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New York | People keep asking what we think of the 10-year anniversary of the collapse of Lehman Brothers. Our answer is that not much has changed. Lehman once had the best performing bank in the US and then it was gone. Why? Fraud on loans and securities. Fraud in different forms still prevails in the world of investing, but has migrated from banks to non-banks like funds and BDCs, and of course structured securities. Derivatives are the enablers of fraud. That is the core lesson of the 2008 financial crisis, but a truth that is rarely discussed. Instead we talk endlessly about "capital" as though it matters. Saying banal, irrelevant things about the anniversary of the Lehman failure certainly helps to fill an otherwise empty media void. But we never, ever talk about the true cause of the crisis, namely securities fraud by some of the biggest firms on Wall Street. These bankers and firms were not punished, thus we remain at risk. Not only has nothing changed since 2008, but as in 2006, we have convinced ourselves that everything is just fine. Residential and commercial real estate valuations have gone crazy since 2010, but everything is fine. Just remember that the financial crisis of 2008 really began in 2005 when Countrywide and Washington Mutual began their slow motion collapse, like a small rock slide at the top of a mountain. By 2006 the mortgage market was slowing -- as it is today -- and smaller non-bank firms were collapsing under the double whammy of falling volumes and rising costs. When New Century Financial and Long Beach collapsed in 2007, regulators were approached about the coming contagion, but nobody at the Fed or other agencies believed it. By 2008 came the avalanche. We identified the cause of the subprime crisis a decade ago in a paper published by Indiana State University entitled: "The Subprime Crisis: Cause, Effect and Consequences." We argued that three basic issues were at the root of the problem -- issues that remain unresolved today. First was an odious public policy partnership, spawned in Washington and comprising hundreds of companies, associations and government agencies, to enhance the availability of affordable housing via the use of creative financing techniques. Second, federal regulators have actively encouraged the rapid growth of over-the-counter (OTC) derivatives and securities by all types of financial institutions. And third, also bearing blame for the subprime crisis is the related embrace by the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board of fair value accounting. Again, nothing has changed in a decade. Most of the "sales" of securities done on Wall Street are not true sales at all. For example, how does a lender transfer the ability-to-repay (ATR) risk in a prime, non-QM mortgage to an end investor? Ben Bernanke, Hank Paulson and Tim Geithner are heroes and the regulators will save us next time. Click here to read the paper on SSRN. Further Reading Why Rising Interest Rates Are Not Always Good For Banks https://www.zerohedge.com/news/2018-09-07/why-rising-interest-rates-are-not-always-good-banks #LehmanBrothers #FederalReserveBoard #NewCenturyFinancial

New York | In this issue of The Institutional Risk Analyst , we take a look at an important player in the world of mortgage finance, Texas Capital Bancshares (TCBI), a $27 billion asset institution that punches well above its weight in regional and national markets. If you want to know how we view the entire US banking industry, including our projections for bank funding costs, the latest Q3'18 edition of The IRA Bank Book is now available in our online store. The first thing to notice about TCBI is that the stock price is up 20% over the past year, outperforming the S&P 500. It currently trades around 2x book value, putting it into the select category of smaller members of Peer Group 1. The equity of the Dallas-based institution has a beta of almost 2, making it twice as volatile as the broad market and a comp for high beta stocks such as Citigroup (C). Bank of the Ozarks (OZRK) has a beta of 1.4, by comparison. Half of the bank’s $22 billion loan book is allocated to commercial and industrial loans, with about a quarter of total loans held in mortgage finance loans. But that statistic is misleading. Over the past six months, the bank originated and sold short-term mortgage finance loans totaling $45.6 billion or twice the bank’s balance sheet. The C&I loan portfolio includes business finance and energy sector loans. A lot of the bank’s exposure is tied to the Texas economy and, directly and indirectly, to residential and commercial real estate, but TCBI has a national footprint. “More than 50% of our loan exposure is outside of Texas and more than 50% of our deposits are sourced outside of Texas,” TCBI notes in its most recent 10-Q. “However, as of June 30, 2018, a majority of our loans held for investment, excluding our mortgage finance loans and other national lines of business, were to businesses with headquarters and operations in Texas. This geographic concentration subjects the loan portfolio to the general economic conditions within this area. We also make loans to these customers that are secured by assets located outside of Texas.” TCBI is a significant lender to mortgage finance companies, an important but increasingly risky business given the parlous state of the residential lending business. One national warehouse lender told The Institutional Risk Analyst last month that most non-bank mortgage lenders are in violation of their loan covenants due to the poor profitability of the industry. The good news is that most of TCBI’s lending is secured, but once the non-bank mortgage company disappears, the customer is gone and so is the revenue. The watchword in the world of mortgage finance today is “forbearance.” TCBI is a very strong financial performer, consistently reporting above peer profits and below peer loan loss rates. The bank is very focused on lending as opposed to non-interest income, with almost 88% of total assets in loans and leases vs the mid-60s for its peers. Interest income from earning assets is near the top of the peer group, but loan commitments as a percentage of total loans – what we call “exposure at default” in the lingo of Basel I -- is actually lower than its larger peers. Significantly, 85% of the bank’s deposits are sourced from “core customers,” the life’s blood of any lender. But with that said, the rate of growth in non-core funding is far higher than its peers, reflecting the above peer rate of asset growth for the bank. This includes $4 billion in advances from the Federal Home Loan Banks or some 15% of total assets. Overall, the funding costs for TCBI have doubled over the past 12 months as with many other banks in the US There are two big potential threats on the horizon for small, growth oriented lenders such as TCBI. First, the real estate market will eventually cool, making the easy money seen in recent years just a distant memory. That process is already underway in many markets served by this institution. When residential and commercial real estate prices start to weaken in markets such as Texas, that's when you learn that all loans have real estate exposure behind them. Second, the phenomenal economic growth experienced in Texas over the past decade may also start to falter. “At a time where rest of the country is challenged by aging populations, slowing workforce growth and a loss of working age population, with this population growth, Texas is bucking a lot of those trends,” says Robert Kaplan, President of the Federal Reserve Bank of Dallas. “Texas is extremely well positioned.” Trees never grow to the sky, even South of the Pecos. But in Texas sometimes the trees can get so tall that you don’t see the clouds forming on the horizon. Remember the oil bust of the 1970s and pass the hot sauce please.

