedge its mortgage servicing book, then why are we even here? But then again, the shambles in the bank’s CSUITE really answers that question. Then finally we come to the House of Jamie, JPMorgan (NYSE:JPM), which actually underperformed BAC in the upward surge we all know as the Trump Bump. The Street has JPM up 3.3% on revenue in Q1 ’17 and a whole 3% for the full year. Looking at the plus 25% for JPM at yesterday’s close, we need to ask the question. Even if Jamie manages to beat the +15% Street estimate for earnings, does the outlook for the business really justify a 25% move since October? No it does not. As the chart below illustrates, there is no real growth in bank earnings when you look at the industry as a whole. The dollar revenue of interest earnings is rising, this due to the growth of bank balance sheets, but there is no corresponding expansion of income as a percentage of earning assets. The top four banks discussed in the post account for about half of industry assets, so the general does inform the view of the particular. Source: FDIC As we noted in the last issue of The IRA , the yield on earning assets for all US banks has been falling since 2008 thanks to the social engineering of Janet Yellen and her colleagues on the Federal Open Market Committee. Quantitative easing is bad for the economy and for banks as well. But don’t blame Jamie Dimon or Brian Moynihan for the stagnation of bank revenue and earnings. That honor belongs to the FOMC, their colleagues among the ranks of the bank regulators, and ultimately Congress. Give President Trump’s comments about deregulation and stimulative fiscal policy credit for driving up the value of financials generally. And thank the generosity of credulous investment managers for the fact that large cap financials have not fallen farther faster as the exuberance of the Trump Bump fades. Fact is, the Buy Side just loves the big banks, this even though the real value creation comes from smaller names. But we continue to believe that in the absence of a remarkable increase in bank revenue and earnings this week and next, the market value of equity for the four zombie dance queens is likely to go lower in the near term as value and stock prices return to balance. #BankofAmerica #BAC #JPMorgan #JPM #WellsFargo #WFC #Citigroup

This week brings the start of Q1 2017 earnings for many banks, large and small. In order to better inform the subsequent prognostications, we borrow a line from the Passover Seder and ask: why is this bank different from all other banks? This question is not only important to understanding bank financial performance and earnings, but also to appreciate the subtleties of the evolving regulatory narrative in Washington around big banks and “too big to fail.” Last week, White House economics czar and former Goldman Sachs President Gary Cohn let it be known that the Trump Administration was considering legislation that would separate the retail banking business from institutional and investment banking. In very simplistic terms, this would equate into spinning the old Chase Manhattan Bank out of JPMorgan (NYSE:JPM) or requiring Bank of America (NYSE:BAC) to sell Merrill Lynch. Does anybody in Washington understand how complex and disruptive it would be to impose such a separation? We doubt it. The kerfuffle about breaking up the big banks makes for breathtaking news copy, yet in practical terms this is not easy or even practical to achieve. For one thing, the much beloved retail business is not particularly profitable, but would require a lot of capital support because of its size. The second issue is that the institutional part of the bank, including over-the-counter (OTC) derivatives, also requires a lot of capital on a risk weighted basis, making the actual act of separation considerably more difficult that just discussing it in front of a group of astonished members of the Senate. The big banks certainly are a government-protected monopoly, but they are also public utilities that provide essential services to the US economy. Mess with that in the wrong way and you’ll take points off of GDP before you see any benefits. Let’s take a look at some numbers to get an idea of what’s involved in separating the different pieces of some of the largest banks. The columns below show the total assets of the banking group, the assets of the subsidiary banks, the ratio of Economic Capital to Tier 1 Risk-Based Capital (T1RBC) for the banking business, and risk adjusted return on capital (RAROC), all taken from regulatory disclosure and the TBS Bank Monitor. Source: FDIC, FFIEC, Total Bank Solutions Economic Capital or “EC” measures risk and describes how much capital a bank would need to cover its obligations in three buckets, lending, trading and investing, during a stressed scenario like 2008. Most little banks have too much capital, thus the ratios of EC to T1RBC tend to be less than 1. The big zombie banks tend to cheat when it comes to risk and thus have too little capital, but not for the reasons that people like Minneapolis Fed President Neel Kashkari believe. The trouble with the biggest banks is not the absolute level of capital, but the poor profitability and equally poor disclosure of risk. Like the large automakers, the big banks do not really generate enough profits over the long-term to meet their cost of capital. Thus big banks have EC to T1RBC ratios well-above 1. They are also forced into aggressive stock repurchase cycles to placate institutional equity investors, making it impossible to retain capital. Nominal equity returns in high single digits don’t get it done when your cost of capital is in the teens, but even more revealing is looking at the zombie banks in terms of risk-adjusted return on capital or RAROC. This measure is simply net income divided by Economic Capital, but it is quite revealing in terms of understanding bank business models and behavior. Big banks tend to be in low single digits on RAROC, while smaller banks routinely have RAROCs in the teens or much higher. The story that these numbers tell is important for investors, firstly because the business models of these top institutions are very different. JPM, BAC and Wells Fargo (NYSE:WFC) have the vast majority of their assets “in the bank,” to recall the immortal words of Angelo Mozilo to CNBC’s Maria Bartiromo around 2007 . We recall that discussion as though it were yesterday because it told us that the trouble was coming. Countrywide was soon sold to its warehouse lender, BAC, which had long coveted Mozilo’s mortgage banking operation. The rest is history…. Today the top universal banks tend to operate most of their retail and institutional businesses in the bank, making any separation like removing selected organs from a living body. In order to actually divide the retail from the institutional businesses, you’d need to create a brand new platform to house one of these silos. Think of surgically removing an implanted alien from Lt. Ripley's chest and you get the idea. Trust us when we say that such a change is not the sort of thing to be handled quickly by federal regulators. The lowest RAROC of the group is JPM, which has an enormous amount of trading risk housed in its banking units. While JPM’s bank units collectively have about $200 billion in T1RBC today, the TBS Bank Monitor model calculates that JPM needs over half a trillion dollars in EC to survive a stressed scenario, this largely due to the big trading exposures and the bank’s OTC derivatives book. So if you really want to split up the retail and institutional sides of JPM, you’d probably need to raise additional capital – and lots of it. WFC generates an equally large EC number to that of JPM, but for very different reasons. The largest component