Grand Lake Stream | The discussions this weekend at Leen’s Lodge in Maine were wide ranging and, as always, of great interest. Will Argentina’s economy implode? (A: Sadly yes). Argentina is trading at a discount to Uruguay. Will the commercial real estate market in the UK likewise collapse as the train wreck called Brexit unfolds? (A: In progress). When will the yield curve invert? (A: Soon). Indian Township, Maine One of the most interesting points of debate was the impact of the 2001 decision by the US Treasury to focus debt issuance on the front of the yield curve in order to minimize the debt service cost to the United States. Along the way, the question arose: Is the United States really a “AAA” credit? Readers of The Institutional Risk Analyst know that we have recently been focused on how Fed policy has manipulated the pricing of the yield curve as well as private credit spreads . But so too has the Treasury’s decision almost two decades ago to limit issuance of 30-year debt affected the cost of credit and, at the present time, is exacerbating the flattening of the yield curve. On October 31, 2001, following the 9/11 attacks, Treasury Undersecretary for Domestic Finance Peter Fisher famously made the following statement: “We do not need the 30-year bond to meet the government's current financing needs, nor those that we expect to face in coming years. Looking beyond the next few years, as I already observed, we believe that the likely outcome is that the federal government's fiscal position will improve after the temporary setback that we are now experiencing.” But of course the Treasury’s fiscal situation did not improve. Since 9/11, continued profligacy in Washington has caused the federal debt to explode. As the surge of tax receipts generated by the aging of the baby boom have ebbed, the indebtedness of the United States has soared and with it the portion of US debt that is issued in short-term maturities. The 2017 tax legislation has only accelerated an already negative fiscal trend. The General Accountability Office notes in its most recent audit that since fiscal year 1997 total federal debt has increased by 275 percent. Also during this period, the statutory debt limit has been raised 17 times. The GAO notes in its most recent audit report: “Debt held by the public as a share of gross domestic product (GDP) was roughly 76 percent at the end of fiscal year 2017, down slightly from roughly 77 percent at the end of fiscal year 2016. Over the longer term, debt held by the public as a share of GDP is expected to grow as a result of the structural imbalance between revenue and spending. Federal spending on health care programs—driven by an aging population—and interest on the debt held by the public are the key drivers of growing spending in the long term… While today’s relatively lower interest rates have kept interest costs down, interest rates are expected to rise in the long term, resulting in increasing interest costs on the debt. The key drivers of spending will continue to put upward pressure on the budget. Absent action to address the growing imbalance between spending and revenue, the federal government faces an unsustainable growth in debt.” On August 5, 2011, Standard & Poor's (S&P) reduced the US sovereign rating from AAA (outstanding) to AA+ (excellent), causing more than a little commotion among the economists and investment professionals attending Camp Kotok at the time. Panicked members of the financial media were seen desperately trying to acquire a cell phone connection in order to opine on the S&P action. Of note, at the time of the rating action, S&P left the transfer and convertibility (T&C) assessment of the US at “AAA” in a reflection of the strong global acceptance of the dollar as a means of exchange. The fact of the dollar’s role as the reserve currency, as a means of exchange and also as a store of value for the citizens of smaller nations enables the US to largely escape the consequences of the libertine behavior of Congress. Nations such as Argentina, Greece, Venezuela and Turkey feel the consequence of fiscal deficits in terms of T&C. Just as investors like to trade the equity of zombie banks like Citigroup (C) and Deutsche Bank (DB) because of liquidity, the world uses dollars because of universal acceptance and size. No other currency is big enough to support international trade flows for things like energy and capital goods, and also be the reserve currency for global finance. This is the key factor that enables the US to avoid the impact of increasingly absurd fiscal decisions in Washington. As noted in the 2010 book “ Inflated: How Money and Debt Built the American Dream, ” Americans like to think themselves prudent in financial matters, but also have a libertine streak a mile wide. The purposeful citizens who a century ago survived depressions and wars have been succeeded by grandchildren who neither know nor understand practical limits to their wants and desires. Whether or not governments in China or Russia buy Treasury debt or not does not matter, for now at least, because the vast world of dollar finance will easily absorb the assets. The slowly deteriorating credit standing of the US seems to prove the old judgment that Americans will always do the right thing after exhausting all of the other possibilities. For now the fact of dollar hegemony saves us from our collective idiocy – as when the Congress confiscates the assets of the Federal Reserve System to paper over what thin budgetary restraints remain. The Fed is the alter ego of the Treasury in financial and economic terms, a nuance that is happily ignored in Washington. In 21st century America, members of Congress pretend that debt forgiveness by the central bank – aka “quantitative easing” -- is revenue. Members of the FOMC are notably silent on the question. When Americans reach the point of seeing debt-to-GDP for publicly held debt over 100%, then both S&P and the other rating agencies will be forced to start weighing quantitative fiscal factors more heavily. In terms of total debt, we're already there. The special role of the dollar as a global exchange medium will come under greater pressure as the public debt grows. When and if the markets ever start to cool on dollars, the management of the Treasury’s debt issuance strategy may also come under scrutiny. Back in 2001, Peter Fisher outlined two possible but “less likely outcomes” for the US following the 9/11 attacks: “First, it is possible that the federal government will return to significant and sustained budget surpluses even more quickly than we now expect. In this event, maintaining current issuance levels of 30-year bonds would be unnecessary and expensive to taxpayers.” “Second, we face the possibility that sustained surpluses do not materialize as promptly as we now expect. If later in this decade it turns out that 30-year borrowing is necessary to meet the government's financing needs, it is still likely that our decision to suspend 30-year borrowing at this time will have saved the taxpayers money. In addition, the reintroduction of the 30-year bond, at some point in the future, if necessary, would likely be costless to the Treasury.” In 2009 during the depths of the financial crisis, the Treasury temporarily reversed the Fisher decision and began to issue longer-dated securities. From an average maturity of just 45 months in 2009 the Treasury issued longer dated debt until the end of 2017, when the average maturity reached almost 72 months, Bloomberg reports. At one point Treasury Secretary Steven Mnuchin actually talked about issuing an ultra-long bond with a maturity of more than 30 years, but such ruminations have stopped with the end of QE. Almost two decades since 9/11, the fiscal situation of the US has reached crisis proportions, but so far Washington is saved by the fact that the dollar is still the biggest game in town. The Fed’s experiment with purchases of trillions in Treasury debt, the kind of behavior seen from developing nations like Mexico and Argentina during the 1980s debt crisis, has also provided a huge subsidy to the Treasury. Congress may one day mandate such an expedient on a permanent basis. In the event, the pretense of Fed independence will be discarded with finality and America’s credit rating is likely to fall further. The decision by Treasury in 2001 and more recently in 2017 to limit the duration of the Treasury’s debt, may have less efficacy in a world where central banks are manipulating interest rates and credit spreads. Or more to the point, if the Treasury today can borrow at 30 or 50 or even a hundred years at low single digit rates, why doesn’t Secretary Mnuchin do that trade? Additional issuance of longer dated Treasury debt might counteract a flattening curve and restore spreads and profitability to many parts of the financial economy such as banking and housing finance. As we'll be discussing in future issues of The Institutional Risk Analyst , US banks are not profitable because they are making great spreads on loans or securities, but because of cheap funding -- an advantage that is rapidly disappearing. Nations like Argentina and Turkey show the dangers of funding in dollars when you have a weak, small currency. Size matters. That is one big reason why the EU, China and Brazil have not been able to create an effective competitor to the dollar. Those remaining “AAA” sovereigns like Canada, Australia and Belgium have limited capital markets access. But if Americans manage to convince the rest of the world that we are indeed libertines and appropriate subjects for ridicule, then size may become a considerable disadvantage. As Mark Twain observed: “Suppose you were an idiot, and suppose you were a member of Congress; but I repeat myself.” View from landing at Leen's Lodge on West Grand Lake #CampKotok #PeterFisher #Treasury #Mnuchin