of risk for WFC is securities investments, nearly $325 billion of the $384 billion in EC calculated for the bank units of this largely domestic bank holding company. Lending is actually less than 20% of the EC number for WFC and trading risk is miniscule. Thus the key point is that WFC and JPM are very different businesses – but neither is very profitable in terms of nominal equity returns much less RAROC. Likewise, BAC generates an EC number of $438 billion vs its T1RBC of $153 billion, again mostly due to securities investments held by the bank’s investment portfolio. The bank’s lending and trading operations account for just a quarter or $100 billion of the EC calculation. And again, the 3% RAROC is nothing to brag about. When we get to Citigroup (NYSE:C), however, the $361 billion in EC is divided about equally between trading and securities investments, like JPM owing to the large derivatives operation. Citi also has the smallest retail business of the top four universal banks, being now mostly a wholesale bank after the sale of the asset management and mortgage servicing segments. Looking at U.S. Bancorp (NYSE:USB), the most highly valued of the top US banks, the risk profile is very similar to that of BAC and WFC. Most of the risk in the EC calculation is on securities investment exposures, not trading or even lending, which are less that 10% of the $90 billion in economic capital calculated for the bank. USB has no significant securities operations and is effectively an institutional customer of the larger universal banks. Despite the relatively low RAROC, USB trades at 2x book value vs about 1.5x for WFC, above 1x for JPM and at or below 1x for BAC and Citi, the two laggards in the large bank group. Some analysts see these low book value multiples for BAC and Citi as an opportunity, but we think these stocks are fairly valued to put it mildly. Once we get to Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), again the business models are very different. First and foremost, the bank units for GS and MS are relatively small compared to the asset footprint of the broker dealer units, which make up the majority of the total assets at the parent level. The GS bank unit, for example, has mostly trading risk, with virtually no lending or investment exposures in the EC calculation. Even though it is considered a bank, the vast majority of the risk in the GS business is institutional and is contained in the non-bank broker-dealer operations. The retail component of GS is miniscule, which perhaps explains why Gary Cohn thinks breaking up the big banks is such a great idea. Such a change would have little impact on Goldman but would badly disrupt the small investment bank’s larger competitors like JPM. MS likewise has most of its assets and business risk in its non-bank units, but its banking operations have a very different profile than the GS banking subsidiaries. GS has most of its bank’s risk in trading. With MS the two primary banks have most of their risk in securities investments for the bank’s depositors, which are mostly the firm’s wealth management customers. Of the $38 billion in EC calculated for MS, less than a billion is for lending or trading. Both MS and GS are primarily investment houses and both trade at a premium to book value, the two businesses are very different. GS relies far more on trading and investment banking revenue for its profitability, while MS relies more on asset and wealth management. Again, the proposal by Mr. Cohn to separate retail and institutional activities would have little impact on either firm, but would badly disrupt JPM. Now let’s look at some smaller banks to further contrast with the zombie dance queens. The $18 billion asset Bank of the Ozarks (NASDAQ:OZRK) is reporting earnings this week and will be keenly watched for any evidence of credit stress in its commercial real estate book. OZRK had a RAROC of almost 29% at year-end 2016 and a ratio of EC to T1RBC of 0.59%. That means that the EC model in the TBS Bank Monitor sees the bank as being more than adequately capitalized to handle its risks, which are about evenly split between lending and securities investments. The bank has zero trading risk, BTW. So in terms of risk-adjusted returns, OZRK is an order of magnitude more profitable than a large bank like JPM or WFC. It is no surprise that OZRK trade at more that 2x book value and has a large constituency among institutional investors, but also has a pretty volatile stock with a beta of 1.7. Needless to say, the bears like to bet against OZRK on the theory that they are over extended on commercial real estate and related C&I loan exposures. But short sellers beware. OZRK has a very strong credit culture and performed extremely well during and after the 2008 credit crisis. Let’s take another relatively small name, Signature Bank (NASDAQ:SBNY), which is located in Manhattan. This $40 billion asset New York State chartered institution was organized by a group of bankers who originally came from Republic National Bank. Signature focuses on C&I lending to small and mid-sized businesses in the US and have some of the strongest credit metrics in their peer group. While defaults did pop above peer at the end of 2016, the bank has historically tracked below peer in terms of credit losses even during the financial crisis. SBNY had a RAROC of over 11% at year-end 2016, but earned an EC to T1RBC ratio of 2.1, according to the TBS Bank Monitor. While the bank has no trading risk, it does have a large securities investment book, which accounted for more than 90% of the EC risk calculation. Unlike the large banks, however, SBNY is actually sufficiently profitable on a risk adjusted basis to cover its cost of capital. SBNY is a $140 stock that has a beta a little over one and trades at well-over 2x book value. The point of all of the above is that when you peruse bank earnings starting this week, remember that banks large and small are not all made the same. While they have some common business model attributes, they also serve different markets and customers, even among the largest names. And while the biggest banks are certainly government sponsored entities protected from true competition by federal regulation, small banks like Ozarks and Signature represent the private sector. The bottom line is that the arguments about breaking up the big banks or requiring higher capital levels miss the point. The big banks are problematic because they are too large to generate sustained equity returns compared with their cost of capital or risk-adjusted measures such as RAROC. Requiring big banks to raise or retain more capital would cause them to slowly collapse as equity returns headed into low single digits and share repurchases ended. Small banks, on the other hand, generate great equity returns, but lack the liquidity that big investors demand. As we argued in American Banker last December: “Before we can have a rational discussion about how to end the systemic risk posed by the largest banks, we must first understand the root of the problem. First and foremost, the top banks are big because the Federal Reserve and other regulators have over the past several decades allowed and even encouraged a series of mergers between strong banks and weak. By countenancing these mergers and leaving inefficient operations intact, the Fed created enormous firms that are clearly too big to manage and generally do not generate positive risk-adjusted or even nominal returns.” The answer is to the problem of too big to fail is to require banks to become more efficient, not raise more capital, and to allow weak banks to die. We should slowly mandate that the big banks get smaller and also gradually separate dealing activities from the depository over a period of 5-10 years. The good news is that policymakers can address many of the most egregious systemic risks in the U.S. banking system simply by understanding why large banks are big in the first place. The answer starts at the Federal Reserve Board in Washington. #JPM #WFC #USB #BAC #C #OZRK #SBNY #GaryCohn #NeelKashkari

JPMorgan (NYSE:JPM) boss Jamie Dimon says there’s something wrong with the US economy and he is obviously right. Here’s our short list: * too much public and private debt * too little income and growth * monopolies in banking and other industries * oppressive regulation for all businesses * political muddle and lack of national purpose * confused, irrational monetary policy A couple of weeks before Mr. Dimon was waxing effusive on the state of the American political economy, New York Fed President Bill Dudley told an audience that excessive student debt was holding back the US economy “despite efforts of the Federal Reserve to stimulate economic activity.” Really? We thought that the Fed was engaged in an effort to manipulate asset prices in a desperate attempt to increase consumption. Since economic expansion is a function of population growth and increases in productivity, both of which are basically the flat, the Fed has never had any real bullets when it comes to encouraging growth save orchestrating debt driven asset bubbles. More, unlike the 1970s and 1980s, today simply lowering interest rates has no apparent impact on consumer spending. The past eight years of near-zero interest rates and massive bond purchases by the FOMC has merely put the key issue of debt temporarily on hold while asset bubbles have bloomed around the economy. Which brings us to the ongoing implosion in demand for automobiles. US automakers including Ford (NYSE:F) and General Motors (NYSE:GM) have seen demand for once-popular sedans basically collapse. More, as we noted in a previous post on David Einhorn’s sudden interest in GM, the residual value of used cars is also falling. Key concept: the upward surge in new car purchases was driven by irrational exuberance (aka credit expansion), which in turn was driven by the FOMC’s policies. But apparently the party in less-than prime auto ABS is over. Mark Wakefield of Alix Partners told Bloomberg News he sees volumes falling by at least 300,000 units from the 18 million peak in 2016, but we’d be surprised if the industry can break 17 million units this year given current trends in the industry and, more important, in credit markets. Part of the problem for automakers is that the surge in new credit that enabled consumers to buy cars in part came from captive leasing units and independent auto lessors that are facing growing losses on existing loans and leases. Nearly one in five cars was leased last year and residual valuations are plummeting, especially for passenger cars. The new arrivals in the below prime auto lessor community are going to take a big hit. The next step will be for these smaller leasing firms and banks focused on providing credit to below prime customers to withdraw credit from the system, which will in turn cause auto sales to fall further. Originating and selling prime auto paper has been a break even prospect at best, thus all of the focus of Wall Street was on below-prime originations over the past year or more. Tales of mortgage market in the mid-2000s? Yes. Repeat after we: “Gain on Sale.” Names like AutoNation (NYSE:AN) and CarMax (NASDAQ:KMX) may be able to survive the credit losses likely this year and next, but smaller players in the leasing channel will pull back quickly on risk exposures, reducing the ability of the automakers to move inventory. Needless to say, even as Yellen & Co try to belatedly raise interest rates, the credit cycle has already turned sour. If anything, the Fed should be pondering when to ease. But hold that thought... Bank Earnings Meanwhile in the world of banks, the prospect of Q1 ’17 earnings is hardly causing great joy among Sell Side analysts, especially for the big universal banks with significant securities operations. In Q1 '17 the bond market has again set new records for investment grade (IG) bond issuance, but the economics of debt deals is significantly thinner than for equity offerings. Initial public offerings have dwindled under the social engineering of Janet Yellen and the FOMC. Simply stated, why issue public shares when you can tap private equity or float a bond deal at what are still historically low rates? For those who think that rising short-term interest rates will somehow boost earnings, it is interesting to note that the majority of US banks saw net-interest margins decline in 2016 – this as the yield on the 10-year Treasury was rising following the election of Donald Trump. Only trouble, as we wrote for Kroll Bond Rating Agency at the time, is that IG and even high yield bonds were rallying as the T-bond sold off. Hmmm. Below is our famous chart showing the cash components of NIM for all US banks through year-end 2016, using data from the FDIC. Notice how low that the Fed pushed the cost of funds for US banks in order to keep the zombie girls dancing -- just $11.5 billion in the middle of 2015. The same figure was almost $15 billion as of Q4 ’16. Note that income rose more, but only because of the bank lending spree in 2016 which is now ended. Swelling balance sheets enabled the big zombie banks to pretend that they are making more money on good old fashioned leverage, but if you look at the impact on the return on earning assets, the picture is different. The chart below shows net interest income divided by earning assets, which clearly shows that the past eight years of extraordinary Fed policy have been bad for bank asset returns and income. On a risk-adjusted basis, the large bank sector looks about as cyclical as the large US automakers. And since mid-March, spreads on high-yield debt have been widening as investor confidence in the Trump Bump has started to wane. Credit losses for US banks are starting to rise, albeit from a very low base. As the chart below suggests, loss rates on the $9 plus trillion in US bank loans bottomed in 2015 and are slowly starting to increase as the great asset bubble created by Janet Yellen and the FOMC begins to deflate. Ask yourself a question: Are the C&I and commercial real estate credits on the books of the largest US banks and, in particular, in asset backed securities (ABS), significantly better quality than the growth of auto exposures to consumers over the past half decade? The answer is clearly “no” as evidenced by the fact that the major rating agencies are all starting to walk back their ratings on post-crisis commercial real estate exposures . As we wander into Q1 '17 earnings next week, we can’t help but notice that those generous souls at KBW decided to upgrade Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) on the theory that lighter regulation and rising interest rates will boost earnings. Really?? Read our comment on Citi from last week if you have not already done so. The gross spread on C&I and CRE loans at Citi is so low that cash flows from both of these enormous portfolio components could be wiped out by charge offs in a stressed scenario. We differ on both points used by KBW to justify the upgrades of Citi and WFC. First, any reduction in capital requirements is a medium term exercise, in other words, no impact in 2017. Capital is THE solution of choice for the political class when it comes to avoiding the dreaded specter of “systemic risk,” even among conservative Republicans. Don’t hold your breath for significant changes in capital requirements. Second, a flat yield curve sinks all boats. Without a serious change in mind on the part of the