New York | Last week Federal Reserve Board Chairman Jerome Powell confirmed that the Federal Open Market Committee intends to keep raising short-term interest rates based upon the strength of the US economy. Powell gave no indication that he is concerned about the rapidly approaching inversion of the Treasury yield curve or what this portends for banks and leveraged investors of all stripes, including the housing finance sector. Also last week, the Federal Deposit Insurance Corporation released the Q2 ’18 data for the US banking industry, allowing us to update readers of The Institutional Risk Analyst on the increasingly dire situation in the credit markets. Spreads are as tight as they’ve been in decades and behavior by issuers grows more absurd by the day. Bank interest income rose 15.7% year-over-year but interest costs rose 61% between Q2’17 and Q2’18. We’ll be updating our projections for the impending peak and decline in bank net interest margins after Labor Day in The IRA Bank Book. Even though the costs of funds for US banks is rising four times faster than bank interest earnings, the degree of financial subsidy -- aka "financial repression" -- to the US banking system c/o the FOMC remains massive. As the chart below illustrates, 83% of bank net interest earnings is still going to bank equity investors vs just 17% to depositors and bond holders. Or to quote Barry Ritholtz over the weekend: “I always translate the phrase ‘financial repression’ as ‘God damn, I just missed a hell of an equities rally.’” Banks have benefited enormously from “quantitative easing” (QE). “Net interest income totaled $134.1 billion, an increase of $10.7 billion (8.7 percent) from 12 months earlier and the largest annual dollar increase ever reported by the industry,” notes the FDIC. But strangely our favorite prudential regulator fails to note that bank funding costs rose $5 billion in Q2’18 and, by year end, interest expenses will be rising as much or even faster than are bank asset returns. The same curve flattening dynamic that is threatening bank profitability will also severely impact REITs and other leveraged investors, which may be forced to liquidate leveraged positions. Unless and until the Fed liquidates its own portfolio down to pre-crisis levels (~ $3.2 trillion), the return on bank assets is unlikely to rise very quickly. Under the baseline scenario released by the Federal Reserve Bank of New York in April 2017, the FOMC would push excess reserves down from $2 trillion today to ~ $500 billion in 2021 in a "normalized" Fed balance sheet. Of note, there is currently a debate inside the Fed as to whether the FOMC should slow its portfolio reduction plans in order to maintain a higher level of excess reserves. In an excellent August 14 research report entitled "The Fed's USD1.0tr question," Kevin Logan of HSBC writes: “[R]ecent money market developments suggest that the demand for bank reserves in a normalized Fed balance sheet could be USD1trn or more, at least twice as large as the USD500bn in the New York Fed’s baseline scenario. New bank regulations imposed after the 2008/2009 financial crisis have increased the amount of high quality liquid assets (HQLA) that banks are now required to hold. Reserves held at the Fed are the ultimate in HQLA for banks. They are completely liquid and, from a credit risk standpoint, are of the highest quality.” Logan argues that the FOMC may end its portfolio reduction program sooner than expected, perhaps by the end of 2019 because regulatory changes have made a larger excess reserve position necessary. But he also notes that: “[S]everal academics and former Fed officials have argued that the Fed should return to a small balance sheet, one in which reserves are scarce. They argue that a large balance sheet distorts capital markets by putting unnecessary downward pressure on longer-term interest rates. A large balance sheet could also impede market functioning and the price signals coming from an active federal funds market that reflects the credit worthiness of banks involved in the market.” Put us on the side of the academics and former Fed officials who understand that the FOMC’s expansion of excess reserves to fund its purchases of trillions of dollars in securities for QE did enormous damage to the US money markets – damage yet to be undone. Instead of encouraging banks to again buy US Treasury debt to fund liquidity requirements, the FOMC apparently prefers to further subsidize the banking industry by indefinitely providing a ready supply of risk-free assets in the form of excess reserves. But doing so also suggests that bank interest income will not rise along with the FOMC’s increase in short-term interest rates, as shown in the chart below. We all need to remember that QE was not a form of economic "stimulus," but rather a backdoor subsidy for the US Treasury. The bonds owned by the FOMC that created the excess reserves ought to be in private hands. The Fed (and other central banks) are suppressing long-term interest rates by holding $10 trillion worth of securities, positions that are entirely passive, not financed in the private markets and also unhedged. These large portfolios of securities held by central banks are not only keeping long-term rates down, but are also responsible for tight credit spreads and low levels of secondary market activity. The only beneficiaries of QE are the growing number of governments among the G-10 nations that are headed for debt problems. Some economists worry that providing banks with risk free reserves discourages lending, but we think the damage to the money markets is a far more grave concern. QE and “Operation Twist” have forcibly crushed credit spreads and loan profitability. Large US banks, for example, lost almost 1% net on residential production in Q2’18, according to the Mortgage Bankers Association. As in 2006, banks in the residential mortgage sector are fighting over conforming loans to put into private label securitization deals, this as lending volumes fall. Only by gradually forcing banks to shed excess reserves and replace these risk free assets with Treasury and agency securities will the money markets again begin to operate. Of course, as excess reserves run off, the real debt load on the Treasury will grow. Do Jay Powell and the other FOMC members have the political courage to end the subsidies for the US Treasury and banks, and thereby end financial repression? If the FOMC sticks to its guns and pushes excess reserves down to $500 billion as now planned, long term rates will rise, the functioning of private money markets will return and savers will see an increased share of the interest rate pie. Banks will trade and hedge and finance larger Treasury positions, and this private market activity will put upward pressure on long-term Treasury yields. Dealers will earn additional income from an increase in trading and hedging activity. Lenders may even start to see expansion of spreads for credit products. Then and only then, when the functioning of private markets have been restored, can the FOMC truly declare victory. #financialrepression #REIT #HSBC

New York | Watching the meltdown of Tesla Motors (TSLA) founder and CEO Elon Musk last week unfold in the pages of The New York Times , we are reminded that enterprises need both vision and operating smarts to be successful. It was obvious years ago that Elon Musk needed help to build a new car company. Yet somehow the members of the board of directors of TSLA did nothing as Elon Musk led this extraordinary endeavor. We noted in Ford Men: From Inspiration to Enterprise that Henry Ford had the vision thing, but his partner James Couzens turned the idea into a successful business. So bad was his reputation for tinkering and racing that Ford was not even an officer of Ford Motor Co (F) when it was founded, but he had an idea. Thanks to Jim Couzens, in less than a decade that idea Henry Ford nurtured exploded into one of the great American fortunes, a transformational fortune built on manufacturing. The business was wildly successful and repaid its investors and more in the first year. And thanks to another Ford Man, engineer Charles Sorensen, Ford Motor Co invented the assembly line that enabled the company to meet the astronomical demand for cars a century ago. Musk is no Henry Ford, but TSLA is the latest case in point to the lesson that solitary leaders often fail. No matter how brilliant or inspired, most of us need the moderation and help of business partners, directors and investors to make an enterprise succeed and endure. Having Horace Dodge on the board of directors of Ford Motor Co, for example, certainly did not hurt the company’s prospects. The Dodge Brothers actually built the early Ford cars as kits until the Ford Motor Co had its own factory. When Couzens resigned as General Manager of Ford in 1915, the company was by then controlled solely by Henry Ford and would suffer for three decades from his distracted, idiosyncratic mismanagement. The fact that Ford Motor Co did not fail prior to WWII is a miracle. How difficult was Henry Ford? Think Steve Jobs squared. Of course, personalities and vision are essential to any enterprise, but the enterprise cannot be dependent upon just one person if it is to be enduring. Over the years there were many managers and bankers who kept Ford Motor Co afloat. But for the singular efforts of James Couzens, though, Ford Motor Co almost surely would have been Henry Ford’s third business failure. Personalities and vision are important in business, no doubt. Henry Ford II saved Ford Motor Co from bankruptcy after WWII, but he had a deep bench of managers and financial minds behind him and the Ford family. Yet fate plays a strange role in business. Ponder how different the auto industry would be today had Horace and his brother John Dodge not both died of the Spanish Flu in 1920. Dodge might be the number one US automaker followed by GM. Ford Motor Co might have already disappeared from view under the erratic leadership of Henry Ford. The Fords are celebrities but not magicians. You need a dose of techno buzz to achieve that. Had Bill Ford announced in 2003 a project to build all-electric Ford cars, he might have caused a bit of a stir. But Bill Ford never would have escaped the financial straight jacket of the existing auto business. Technology demigod Musk, on the other hand, was able to launch a “new” car company at a technology market multiple based upon the dubious promise of future profits from battery power. But Musk also is TSLA's single point of failure. The dependence upon Musk to maintain the nose-bleed valuation of TSLA seems a key reason why TSLA's timid board has not tolerated any competition in the CSUITE. Despite the tech sector pretensions, the impact of TSLA and Musk on the auto industry is enormous. Consider the fact that Geely expects to IPO Volvo Cars at a $30 billion valuation – more than 16x the $1.8 billion Ford received from the sale of the business in 2010. The Volvo IPO owes as much to the hype surrounding TSLA as it does to the credit market machinations of global central banks. Does a business that made half a million cars last year with a single digit profit margin really deserve a $30 billion valuation? Only if you really, really believe that TSLA is worth $52 billion or more with a fraction of that output. But if TSLA crashes, then the Volvo IPO very likely is toast as well. Just as Tesla had thrived due to the vision and passion of Musk, the company’s prospects and equity market valuation would suffer greatly in his absence. Tesla without Elon Musk is just another unprofitable car maker, albeit one that promises to “accelerate the world’s transition to sustainable energy.” Really? To us, Musk and his investors are stuck on the horns of a very nasty dilemma. In order to make TSLA a functioning car manufacturer, CEO Musk must bring in some operators before he burns out or worse. But to do so means destroying the techno hype that has fuled TSLA's forwad equity valuation, enabling Musk to burn through billions in debt and equity capital based upon a promise of “green” transportation. Anybody familiar with making lithium batteries knows that this technology is anything but green or sustainable. The most recent outburst by Musk about a fictional going private transaction illustrates that the reputation of a successful inventor may not necessarily translate into business acumen. Visionaries such as Musk and GM founder William Durant, on the other hand, are showmen. They are great at building new businesses so long as they are spending someone else’s money. Ultimately, the iron law of profit and loss destroyed the lofty dreams of Durant, forcing GM into the arms of JPMorgan and the DuPont zaibatsu twice prior to WWII. We suspect that the same fate awaits TSLA and its credulous shareholders. And as we've said before, the bond holders are the true owners of TSLA. Investors rightly love Elon Musk because he is more than a mere speculator like Durant. Musk imagines big ideas and turned many of them into reality, a