FOMC, rising short-term rates and falling 10s to 30s sure does not look like a winner to us. Indeed, if the FOMC goes forward with three more short-term rate hikes in 2017 without starting to sell MBS from the $4 trillion portfolio, look for NIM for the whole banking industry to take a swan dive. In the latest FOMC minutes we see this important tidbit: “participants agreed that reductions in the Federal Reserve’s securities holdings should be gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings.” This passage from the FOMC minutes illustrates that the members of the Fed’s policy making body clearly do not understand what is happening in the bond market. Agency issuance is down dramatically compared with 2016, like minus 15-20% YOY ($300-400 billion) over the course of 2017. If the FOMC really wants to see long-term yields rise in concert with short-term benchmark rates, then selling at least $50-100 billion per month in MBS from the Fed’s portfolio is entirely necessary. If the FOMC keeps to its current plan, however, the curve will flatten, bank earnings will suffer and the US economy will start to contract. Details aside, it will be called the Yellen recession for a reason. #fomc #yellen #banks #jamiedimon #recession #really

Over the past decade we have periodically talked to our brother Michael Whalen (MW), Emmy award winning composer, film editor, and now agent to a growing list of performers, about the rapidly changing state of the world of content. With theater admissions and revenues flat, the final break in the Old World of Hollywood came several weeks ago with the major studios announcing a new model for releasing content online almost immediately after the theatrical release. Will we even be watching the Academy Awards in 20 years? The IRA: So Michael, the change in the relationship between the movie studios and theaters that you have long predicted has come to pass. The studios have announced that they will be releasing films to online distribution only weeks after the release to the theaters. Talk a little about the economics of making movies today and how the investors/creators are able to cover costs much less make money. MW: The situation facing the movie industry is a classic case of supply and demand. It is so much easier to produce a movie now than 20 years ago. Technology has knocked-down a lot barriers and walls. Also, another factor is state issued tax credits. Localities are tripping over themselves to have even low-end filmmakers use their states. It might sound like a joke but there are people making quality videos and shorts with their iPhones. The IRA: Hey, we’ve been experimenting with new platforms like Collide. Our friend Stacy Herbert shot a TV segment in Central Park with me and Max for The Kaiser Report last year on an iPhone. Looked great. But it sounds like the traditional distribution channels for films are the victims of innovation. MW: Precisely. Trapped inside this rapidly changing economic environment are theatre owners. They charge $12 - $25 a ticket to watch films that I can rent at home for $4. We live in a time where people under the age of 30 have no real need to go to the theatre to see anything. They watch YouTube on their phones. The theatre chains have done little to make the basic experience of going to the theatre compelling for a young audience. It’s a value conversation: you’ll probably get dinner (for 2), gas for the car, tickets and theatre food. It’s $100+ evening. This better be the best movie ever. Seriously, many people today don’t have the disposal income to go to theaters, much less sports events or other types of live entertainment. The IRA: OK, but how about the films themselves? Brent Lang put out a great piece in Variety recently talking about the whole movie business being in trouble. Do you agree? MW: Yes, the finances around film have never been for the faint of heart. These days, beyond the theaters to the world of content the upside is so much less than it used to be even a few years ago. There are hundreds of new platforms and outlets around the world for quality content - however, no one wants to pay for it. Well, to be fair - - they don’t have the upfront dollars to pay for it. Therefore, most licensing deals are some kind of revenue sharing scheme. The IRA: So you need to find investors for a film and the studios bare no risk for the project? How many films actually make money? Is this like people supporting Broadway shows out of passionate devotion or charity? Does not sound like a business any more. MW: The truth is that investors in these schemes often cannot cover their investments. These are breakeven scenarios at best. In the old days, you could release a decent film - breakeven in the theaters and then the foreign licensing and home video would give you a nice multiple. Now, if you’re lucky, you hope your revenue share deal with NetFlix gives you a little income. The IRA: So is the theater channel now a significant contributor to revenue or are we talking about online as the biggest contributor? MW: Being nominated for an Oscar can translate to a VERY big payday for the movie, its stars and those associated with making the film. That said, Best Picture winners typically earn an additional $14 to $15 million in box office revenue. Movies like, The King’s Speech, garnered $138 million in domestic box office – over $100 million more than was expected before it won. That is very unusual. Moonlight (this year’s Best Picture Winner) had only made $22 million before the award. The IRA: Wow, so a critically acclaimed film may not ever break double digits at the box office? MW: Nope. To date, Moonlight has made $55 million. It is also the lowest grossing Best Picture winner in history. In Hollywood, talent agents and managers estimate that their clients will get a 20% boost in pay for their next film if they win the award for Best Actor or Actress. According to Reuters, an Academy Award nomination can boost ticket sales by one-third and cause a jump in the home video sales and streaming of movies no longer in theaters. When you add-up downloads, streaming and cable TV revenues, the monetary rewards from receiving a nomination can be substantial. The IRA: Ok, so is this something that is attractive to investors or just a passionate crapshoot? MW: Most of the movies that made money in the last 2 years are HUGE “tentpole” franchise movies. This is important because these films typically have the movie itself as one platform of 4 or 5 marketing platforms for an entire project. For example, Disney released “Rogue One” the Star Wars standalone movie. According to Box Office Mojo, it has brought-in $1 billion in worldwide theatrical ticket sales against a production budget of at least $200 million and a marketing budget of at least that much. So, despite HUGE numbers being brought-in, the net profit is relatively small. But Disney has ancillary merchandise, video games, toys, TV licensing and a host of streaming options for this material that will add to the bottom line of the movie - - probably in the $400 - $500 million dollar range after all the costs are deducted. The IRA: Sounds like the big names and titles are the only sure bet. Correct? MW: Yes. For investors, the best course in dealing with film or video content is to finance as big a slate as possible (to increase the statistical probability of having a movie that makes money). Or, to look at creating stand-alone outlets for content. For example, comedian Louis CK directed and produced a video of his stand-up from his show at the Beacon Theatre in NYC. He posted the video on his website in 2011. In a month, 800,000 people had spent $5 to download the concert. To date, he has made millions from a production that cost him $220,000. He has given bonuses to the people who helped him make it, contributed to charity and he shattered how such videos are distributed by doing it himself. Then, the video won a Primetime Emmy® for best live comedy performance. This is the paradigm: great content. Low cost. A simple distribution method that can be driven by social media. Link here to the video: https://louisck.net/purchase/live-at-the-beacon-theater The IRA: So is Louis CK the new role model for content? MW: The key to investing in film is to lower your risk through diversifying – which is obvious. What is not obvious is to lower your expectation on possible returns as well. Unless you have a sophisticated multi-platform release where multiple income streams can help recoup your “hard dollars,” you will probably fail. The percentage of movies that break even in 2017 is at its lowest level in history. Even with multiple streams of possible income, we know that film finance is risky at best. However, streaming models work when the actual cost of production is low. So, look for intense downward pressure on costs, more and more supply of content and fewer reliable financial outlets for this content in the United States and in other territories as “winners” and “losers” begin to emerge in the video streaming market. Said another way, do your homework and make sure you understand the distribution deals that you are getting involved with BEFORE you sign. Some investors “roll the dice” with such deals without fully understanding the dynamics. Frankly, there’s not enough financial headroom to mess around like that on a typical deal. The IRA: Sounds like investing in blockchain startups….. MW: Finally, the premium that is paid for “known” talent is ending. In its place we see increased emphasis on content that is compelling and well made. Yes, “A” list actors will continue to command fees for the foreseeable future – however, more and more, those fees will be replaced by rev share models that put that actor’s ability to attract to the test every time out. Don’t be afraid to put those types of deals in place and be ready to reward actors and other “top-line” personnel who bring the most allusive currency of them all: attention. The IRA: Thanks Michael. #content #hollywood #michaelwhalen #theaters

David Einhorn of Greenlight Capital recently proposed that General Motors (NYSE:GM) divide its common equity into two parts, one that pays a dividend and another that captures the appreciation potential of the automaker. This is a demonstrably bad idea from one of the smarter people on Wall Street, thus we ask: What Is David’s game? Einhorn, in case you’ve been trapped in cryofreeze over the past few years, is one of the more accomplished managers on Wall Street and is also a world-class poker player. Thus when he emerged from his bunker to put forward an idea that seems to be complete nonsense, we ask: why? What is the agenda of one of Wall Street’s smarties? First and foremost, the idea of somehow bifurcating the equity component of a large automaker makes no sense at all. As we outline in “Ford Men: From Inspiration to Enterprise,” attempts to shed or divide the capital intensive portions of the business and/or cash flows of automakers have usually ended badly. Randal Forsyth gives a pretty thorough review of the past bad ideas in Barron’s this week, “What’s Good for Einhorn Isn’t Good for GM or U.S.” But the more basic issue that Einhorn seems to ignore – we know he understands it – is that in the world of autos today’s excess cash flows are tomorrow’s operating losses. You cannot look at an automaker on an annual or even multi-year basis and make broad assumptions about future earnings and cash flow. Simply stated, those “excess” cash flows represent savings for future periods of sales drought and outright privation. The auto manufacturers are hideously cyclical. When capacity utilization dips below 60-70%, they loose money and start to hemorrhage cash. Does anyone remember the spin-offs of Visteon and Delphi, two sad attempts to shed the “capital intensive” portions of the auto business that ultimately failed. As we wrote in Ford Men: “Just as GM had separated itself from Delphi, Ford would sell Visteon to the public on the theory that the two remaining companies would will have higher profits and better returns for shareholders.” These new age ideas about dividing the capital intensive and capital light segments of the auto makers ultimately failed when GM and Ford had to support these supposedly separate businesses. It was only a decade ago that both GM and Ford (NYSE:F) were on the ropes, bleeding cash and looking for alms in Washington. After years of debt induced recovery c/o Janet Yellen and the happy campers on the Federal Open Market Committee, autos look positively solid – except that they are not. Once the irrational exuberance of the subprime auto market cools, the heady estimates regarding auto sales volumes will also revert to the mean. It is no accident that analysts at Wells Fargo & Co., one of the biggest underwriters of U.S. subprime auto debt, say investors in the bonds are well protected from rising loan losses in the securities, but that it is still a good time to take some risk off the table. The reason is that the residual credit risk in auto sales financing ultimately backs up to the automakers themselves in the form of losses on lease receivables, which account for more than 20 percent of total sales. As the Yellen Bubble deflates, the appearance of aggregate demand created by extraordinary monetary policy will resolve into the familiar visage of unpayable debt. As UBS analysts Matthew Mish said in a report this week, the U.S. central bank’s quantitative easing and low interest-rate policies have exacerbated wealth inequality in the U.S. by fueling higher asset prices and wealth creation for some, while credit has made up the difference for everyone else. Years ago, at a Ford annual meeting, we asked Bill Ford if, given a choice, he would put all of the family’s money into the auto market of today. He smiled and said “of course,” the answer you would expect since the Ford family today holds less than 4% of the economics of Ford Motor Co and 40% of the vote. But even with this extraordinary leverage, holding a stake in Ford is a marginal proposition in economic terms. The global auto industry is comprised of a collection of large enterprises that engage in brutal competition for a fickle retail customer and only ever earn nominal profits on the most expensive units. The reality is that the global automakers like GM and Ford never really make money, even in good times, measured against their true cost of capital, which is well into the teens. So yes, GM and Ford are reporting profits today, but you must assess these results through the cycle to understand whether these business actually make money. Of note, default rates in prime bank owned auto loans are also starting to rise, an indication that the credit cycle in auto finance is fully mature. We should expect that the credit fueled boom in auto sales volumes is over and those fat cash flows at GM and Ford will eventually disappear. The chart below shows net charge off rates for bank owned auto loans through year end 2016. Source: FDIC So when we assess the proposal of David Einhorn to divide the equity of GM into a debt-like piece that pays a set dividend and an equity component that reflects the appreciation of the firm’s business, we must respectfully disagree. The increase in defaults in below prime auto loans is the early warning of a sales correction in the auto sector. Those cash flows that today so attract Einhorn will eventually fade away and the auto makers will once again be marginal propositions for investors.