proud achievement that he shares with another great American inventor, Thomas Edison. It was Edison, never forget, who loved the idea of electric vehicles. Yet ultimately when Henry Ford left Edison’s employ in 1900 to build cars, he chose to use gasoline instead of electricity. After creating and selling what would become the General Electric Co, Edison’s business fortunes declined. Merely being brilliant and having a vision of the future was not enough. Ford’s immensely powerful mind generated its own inspirations based on observing the industrial activity that was welling-up from the ground in and around the Detroit region in 1900. He took counsel with peers like Edison, Dodge and Harvey Firestone. Musk belongs to this same exclusive category of visionary inventors inspired by change. But Ford, Edison and Musk all stand as examples of why being a visionary is not sufficient to be successful in building and operating a business. As we noted in an earlier comment (" Should Elon Musk Sell Tesla? "), Musk has defined a market for electric cars and created a brand, but the better part of valor may be to declare success and sell his creation to a larger global manufacturer. Henry Ford called Edison “The world’s greatest inventor and the world’s worst businessman,” a telling assessment that was confirmed by the series of failed commercial ventures. Edison himself said that having an idea is not enough. But Ford’s criticism of his longtime friend and mentor was more than a bit ironic. Henry Ford’s fortune also required the efforts of many, many other people, as described in Ford Men . John Kenneth Galbraith summarized the basic truth when he wrote in Atlantic Monthly more than a half a century ago: “Although Ford conceived of the Model T, Couzens made the Ford Motor Company.” Elon Musk now faces this very same challenge of how to turn inspiration into an enduring and profitable commercial enterprise. Leaving aside the particular operational concerns of building an electric car, Elon Musk and Tesla face a more basic problem. In the century and more since Henry Ford, James Couzens and Horace Dodge began to build cars, the automobile has become a very relevant but entirely undifferentiated commodity good. There are basically three types of cars: small, mid-sized and full sized. Most of these are now styled outwardly as SUVs, but are designed to maximize efficiency and minimize price. And the companies that manufacturer these vehicles all barely make money. The fact that TSLA vehicles are driven by batteries is interesting, but there is nothing transformational about TSLA despite all of the hype about green transportation and "sustainability." Yes, electric motors and batteries are far more efficient today than a century ago, but strides made in internal combustion engines are impressive as well. Compared with the explosive event of the first Ford Model T, when Americans learned 110 years ago that they could get a gasoline powered car instead of a horse, today’s innovations in transportation are incremental. Electricity, gasoline engines, radios and semiconductors, are all the inventions of the past century, while the innovations of today are largely derivative. Seen is this harsh light, is TSLA really worth $50 billion as Friday’s close suggests? Is Volvo Cars worth $30 billion? Really? We shall see. #Tesla #ElonMusk #JPMorgan #Ford #GM

By any standard, credit spreads in the US bond and loan markets remain very tight. Now several years into a Fed interest rate tightening cycle, short-term interest rates are rising but spreads do not expand. A year ago the two year was yielding 1.35%, but today is 2.6%. The 10-year Treasury note, on the other hand, has barely moved in a year, 2.2% then vs 2.85% today. Last we looked, Treasury 2s vs 10s was 25bp compared to almost a point a year ago. What a flattening yield curve and tight spreads say to us is that while the FOMC may raise short-term rate targets, in fact the demand for longer duration assets remains very strong indeed. Turkey or not, the 10-year rejects three percent yield. The fact that the Treasury has greatly increased debt issuance also seems to have been shrugged off by the global debt markets. And the surging dollar is crushing global debt issuers like Turkey and Argentina, and the US benefits -- for now. High yield corporate spreads remain below 400bp over the Treasury yield curve, according to ICE BAML. Spreads for “BBB” rated issuers are inside of 200bp over the curve and “AAA” rated corporates are inside of 50bp over so-called risk free rates. As in 2007, all manner of idiocy is visible in the US credit markets today. Yet every news report about problems in the emerging economies seems to only increase demand for US sovereign risk. The combination of even moderately higher rates and credit crunch around the world has turned the US economy into a voracious, capital consuming black hole. The reason that credit spreads are important is that when spreads rise, lending and capital formation tend to slow down – a lot. When credit spreads for high yield issuers rise above 500bp over the curve, risk lending by banks, funds and bond investors basically slows to a stop. The chart below shows the credit spread indices from ICE BAML c/o FRED with our annotations showing different policy actions by the FOMC over the past decade. Yardeni Research has a great annotated QE timeline . If you compare the market actions of the FOMC and coincident movements in credit spreads, with public statements by Fed officials, a fascinating and somewhat confused picture emerges. But let's start with some context. Spreads were actually quite elevated in the early 2000s, both before and after the 911 attacks, but responded to Fed ease by gradually falling until HY spreads bottomed out at 250bp over the curve in June 2007. Indeed, HY spreads today are unchanged from a decade ago, just before the financial crisis. With the failure of a REIT called New Century Financial and other private obligors in 2007, HY credit spreads exploded, hitting a near-term peak of 800bp over the curve in March 2008. By November of 2008, the failure of dozens of banks, non-banks and two of the four housing GSEs, caused HY spreads to soar more than 2,000bp over the Treasury curve and capital markets activity stopped. Private label mortgage paper was no-bid and even agency obligations were trading at a steep discount. When the FOMC initiated the first quantitative easing (QE), the objective was to re-liquefy the banking system and force credit spreads down. We credit Fed Chairman Ben Bernanke and the FOMC for understanding the important of getting credit spreads to fall so that the financial markets could again start to function. Indeed, by March of 2010 when QE1 ends, credit costs fell dramatically with HY spreads inside of 600bp over Treasury yields. Spreads rose again following the end of QE1, but over the summer the FOMC would announce the reinvestment of all securities purchased via QE1 and by year end announced further purchases via QE2 – even as credit spreads had begun to fall. By March of 2011, HY spreads had fallen to below 500bp over the curve. In September 2011, with credit spreads again starting to rise, the FOMC made a dreadful mistake. It decided to actively manipulate the Treasury yield curve via Operation Twist, selling short-dated paper and buying longer durations. Ironically, the Fed commenced Operation Twist even though conditions in the bond market were already starting to improve. The FOMC noted in June 2012: “This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.” By December 2012 when Operation Twist officially ended, HY spreads had fallen to relatively normal levels ~ 550bp over comparable Treasury yields. Investment grade and high IG bond spreads were likewise compressed. The FOMC then trippled down via QE3 and continued to reinvest principal repayments in the System Open Market Account (SOMA) until the end of 2017. Did the overt market manipulation of Operation Twist push down credit spreads as well as Treasury yields? Or did QE and the rollover of principal do the trick? We may never know which policy action was or was not effective. HY spreads bottomed out at 360bp over in June 2014. Credit spreads then spiked going into 2015 because of concerns about credit losses in the oil patch – losses which largely never materialized due to the surfeit of funds engineered by the Fed. Spreads rose further early in Q1 2016 over concerns about an overheating Chinese economy. These fears then gave way to concerns about the November election and, surprisingly, the win by Donald Trump. But, again, credit spreads quickly retreated because of the huge amount of liquidity chasing too few assets. By the start of 2017, HY and IG credit spreads were back to decade lows, a reflection of the extraordinarily low credit losses experienced since 2012. Did the overt purchases of securities and, via Twist, the deliberate manipulation of the yield curve, promote “a stronger economic recovery” that the FOMC promised? Maybe. But looking at credit spreads since 2015 when QE3 ended, a case can be made that the FOMC overshot the mark, first with QE3 and then by reinvesting principal through 2017. The Fed's action will leave the financial markets badly distorted for years to come and with little to show for it in terms of growth. In particular, the long period of suppressed credit losses in the private sector (which are mirrored in the remarkably good bank portfolio data) suggest that credit losses are now going to follow interest rates higher – at least without further FOMC market intervention. How long will it take to get to something like “normal” in the credit markets? Years. The chart above from Robert Eisenbeis, Chief Monetary Economist at Cumberland Advisors in Sarasota, shows the runoff of the FOMC’s system open market account or “SOMA.” “SOMA has actually bought some securities and sometimes on a weekly basis the portfolio has increased. MBS runoff has been slower than projected but they have not sold assets,” as Eisenbeis told us in a discussion last year . “If runoff is greater than the target, their policy calls for reinvestment, which they did, especially early on when the caps were small.” As the FOMC decreases their share of Treasury and agency securities relative to the portion held by private investors, credit spreads and loss rates more broadly should also revert to the mean. Newbie fintech lenders will cry terrible tears as the cost of credit appears in the portfolio of home improvement/flipper loans they’ve assembled using "artificial intelligence." And commercial as well as residential loss rates will also revert to the mean. Further Reading Projected Evolution of the SOMA Portfolio and the 10-year Treasury Term Premium Effect RealVision: Bank Earnings: Watch the Spread | Chris Whalen #Eisenbeis #Cumberland #Bernanke #FOMC #SOMA