New York --- Mohamed A. El-Erian’s day job is Chief Economic Adviser at Allianz, but he is also a key indicator – a canary -- for the financial establishment. In his latest post on Project Syndicate, “America’s Confidence Economy,” El-Erian states the obvious, namely that the financial bubble created by the election of Donald Trump is deflating. “[S]entiment is not always an accurate gauge of actual economic developments and prospects,” he says with considerable understatement. This is a nice way of stating that the Trump bubble in US stocks is an anomaly and that markets will soon reflect the underlying fundamentals. In his public pronouncements, Mohamed El-Erian is a polite but powerful indicator of directional change in the global political economy. That said, the near-term surge in prices for stocks and corporate bonds since last October is modest compared with the vast asset bubble encouraged by the Federal Open Market Committee (FOMC) under the Chairmanship of Janet Yellen. Going back to the turn of the 21st Century, the US economy has been lifted and nearly ruined by a series of Fed-induced financial bubbles, manic events encouraged and driven by policy actions in and omissions by our platonic guardians in Washington. Because of what policy makers have done, and what they have failed to do, to paraphrase the Penitential Act, markets have soared and plummeted, but with little or no value in economic terms resulting. The dot.com mania was followed by the Y2K hype fest, each of which encouraged short-term investments that temporarily boosted growth, followed by a sharp decline in demand and asset valuations. Later, in the 2000s, a vast credit bubble was created in residential real estate, encouraged by the earlier acts and omissions of the Clinton White House and Congress, and fueled by hyper-low interest rates c/o the FOMC. Since 2010, a similar sized bubble has grown in commercial real estate, commodities and consumer lending, in particular auto loans, that now threatens investors, auto makers and banks with significant losses over the next several years. Let’s recall the mini-dip recession that began at the start of 2001, when GDP change slipped into negative territory and credit losses for major US banks began to rise. By the time of the September 11, 2001 terrorist attack, the US economy was already well on its way to recession. The Federal Open Market Committee took the effective federal funds from 6% at the start of 2001 to 1.8% by the end of that terrible year. Spurred by the 9/11 attacks, the FOMC under Ben Bernanke put the proverbial pedal to the metal. The Fed kept the effective fed funds rate below 2% until the summer of 2004, by which time the residential real estate boom and related Wall Street machinations were running wild. The fed funds rate rose to 5% by June of 2006, but not in time to prevent names like Countrywide Financial, Washington Mutual, Wachovia, Citigroup (NYSE:C) and the GSEs from failing 18 months later. As readers of this blog will recall, in 2005 we noted that both Countrywide and WaMu were reporting negative default rates, this just as the FOMC began to try to throttle down the economic reactor. When a large bank tells you that extending credit has no or even negative cost, you know that bad things are about to happen. Big Credit Canary: Citigroup Among large cap financials, the key crisis bellwether for those of you who read The Institutional Risk Analyst a decade ago was Citigroup. Citi is the outlier among large banks. It saw credit losses almost double during 2001 even as the rest of the large bank peer group remained relatively normal. This idiosyncratic skew in the gross credit losses of one of the largest US banks presaged the bank’s failure just six years later. The chart below illustrates that period and also suggests just how much more risky is the credit profile of Citi compared with other large banks. Source: FDIC Even today, the relatively elevated credit profile of Citi’s customer base is reflected in a gross loan charge-off profile that at 126bp at the end of 2016 is more than a standard deviation higher than the average for the large bank peer group. Loss given default (LGD) for Citi is almost 80%, again far higher than large cap asset peers like JPMorgan (NYSE:JPM) and Bank of America (NYSE:BAC). Indeed, Citi in credit terms is really more comparable to below-prime lenders such as CapitalOne (NYSE:COF) and HSBC (NYSE:HSBC). The 126bp of default reported by Citi in 2016 maps out to roughly a “BB” credit profile for its portfolio, again reflecting a deliberate business model choice that has selected a below-prime business as the bank’s model. COF, by comparison, reported 265bp of gross defaults at year-end 2016, roughly a “B” credit profile. COF’s loan loss rate is more than three standard deviations above the large bank peer group with an LGD of 77%, according to the TBS Bank Monitor. Of note, COF showed a risk-adjusted return on capital of just 1.6% at year end ‘16 while Citi reported a RAROC of 3.8%. Since the nominal cost of capital for most large banks is well into double digits, you may be wondering why these banks are still here. Indeed, most large banks don’t earn their cost of capital, either in nominal or risk adjusted terms. But it is only when you look at these banks based on RAROC that you understand that the big zombie banks are perennial value destroyers. Smaller regional and community banks, by comparison, routinely earn double digit real, risk-adjusted returns on capital. As in the early 2000s, today the relatively higher risk credit profile of Citi is an important indicator for what is happening in and around the US economy. Press reports regarding the rising level of defaults in the auto loan sector, for example, suggest that both gross losses and LGDs for all US banks are likely to rise over the next several years. But for Citi, due to its higher internal targets for credit loss rates, the bank is likely to feel the pain of a deteriorating economy earlier and to a far larger extent than its peers. Have a look at Page 12 of Citi’s most recent Y-9 performance report published by the Federal Financial Institutions Examination Council (FFIEC) to get a real sense of just how different this bank is from the other members of Peer Group 1. Citi is particularly exposed to a downturn in corporate credits in the commercial and industrial (C&I) sector, not only because the bank has a relatively high LGD rate (60bp) on its loans but also because of the large amounts of unused credit available to the bank’s customers (50bp). The classical Basel measure for “exposure at default” (EAD) for Citi is the highest in the large bank peer group at almost 200%, meaning that on average C’s customers can access another $2 in credit for every dollar of loans currently drawn. Today Citi’s credit exposure in the event of customer defaults is two standard deviations above its peers, but to be fair the bank’s EAD was even higher – nearly 300% -- before Citi failed in 2008. The key credit issue facing many US banks in 2017 and beyond is commercial loans and related commercial real estate credits. At present, one quarter of Citi’s loan book is in C&I credits with a gross spread of just 160bp vs almost 300bp for its real estate loans. By comparison, Bank of America has a cross spread on its C&I portfolio of 227bp, JPMorgan is 264bp, US Bancorp (NYSE:USB) is 260bp and Wells Fargo (NYSE:WFC) is at 380bp, a stark illustration of just how aggressive Citi has been in pricing its business loans. Citi’s equally large credit card book – in nominal terms the most profitable part of the business – has a gross spread of almost 1,100bp, but also reported over 300bp in defaults in 2016. Still, with a 800bp net margin before SG&A, credit cards are Citi’s best business. Indeed, Citi’s payment processing and credit card business are the crown jewels of the franchise. If there were some way to sell the rest of the Citi operations, the payments processing and credit card business could be worth a multiple of Citi’s current equity market valuation. The trouble with Citi and many other US banks is that their business are dominated by consumer credit and real estate exposures, with little in the way of pure C&I loans. When you look at most US banks, the vast majority of the exposures are related to real estate, directly or indirectly. Thus when the Fed manipulates asset prices in a desperate effort to fuel economic growth, they create future credit problems for banks. As our friend Alex Pollock of R Street Institute wrote in American Banker last year: “[T]he biggest banking change during the last 60 years is… the dramatic shift to real estate finance and thus real estate risk, as the dominant factor in the balance sheet of the entire banking system. It is the evolution of the banking system from being principally business banks to being principally real estate banks.” So whether a bank calls the exposure C&I or commercial real estate, at the end of the day most of the loans on the books of US banks have a large degree of correlation to the US real estate market. And thanks to Janet Yellen and the folks at the FOMC, the US market is now poised for a substantial credit correction as inflated prices for commercial real estate and related C&I exposures come back into alignment with the underlying economics of the properties. Net charge offs for the $1.9 trillion in C&I loans held by all US banks reached 0.5% at the end of 2016, the highest rate since 2012. In New York City, for example, the term “overbuilt” does not begin to describe the situation in the commercial real estate sector. Rental rates for residential and commercial properties are falling. And more capacity in multifamily, office space and even hotels is coming to market in New York over the next several years. Jonathan Miller of Miller Samuel has been chronicling the travails of the high end condo market in New York, where only sharp price cuts and incentives have been successful in moving the rising amounts of inventory. He writes about the iconic One57 West 57th Street skyscraper: “When we talk about super luxury condos in Manhattan, One57 is top of mind. After years of slow sales, and no sales in the first half of 2016, they saw a surge in activity at the end of 2016. This bump was likely not related to improving market conditions but rather the introduction of their lower priced former rental units priced closer to current market conditions.” So if you want a good bellwether for what is going on in the world of large C&I and commercial real estate loans, keep a close eye on Citi – the clear outlier among the large US money center banks. In terms of the pricing of its loans, its loan default rates and key operational credit metrics such as loss given default and exposure at default, Citi is easily one of the most aggressive banks in the top 10 US banking institutions by assets. When the impact of the deflating Trump bubble, rising interest rates and ebbing exuberance among investors starts to really bite on US lenders this year and next, the pain will be visible earlier and in larger proportion at Citi than at its large cap peers. Citi is, as it has always been, the proverbial canary in the coal mine of finance.