New York | Which are the best performing banks in the US? Equity returns for the entire industry averaged 11.4% in Q1’18, up from 9.6% for all of 2017. There are some smaller banks, however, that generated returns on equity (ROEs) far higher than the average. Large banks tend to significantly underperform smaller peers. Growth rates, margins and equity returns all increase as size declines. In this issue of The Institutional Risk Analyst , we look at some of the better performers in the industry based on ROE. We use the Q1’18 financials from the Fed and FDIC for the comparison. Results in the first quarter featured significant noise due to the downward adjustment of tax loss assets, and upward adjustment in after-tax returns, so look for bank asset and equity returns to be even higher in the future. Among the large banks over $100 billion in total assets, the exemplars will surprise most investors. While the lead units of Bank of America (BAC) and JPMorgan (JPM) made it into the top ten, most of the names are new to our readers. Here are the top seven large bank units by return on equity (ROE) as shown from the TBS Bank Monitor published by Total Bank Solutions. Over $100 Billion Total Assets 1. Discover Bank 2. Charles Schwab Bank 3. Capital One Bank (USA), National Association 4. Morgan Stanley Bank, National Association 5. Fifth Third Bank 6. The Northern Trust Company 7. U.S. Bank National Association The best performer among large banks above $100 billion in total assets is the credit card unit of Discover Financial (DFS). The bank’s 371bp of default in Q1’18 earns it a “B” rating from the TBS Bank Monitor, but the 12.7% gross loan yield (3x its large bank peers) and resulting 24% ROE tell the tale. In second place is the $200 billion asset bank unit of Charles Schwab Financial (SCHW), Charles Schwab Bank in Henderson, NV. With a 21% ROE and zero credit losses it ranks “AAA” in the TBS Bank Monitor. Less than 10% of the bank's business involves lending, while 90% of the bank's risk taking is focused on non-interest income and investing. In third position is the lead bank unit of Capital One Financial (COF), Capital One Bank (USA), which sports a 17% ROE and 711bp of gross defaults in Q1’18, and thus gets a “B” default experience rating. Capital One Bank (USA) outperforms most larger banks by three-fold in terms of equity returns because of the high gross loan spread. Indeed, among the multi-line banks, only the lead bank units of Fifth-Third (FITB) and US Bancorp (USB) made the top seven among the largest US banks in Q1’18. FITB is a leader among the regionals in terms of ROE and stability overall. At $400 billion in total assets, USB is the smallest money center, with national lending and fiduciary businesses. To their credit, USB has stubbornly refused to heed the siren song of asset growth, the sure road to mediocrity. $10 Billion to $100 Billion Total Assets 1. American Express Centurion Bank 2. American Express Bank, FSB. 3. Comenity Bank 4. Stifel Bank and Trust 5. Sallie Mae Bank 6. MidFirst Bank 7. Silicon Valley Bank The next group of banks is between $10 billion and $100 billion in assets and features some strong performers. One and two on the list are the bank units of American Express (AXP). Sporting ROEs of 44% and 38%, respectively, the two bank subsidiaries of AXP have default rates in the BB-B range and asset returns that are four times the industry average. Now you know why the Centurion is smiling. No surprise that credit card specialist AXP trades at 4x book value, a multiple its larger bank peers could never achieve. Also notable among the top seven banks between $10 billion and $100 billion in assets are Stifel Bank & Trust with a 24% ROE, a unit of Stifel Financial (SF), and Silicon Valley Bank, the subsidiary of SVB Financial (SVB), at 20% ROE. The SF bank unit is evenly split between lending and investing, and has a very low efficiency ratio below 20%. The $14 billion total asset credit card specialization bank Comenity, a unit of Alliance Data Systems (ADS), is another solid performer in this size class with a 30% ROE. ADS trades at 6x book value by no coincidence. $1 Billion to $10 Billion Total Assets 1. WEX Bank 2. Cross River Bank 3. Metro City Bank 4. First National Bank of America 5. Merrick Bank 6. NexBank, SSB 7. Green Dot Bank DBA Bonneville Bank Once you go below $10 billion in assets, the equity returns tend to increase as well as the diversity of business models. Consider WEX Bank of Midvale, UT, a $2.6 billion asset commercial lender with a gross spread on its loan book of 23%, an ROE of 84% and a “BB” equivalent loan default rate, according to the latest data from the FDIC. The weighted average maturity (WAM) of the WEX Bank’s loan book is just 90 days. Asset returns are just a tad under 10% or 10x the industry average. Did we mention that half of the WEX loan book is funded with brokered deposits? First National Bank of America is a $1.4 billion residential mortgage lender based in East Lansing, MI. There are a lot of mortgage folks who have made Michigan their home: Quicken Mortgage, Flagstar Bank, Fay Servicing (well, OK, Chicago). Of note, the annual Fay Servicing event, which is held in late August down the street from Wrigley Field in a fine Chicago pub, is rapidly becoming the most interesting discussion in mortgage finance. Speaking of housing, here is a little chart from The Garrett, McAuley Report (August 5, 2018) that tells you all you need to know about the disastrous state of the mortgage sector in 2018. First National Bank of America, the bank unit of First National Bancshares (FNBI), has a 2.8% ROA and a 30% ROE, results that are indeed quite miraculous for a small residential mortgage lender. Even more interesting, this little bank has a 16% risk-adjusted return on capital or RAROC in the TBS economic capital simulation, again confirming our empirical observations that the RAROCs of small banks are better that that of the zombie dance queens of Wall Street. FNBI's bank unit has a 6% NIM, 2x the industry average and 3x large bank results. Loss given default is 85% of par and the bank boasts just 11bp of defaults, well-below peer. First National Bank of America has a collosal WAM of 14.5 years, which means that they are retaining a lot of long-duration mortgage loans. And the gross spreads on the FNBI real estate book are north of 800bp vs maybe half that amount for a large urban lender like JPM or Wells Fargo (WFC). Banks make money on spreads, not interest rates. Merrick Bank is a subsidiary of CardWorks, Inc., a non-bank financial firm in Draper Utah. The $3.5 billion asset bank is a top-20 issuer of Visa cards and also lends on boats and RVs. Despite the high default rate of 1,400bp, which results in a "CCC" loss experience rating, Merrick generates impressive asset (5.7%) and equity (29%) returns. As with WEX, the key to Merrick's success is a strong credit cutlure and a very short duration loan book with a WAM of well-less than a year. Then we have Metro City Bank, the $1.3 billion asset subsidiary on MetroCity Bancshares (MCBS). This small institution is generating in excess of 30% ROE's by charging twice the spread on real estate and consumer loans that a larger bank charges, with below-peer defaults and an efficiency ratio in the 37% range. The bank has 15% Tier 1 Risk Based Capital and a net interest margin in the mid-4% range. Total funding costs are just over 1% vs 3x that amount for larger banks. One of the best performers in the under $10 billion category is NexBank SSB of Dallas, TX. The $8.4 billion bank has a “AAA” rating from the TBS Bank Monitor due to the ultra-low default rate and a 29% ROE. The WAM of NexBank’s loan book is just shy of 10 years or almost two standard deviations above the industry average, reflecting a retained book of hand picked residential and other credits. The pristine credit performance – NexBank has not reported a charge-off since 2015 – pretty much says it all. Chairman James Dondero, Co-Founder and President of Highland Capital Management in Dallas, leads the bank's board. Most important, NexBank does not pay dividends and instead retains capital to fuel its impressive record of growth and credit management. NexBank Capital, the parent company, has a 41% retained capital ratio to total capital vs 8% for the bank's asset peers, according to the FFIEC . What all of these superior performers among large to mid sized banks have in common is that they are closer to the customer and thus better able to provide capital to fuel economic growth. The capital and asset returns of these top performers are indeed stellar because these banks know their customers and can thus better create and manage credit. Part of the reason that the US economy is growing so slowly is that there are far fewer small banks in the US than decades ago, meaning less capacity to provide risk capital, fuel new businesses and manage the credit of small enterprises. If we want faster economic growth, then we need more, smaller banks to provide the capital. Great place to start is by breaking up some of the largest, most poorly performing institutions to get the party started. More on that in a future comment. #FNBI #JPM #BAC #WFC #WAM #Nexbank

Dana Point | Since the lows of late-June, financials have rebounded more than 10% even as issues such as trade and the flattening Treasury yield curve have dominated the Wall Street narrative. Meanwhile, the bloom is clearly off of the rose in the world of real estate as prices for high-end residential and commercial assets have started to swoon. Lower prices mean higher loan-to-value (LTV) ratios, rising loss given default (LGD) and eventually increased loan default rates. While backward looking measures such as the Case-Shiller 20-City Composite Home Price Index do not yet show the turn, more granular measures such as the Weiss Residential Research index show the number of homes rising in price is decelerating rapidly. At the moment this trend seems to be mostly confined to high end properties, but past experience shows that market turns in home prices typically start at the top where there are relatively fewer buyers vs the available supply. In beautiful Orange County, for example, luxury home sales in expensive venues such as Newport and Laguna Beach have basically slowed to a trickle. As is the case in New York and Connecticut, luxury homes prices in Southern California have experiencing growing price compression, especially since the first quarter of this year. The chart below shows the S&P/Case-Shiller 20-City index and sub indices for New York, San Francisco and San Diego. Notice the extreme volatility of the San Francisco and San Diego indices. Anecdotal reports from the world of real estate brokerage suggest that the asset price bubble created by the Federal Open Market Committee is generally starting to deflate. In particular, the “aspirational pricing,” to paraphrase Jonathan Miller of Miller Samuel, is basically done. Prices for high-end homes are now being marked down rather than up as sellers are forced to capitulate in order to close the deal. It is worth reviewing the factors that led to this latest bubble in residential real estate prices. First and foremost we have the actions of the FOMC, which not only forced down short-term interest rates but also explicitly manipulated the shape of the yield curve via “Operation Twist.” In our previous comment in The IRA , we featured the comments of Senator Pat Toomey (R-PA) on same to Fed Chairman Jerome Powel. As several pundits have noted in recent days, Operation Twist is still affecting the markets, holding down long-term interest rates and causing the Treasury yield curve to flatten. The compression in credit spreads caused by the FOMC’s reckless and ill-advised market manipulation has also reduced profits for lenders and curtailed residential lending volumes. Literally hundreds of banks and non-banks focused on mortgage lending, confronted by mounting operating losses, are laying off employees and shutting down operations around the country. The 4% GDP print last week was definitely not a reflection of business realities in the mortgage sector. Q: Wasn’t Operation Twist supposed to help the housing market? Perhaps Senator Toomey ought to ask Chairman Powell to comment on the current dire situation facing many mortgage lenders and how the FOMC has contributed to this disaster. One industry veteran commented to The IRA last week that the poor financial performance of many mortgage lenders has caused them to blow through credit covenants with bank warehouse lenders. So far, the banks have not pulled the plug on these important commercial customers, but at some point prudential regulators will force the banks to act. As we have noted in past comments, in the current regulatory environment, when non-bank lenders eventually fail, the lender banks won’t buy the non-bank and take over the servicing portfolio as in days gone by. The non-bank will instead file bankruptcy and the secured creditor bank will simply take the loans pledged as collateral on warehouse lines and walk away. In 2018, new loan originations will be about $1.6 trillion – maybe – the lowest level since 2015. With new loan profitability negative in Q1’18, making up for operating losses with more volume is not an option. Of note, the Mortgage Bankers Association has been steadily revising down their estimates for future residential loan origination volumes, but remain optimistic about the out years as shown in the chart below. Source: MBA The other factor that has caused home prices to surge is increases subsidies from the government sponsored housing agencies, Fannie Mae, Freddie Mac and Ginnie Mae. Ed Pinto at the American Enterprise Institute lists several actions by the GSEs that have exacerbated the home price bubble and created greater risk for the US taxpayer, including: * Greater availability of income leverage, which is allowing borrowers to compensate for faster home price appreciation. This trend has been aided by the QM exemption for government agencies and Fannie Mae’s decision in August 2017 to raise its debt-to-income (DTI) limit. * A shift towards lower down payment loans. For FHA loans, often times such low down payment loans are combined with down payment assistance. * A greater presence of cash out (CO) refis; as homeowners’ equity has increased, the share of COs has increased in tandem. COs by nature are riskier than other loan products and they are rapidly getting riskier. “The multiyear surge in home prices, particularly for entry-level homebuyers continues unabated and is fueled by high-risk mortgages guaranteed by taxpayers,” notes Pinto, codirector of the AEI’s Center on Housing Markets and Finance. “We see no halt to this trend so long as FHA, the GSEs, and the VA continue offering easy mortgage credit terms which keep demand for homes well in excess of supply,” Pinto adds. Other factors that have driven the sharp upward move in home prices since 2012 include the increase in the number of people who can qualify for a mortgage under various government programs. Writing in The Scotsman Guide on the 10th anniversary of the failure of Lehman Brothers, industry veteran Dick Lepre of RPM reminds us that government programs to encourage home ownership begun in the 1990s caused the 2008 mortgage bust. Similar efforts in Washington are again setting the stage for a crisis in housing finance. He writes: “One cause of the 2008 financial fiasco was the vast expansion of the number of people who could borrow money to buy property. There are at least two things already happening that are allowing people to obtain loans who would not previously qualify. “One was instituted by the Consumer Financial Protection Bureau last year, which persuaded credit bureaus to remove most civil debt liens and tax liens from credit reports. The Wall Street Journal estimated this would improve credit scores for 12 million individuals, some by as much as 40 points. “Another is the expansion of Fannie Mae’s Home-Ready program, which is aimed at low- to moderate- income borrowers. One of the features of the program is its liberal interpretation of income, which allows lenders to consider the income of nonborrowers living with a borrower — such as adult children, friends or extended family. That nonborrower income can be viewed as a compensating factor in the loan-approval process for the program. “HomeReady is similar to the National Homeownership Strategy of 1995 in that it has a social goal. Under the Federal Housing Finance Agency’s housing goals for Fannie Mae for 2015 to 2017, at least 24 percent of the single-family, owner-occupied mortgage loans acquired by the government-sponsored enterprise (GSE) must involve low-income families. At least 6 percent must be to very low-income families. “Borrowers need at least a 620 credit score to qualify for the HomeReady program. Freddie Mac has a similar program called Home Possible. If the Feds increase the percentage of such loans the GSEs must purchase, be concerned. Mortgages to folks with bad credit or high debt should stay inside the Federal Housing Administration (FHA) program. As long as the FHA mortgage insurance premiums cover the inevitable losses, the taxpayer is not picking up the bill.” These programs to expand home ownership by the GSEs have added to the buying pressure on moderately priced homes, but that may not continue for much longer. Indeed, a change in the behavior of the GSEs may come sooner than many investors realize. As and when Federal Housing Finance Administration (FHFA) Mel Watt leaves the agency, the Trump Administration intends to significantly cut back the loan guarantee activities of the GSEs. Loan size limits are likely to be reduced for Fannie Mae and Freddie Mac, financing for investment properties is likely to end and the pricing of GSE loan guarantees may also change. The mission creep into new areas, such as Freddie Mac’s initiative to provide financing for non-banks to acquire mortgage servicing rights (MSRs), is also targeted by Republican policy operatives. A final factors driving the next, downward leg in US home prices is the 2017 tax legislation, which has significantly increased the cost of home ownership in high tax states such as CA and NY. While the greatest pressure is felt on the luxury end of the market, the cost of living in the high-tax, blue states will over time tend to drive broader emigration to other states. With all of the different government programs put into place since the 2008 financial crisis to manipulate the credit markets and artificially boost home ownership, the fact of a bubble in home prices is no great surprise. Add to that the limitations on bank lending for new residential home construction and you have the perfect formula for killing the American dream of home ownership of American families. We believe that the year 2018 may be remembered as marking the peak in both bank equity valuations and residential home prices. Residential loan default rates are unlikely to rise very quickly given the shortagge of moderately priced homes, but as we note in The IRA Bank Book , bank net interest margins are likely to be as flat as the yield curve by year-end. And the embeded credit risk in the financial system will continue to build with each passing day and largely due to the conflicting policy decisions emanating from Washington. Further Reading Italy Succumbs (Again) to Mob Politics The American Conservative Letters: Private Loans Barron's

New York | President Donald Trump caused a bit of a stir last week when he suggested that rising interest rates are cause for concern . Pundits fretted about “Fed independence,” a concept rendered completely meaningless in the age of quantitative easing. We agree with the President that Federal Reserve Board Chairman Jerome Powell is “a good man,” yet we also think it is high time that elected officials started to hold the Federal Open Market Committee more accountable for its policy decisions. Powell nicely describes the concept of accountability. “We owe you and the public in general clear explanations about what we are doing and why we are doing it,” said the Fed Chairman to the Senate Banking Committee last week. “Monetary policy affects everyone and should be a mystery to no one.” With the yield curve also last week nearing a zero difference between short and long-term government debt, Powell’s comments are timely. In an exchange with Senator Bob Menendez (D-NJ), Powell essentially endorsed QE2 and Operation Twist, saying that he was “glad” that the FOMC continued to manipulate the bond market years longer than necessary in the quest for the holy grail of full employment. Agreeing with the position taken by Treasury Secretary Steven Mnuchin, Powell also endorsed the privatization of the GSEs. He told Senator Jon Tester (D-MT) that it was important to get the housing finance system “off of the federal government’s balance sheet” to foster long term economic growth. In the subsequent exchange with Senator Pat Toomey (D-PA) at ~ 2:05, Powell deflected a fairly pointed question about the Fed’s “deliberate” manipulation of the Treasury yield curve. “Historically, the Fed has just manipulated short-term rates, the discount rate and the fed funds rate, and let the markets decide other interest rates” said Senator Toomey. “That all changed with quantitative easing when the Fed became the biggest market participant in with respect to the purchase of Treasuries and it changed in an explicit way when the Fed decided that it would intentionally manipulate the shape of the yield curve with Operation Twist, which was very consciously and willfully designed to change the shape of the curve.” “Some people are concerned that a flattening curve or an inverted curve correlates with economic recession,” Toomey continued in a remarkably cogent question. When he asked Powell about whether the changing shape of the curve would alter Fed policy regarding the composition of the balance sheet, Chairman Powell responded: “What really matters is what the neutral rate of interest is. I think people look at the shape of the curve because they think there is a message in longer run rates, which reflect many things, but that longer rates tell us something about the longer run neutral rate. That is really why the slope of the yield curve matters. So I look directly at that. If you raise short-term rates higher than long-term rates, then maybe your policy is tighter than you think.” Powell may not be an economist by training, but he is sure starting to sound like one – to our great concern. Conceptually, the neutral (or natural) rate of interest (R* in economist lingo) is the rate at which real GDP is growing at its trend rate, and inflation is stable. This decidedly indefinite concept is widely attributed to Swedish economist Knut Wicksell and, it is alleged, “forms an important part of the Austrian theory of the business cycle.” In 2006, Joachim Fels and Manoj Pradhan put forward the case for using neutral interest rates in formulating monetary policy in the Financial Times : “Put simply, the natural rate of interest is the interest rate that keeps output at its potential and inflation stable, once any shocks to the economy have played out. Wicksell saw fluctuations of the interest rate set by the central bank around the natural rate as the main driver of the business cycle and swings in the price level. His work foreshadowed and influenced the Austrian monetary business cycle theorists in the