Below follows an extended soliloquy by my friend and mentor Fred Feldkamp, who was a partner at Foley & Lardner in Detroit, about how the SEC’s changes to Rule 2-a7 in 1998 caused the failure of LTCM. Here's a comment on your presentation that you and your team should understand. It makes a big difference in what "should" be done. If you look at the front cover of the 2005 book I wrote, you'll note that the "Rule 2a-7 Amendments Take Hold" balloon is right at the seam (on the bottom). That's because the amendments were adopted in March or April of 1998, before LTCM got in trouble, NOT because of that trouble.. If you focus on the red line of that chart (spreads between high grade and high yield debt, you'll see that I began an entirely new (and very disastrous) market phase at the point then the amendments took hold. THE AMENDMENTS WERE NOT ADOPTED IN "RESPONSE" TO LONG TERM CAPITAL'S DIFFICULTIES, CHRIS, THEY CAUSED THOSE DIFFICULTIES!! The jump in spreads that killed LTCM is the one that starts at that seam of the book cover and does not trend down until late Sept. of 1998 (on that cover, credit spreads are INVERTED so "up" is actually "down"--to show the inverse correlation between spreads and equity prices). The uptrend that killed LTCM began about 60 days before the 1998 amendments took hold. The trigger event was a requirement that "new" MMF investments in ABCP had to track "10% obligors" for commercial paper (CP) that the money market fund (MMF) would hold as of July 1, 1998. The definition of what was and was not a "10% obligor" was totally indiscernible in practice (for reasons far too complex to put in writing--I did a PowerPoint presentation to explain that when the SEC finally asked my client to come to DC and explain what the heck happened to all short-term credit markets, starting in May 1998). I explained to them that was when lawyers representing sponsors of MMF's told their clients they'd need to ask CP sellers from which the funds bought paper whether there were any 10% obligors supporting any new asset-backed commercial paper (ABCP) investment (if it would mature after July 1, 1998). When ABCP sellers would ask the fund "What the heck is a 10% obligor?" the usual response was "I don't know, but my lawyer says we need to know that and to track those obligors." The ABCP issuer would then reply: "What will you do with that information?" The KEY response then was: "Since we don't know how to track those things, we'll just have to refuse to buy any ABCP from you." AS A RESULT, CHRIS, ANY INVESTOR THAT WAS FUNDING LONGER TERM MORTGAGE BACKED SECURITIES (MBS) OR ASSET BACKED SECURITIES (ABS) ASSETS USING ABCP SUDDENLY LEARNED THAT THEY'D BE CUT OFF FROM FUNDING IF THEY HAD DIVERSIFIED THEIR INVESTMENTS BY WELL-STRUCTURED SECURITIZATIONS. In short, the SEC's division of investment management TOTALLY CUT OFF ANY NON-BANK ABCP ISSUER AND FORCED EVERY MONEY MARKET FUND TO RELY ENTIRELY ON BANKS AND BANK-SPONSORED SIVs FOR THEIR CP INVESTMENTS. It was totally misguided. The cause was the support of bank SIVs by the ASF. That commitment of bank-dominated attorneys and issuers did not dissolve until the market finally rejected Paulson's "super SIV" in 2007-8. THE REASON WE HAVE NEVER OVERCOME THE DRAG CREATED IN 1998 IS THAT WE HAVE NEVER FUNDAMENTALLY CHANGED THAT 1998 RULE. That failure can be attributed to the fact that they guy who did the rule did not leave the SEC until the Dodd-Frank rules were done (2012). Failure to see through that guy is THE FAULT OF ART LEVITT AND THE BUSH/OBAMA TEAM PEOPLE WHO LISTENED ONLY TO BANKERS FOR FAR TOO LONG. At the start of my client's SEC August/Sept. presentations to explain how the div of inv. mgmt. had entirely destroyed the nation's non-bank funding mechanisms, the arrogant jerk in charge of that area said "You know, we can't do anything for you that we won't do for everyone else." To which my client (which long-predated the SEC's existence) responded "We'd never make that request." At the point in my PowerPoint when it became entirely obvious that the SEC had, in fact, destroyed not just LTCM but the entire ability of productive sector firms to access MMFs, this same numbskull actually looked at my client and said: " Mr. ______, WHAT CAN WE DO FOR YOU?" (During the presentation, moreover, he actually said he found no problem with restricting MMFs to only buying paper from banks. He had no concept of how markets should work.) NOW, BACK TO THE COVER CHART. The reversal of trend that occurred in Sept. 1998 (the point where the red line on that cover chart turns "up") occurred on the day that we and the SEC agreed to a "grandfathering" of MBS/ABS that existed on the day the dumb regs were effective (July 1, 1998). We know that because as we worked out the last details, the SEC told us they wanted to finish the work quickly because lots of NYC people were blasting them for details of the relief that the SEC told them was forthcoming. This made it clear that the SEC knew it was THE cause of the 1998 crisis. Since that relief coincided with the purchase of all LTCM's assets by a Fed-arranged consortium of big banks, the investing banks profited because of the relief my client arranged. We told those SEC blockheads who wrote that idiotic rule that the impact of grandfathering was merely a delay in the crisis they caused (for about a year and a half or so). If you look at the red line on the chart for the year 2000, you'll see that failure to substantively change the Rule 2a-7 mistake caused a much bigger crisis that year. STILL, the SEC staff never proposed to change the rule's impact to create a bank monopoly/monopsony of MMFs. That is what caused non-banks to issue garbage deals that met the garbage reg (e.g., the famous Lehman 105 fraud) in 2000-2005. It is, in turn those disastrous speculations that caused the debacle of 2007-9 and, since the SEC has never gone back to look at the substance of their 1998 blunder, it is now causing the US to have absolutely no creativity in debt funding. So, all we have is an out of date bank-controlled lending system that, as it always has, simply cannot get the nation out of a rut. THE JERK THAT REFUSED TO MAKE SUBSTANTIVE CHANGE IN THE 1998 RULES ACTUALLY ACKNOWLEDGED THAT THEY CAUSED THE 1998 PROBLEM. HE "JUSTIFIED" REFUSAL TO DO WHAT WAS RIGHT BY SAYING: "Since the Commission so recently adopted the rules, it's too embarrassing for them to reverse that now." He was really saying "I'd be fired if they learned what we actually did by those rules." Since the guy left the SEC in 2012, there is "hope" that the SEC may change course and fix that mess, but it will do so only if it has realized just how destructive that guy was and is trying to fix whatever mistakes he made.