early part of the last century, most notably Ludwig von Mises and Friedrich von Hayek.” Most adherents to free market economic ideas agree with the 20th Century American economist Irving Fisher (1867-1947) in rejecting the idea of a discernable “business cycle” along with speculations about natural or neutral interest rates. Concepts like neutral interest rates, equilibrium and full employment are, by definition, indefinite and speculative, much like calculating the position of an object moving through space-time, to borrow from the work of Stephen William Hawking (1942 - 2018). Irving Fisher put the issue nicely in his 1933 essay on debt deflation when he refuted the existence of business cycles: “The old and apparently still persistent notion of "the" business cycle, as a single, simple, self-generating cycle (analogous to that of a pendulum swinging under influence of the single force of gravity) and as actually realized historically in regularly recurring crises, is a myth. Instead of one force there are many forces. Specifically, instead of one cycle, there are many co-existing cycles, constantly aggravating or neutralizing each other, as well as co-existing with many non-cyclical forces. In other words, while a cycle, conceived as a fact, or historical event, is non-existent, there are always innumerable cycles, long and short, big and little, conceived as tendencies (as well as numerous noncyclical tendencies), any historical event being the resultant of all the tendencies then at work. Any one cycle, however perfect and like a sine curve it may tend to be, is sure to be interfered with by other tendencies.” Unlike market interest rates, the neutral rate or R* is the product of a model. The whole notion of “neutral” market rates goes hand in hand with neo-Keynesian concepts such as market equilibrium and full employment. Neither can be observed or even described scientifically, much less replicated via experimentation. This fact did not prevent Chairman Powell from telling Senator Toomey that he “looks at it” – namely the invisible and indiscernible natural rate of interest -- when assessing US monetary policy. Sadly, Senator Toomey ran out of time and was not able to follow-up with Chairman Powell on the rapidly flattening yield curve. One question he ought to ask is why the FOMC thinks that “deliberately” manipulating the prices of and yield spreads between different securities is OK but that the Committee is now justified in doing nothing to manage the process of normalization as the curve very deliberately inverts. Powell’s view of the neutral interest rate apparently includes doing nothing to raise long-term yields while we see a steady runoff of the System portfolio and an attendant decrease in excess reserves and, of necessity, bank deposits. A flat yield curve is apparently not a concern for the FOMC, parsing Powell’s comments, because the neutral interest rate is above current market rates. But nobody reall knows. As Tao Wu of the San Francisco Fed noted in 2005 : "The difficulty policymakers face is that it is not obvious exactly what the level of the neutral real rate is. It cannot be observed directly. There is no reliable way to estimate it. And it can change." Of course, in order to assess the “neutral” rate of interest, you need to have an accurate idea about the current level of inflation. As we’ve noted in past comments, key measures of inflation such as the PCE deflator seem to be distorted to the upside because of noise coming from, of all things, financial services. Strangely, nobody at the Fed seems to be worried that a key benchmark for describing inflation may be overstated – and this may be due to the financialization of the US economy described so eloquently by Senator Toomey last week. Our friend Brian Barnier of FedDashboard reports from a distant airport that he’s continuing to poke around to understand the weird behavior of financial services in the PCE deflator. “I am still tearing apart the time series,” he reports. “At the moment it seems the distortion comes from a combination of excess reserves and not accounting for how banks have become more digital. Will see what it looks like after they send me more specifics.” Chairman Powell and other FOMC members may think they know where the neutral interest rate is at present, but we’d like to see our esteemed Fed chief be a tad more specific about this key policy metric. Of note, in an April 2018 IMF working paper, "Estimates of Potential Output and the Neutral Rate for the U.S. Economy," the authors state that: “Estimates of potential output and the neutral short-term interest rate play important roles in policy making. However, such estimates are associated with significant uncertainty and subject to significant revisions.” If Chairman Powell is wrong about the neutral rate, and continues to ignore the market message contained in a flattening yield curve, then the consequences for markets and investors could be quite serious. We notice, for example, that Morgan Stanley (MS) saw a 76% increase in interest expense in Q2 ’18 compared with a year ago. (See the most recent edition of The IRA Bank Book for our view of how a flat curve will impact US banks.) At a minimum, the FOMC should consider engaging in open market intervention of the same magnitude as Operation Twist to manage the yield curve on the journey back to normal. As Powell stated last week, when short-term rates rise above long-term rates, then "maybe your policy is tighter than you think." Further Reading What the Fed Is Missing, Again Wall Street Journal Bullard Discusses R-Star: The Natural Real Rate of Interest Federal Reserve Bank of St Louis Do not overlook natural interest rates Financial Times

New York | In the steamy days of July 2018, bank earnings are more interesting than usual, in part because our beloved friends and colleagues in the financial world continue to intone the false mantra that rising interest rates are good for banks. And our former colleague at Bear, Stearns & Co many years ago, David Solomon, took the baton at Goldman Sachs (GS). Break a leg David. First off, it is not true that rising rate rates are always good for banks. Increased interest rates, for example, have not helped GS in the past few quarters. "Banks make money on the spread, that's it. That's the story," said our friend Josh Brown on CNBC’s Fast Money this week. At the time, Brown was surrounded by a bunch of earnings happy pundits singing the praises of higher short-term interest rates for bank earnings. Banks make money on widening spreads, not because of a quarter point move in Fed funds. Spreads, of course, are not really widening as the Federal Open Market Committee pushes up short-term rates. After moving up about 75bp points over the past year, non-investment grade spreads started to fall after the most recent FOMC rate hike in June 2018. Indeed, the 10-year Treasury has declined about 30bp in yield over the past month, reflecting the continued tightness of credit spreads – at least for some issuers. Second comes the earnings themselves. The Q2’18 bank results released so far confirms the accelerating upward trend in bank funding costs. As we detail in the most recent, Q2’18 edition of The IRA Bank Book , the rate of increase in funding expense for all US banks should exceed the rate of growth in interest earnings by Q2’19. This will mean that net interest margin or “NIM” will be shrinking, an eventuality that most market analysts and institutional wealth managers really are not prepared to accept -- much less reflect in asset allocations. The extract below from The IRA Bank Book shows our projection for aggregate funding cost through Q4’19. Notice that we hold the growth rate in total interest income steady at 8% through the end of 2019, an admittedly generous assumption given the way that the FOMC has capped asset returns via QE. On the other hand, we limit the annualized rate of increase in funding costs to “only” 65%, a rate of change already more than reflected in the rising funding costs of names like First Republic Bank (FRC) and Bank of the Ozarks. Source: FDIC, WGA LLC Most of the largest US banks that reported earnings this week saw interest expense rise by mid-double digits even as interest earnings rose by single digits. Goldman Sachs, for example, saw its funding expenses increase 61% year-over-year (YOY) in Q2’18 while interest income rose just 50%. Citigroup (C), on the other hand, being already positioned in the world of institutional funding, saw interest expense rise only 28%. But the Q2’18 earnings seem to confirm a rising trend in funding costs that could see NIM flatten out and decline by 2019. When Solomon’s ascension to the top spot was announced at Goldman Sachs, our friend Bill Cohan commented on CNBC that this amounted to a takeover of GS by alumni of Bear, Stearns & Co. God does have a sense of humor. He also reminded Andrew Sorkin et al on Squawk Box that the freewheeling Goldman of old is long gone and that GS is now run and regulated as “a bank.” Well, no, not really. Goldman Sachs is basically a broker-dealer with a small bank in tow. When you compare the net interest margin of GS with its peers, for example, the other members of Peer Group 1 defined by the FFIEC reported NIM of 3.28% vs 0.41% for GS in Q1’18. Because the bank unit of GS is so small, the overall NIM for the group is 1/10th of its peers compared with total assets. Goldman makes less than 2% on earning assets vs almost 4% for its asset peers. So to paraphrase the wisdom of Josh Brown, GS does not make money on interest rates, up or down, but rather earns fees from trading and investment banking. GS profits from the spread, both in terms of price and volume. The basic problem confronting David Solomon and his colleagues is that GS really is not a bank. It is regulated like a bank and therefore constrained in terms of business activities, but it does not earn the carry on assets that most banks take for granted when they turn on the lights each morning. Talk of expanding the banking side of the business (aka “Marcus”) is fine, but progress in this regard is very slow indeed. Of the $9.4 billion in net revenues reported in Q2’18, just $1 billion represented net interest earnings. The gross yield on GS’s loan book (5.24%) is superior to its larger peers (4.68%), but the numbers are so small that they are not really significant in the overall picture. The total return on earning assets for GS at 1.85% is less than half of the 3.94% earned by its larger peers. Why the poor performance? Because GS pays up for non-deposit funding compared to its larger peers. Because it has such a small deposit base, Goldman’s total cost of funds is more than twice (2.45%) that of its larger bank peers (0.97%) as of the end of Q1’18. Organically growing GS into a true commercial bank will take time and a lot of work, a task that Solomon et al may or may not be able to accomplish. Building a bank starts first and foremost with stable funding in the form of customer deposits, particularly commercial deposits from small and mid-size businesses. With the intensifying competition for bank funding now very visible in the money markets as the FOMC shrinks reserves, don’t hold your breath waiting for GS to transform itself into a traditional depository. Such a transfiguration is possible, but not very likely in today’s markets. Thus the question for David Solomon and his colleagues: Do you really want to be a bank? Really?

New York | Last week we posted a snippet from Rob Chrisman’s housing finance blog about former Fed Chair Janet’s Yellen being "puzzled" due to the lack of home ownership by Millennials. The ensuing reaction was an order of magnitude above our normal level of discourse, leading us to think that there is a raw nerve among Americans when it comes to home prices. Here is the Chrisman excerpt: I found this note sent to me a few years ago by John Hudson by Roy DeLoach of the DC Strategies Group titled, "Hang-in there, Millennials - The New Sub-Prime Mortgage Wave Is Coming." Roy is a former CEO of the National Association of Mortgage Brokers. "Hang in there, Millennials and all you other wanna-be first-time buyers still residing in Mom's basement. The Federal Reserve, Fannie Mae and Freddie Mac could soon be riding to your rescue. Well, not just your rescue, but perhaps more importantly, to save the economy, too. Which is the real reason they want you to take your 'rightful' place in the chain of life known far and wide as the 'Housing Ladder.' "Actually, Fed Chairwoman Janet Yellen is perplexed 'why so many Millennials choose to rent' rather than purchase a home. There was a collective chuckle in the room when I heard her make that statement at a recent House Financial Services Committee hearing. I only pray there are some in Washington who are not only not as confused as the Fed Chair, but also are seeing the very same statistics I am looking at and coming up with the same answer. The way I read the tea leaves, housing is in deep trouble and will likely fall apart sometime in late spring 2016 -- just in time to become an election year issue." In terms of housing market operating dynamics, De Loach was accurately describing the internals in the world of lending and servicing residential loans. But like many of us in the industry, he could not know just how high the Fed’s bond market manipulation via QE would take home prices. In the new edition of The IRA Bank Book , we describe the continued distortion of credit loss metrics in both residential and multifamily asset classes. Eventually, these metrics will revert to the mean and beyond. The importance of the fact that US bank credit metrics are showing essentially zero cost in residential lending from portfolio loans is that it begs the question as to home price valuations and thus loan-to-value (LTV) ratios. A number of analysts have predicted an imminent reset in terms of home prices, but this has not happened for several reasons. The chart below shows the Case-Shiller average for US home price appreciation. First, real estate is a local market, so generalizations such as Case-Shiller are dangerous. New York City has been slumping for the past two years, but other markets around the country such as Denver remain hot. The work of Weiss Residential Research clearly shows a turn in some major urban markets that have been moving higher since 2012 and before. But these moves seem more a function of buyer exhaustion than a permanent move to a buyers market. They key factor is cheap money chasing a limited supply of homes. Second, the US home market is in a classic supply squeeze. Referring to the work of Laurie Goodman at Urban Institute, the US is adding less than 1 million new units per year net of attrition of obsolete homes. Basically, new household formation is 50% higher than the growth in new housing units. More, the Fed’s manipulation of interest rates and credit spreads encouraged Wall Street to allocate capital to buying residential homes as rental properties, further limiting supply of homes available for sale. Net, net, Millennials have been priced out of the housing market because the omniscient souls on the Federal Open Market Committee think that boosting asset prices will lead to more spending and job creation. Instead, low interest rates and help from the GSEs (Fannie, Freddie and Ginnie) have driven up home prices beyond the reach of many home owners in major metro areas. Ed Pinto and Paul Kupiec wrote in The Wall Street Journal in March 2018: “Since mid-2012, real home prices have increased 28%, according to data from the American Enterprise Institute. Entry-level home prices are up about double that rate. In contrast, over the same period household income has barely kept pace with inflation. The current pace of home-price inflation is increasing the risk of another housing bubble.” Lenders will be happy to hear that home owners are not even tapping the increased equity in their homes as in the 2000s, one reason why home equity loans (HELOCs) continue to shrink by double digits as a bank asset class. CNBC’s Diana Olick had a good segment “ More homeowners leaving home equity untapped ” on Monday. Given the Yellen Inflation in home prices, the question for lenders, of course, is how much to discount home prices over a 15 or 30 year time horizon? This week we got to sit with one of the leaders of the mortgage finance world. The conversation eventually turned to credit. The consensus was that a recession in 2020 was not necessarily going to bring significantly elevated credit loss rates, but that by the mid-20s credit costs would be rising appreciably. We continue to point to 2015 as the trough for credit costs at US banks generally and note that more normal portfolios like commercial and industrial loans (C&I) are showing rising defaults and loss rates, what you would expect at the end of a Fed-induced boom. But meanwhile in the world of mortgage finance, things are anything but normal. Just look at the intense competition among JPMorgan (JPM) and the other megabanks for non-bank fiduciary balances in the commercial deposit market. The FOMC has indicated that short-term interest rates are rising, but long-term benchmark rates such as the 10-year Treasury bond are falling. Because of this move in long-term yields, modeled valuations for mortgage servicing rights (MSRs) will likely fall this quarter, requiring “fair value” adjustments to capital and income. Meanwhile, MSRs are trading in the secondary market at record cash flow spreads, in excess of 5.5x annual cash flow for conventional servicing. And the cost to originate and service loans has never been higher. If this environment of extraordinary high prices and low operating spreads is intended to be helpful to the housing finance sector, then we respectfully suggest that our friends on the FOMC ought to think again. Sadly, even as home prices have surged, none of the FOMC’s promised benefits have materialized when it comes to jobs, income or overall GDP growth. Indeed, the increase in home prices has locked-in many empty nesters in states like CA and NY. The big question: Is the Yellen Inflation in home prices permanent? Further Reading Bank Earnings & QT: Mysterious Shrinking NIM https://www.zerohedge.com/news/2018-07-04/bank-earnings-qt-mysterious-shrinking-nim

New York | Last week The Institutional Risk Analyst attended an evening presentation by Professor Edward Altman of NYU Stern School of Business at The Lotos Club of New York. Entitled “The Altman Z-Score After 50 Years: What is it Saying About Current Conditions & Outlook for Global Credit Markets,” Professor Altman’s comments were as usual understated and entirely on point. “Fifty years ago, we published the Altman Z-Score,” Dr. Altman told the audience of friends, colleagues and former students. “Frankly I am as surprised as anyone that it is still around.” The five factor Z-Score model published by Dr. Altman in 1968 is shown below: Dr. Altman attributes the longevity and, indeed, growing popularity of the Z-Score to the fact that the model is simple and easily replicated, and the fact that is works. “Empirical finance models generally have a half life of a couple of years…. But if the model is simple, easy to replicate – and replication is really important in scholarly finance – and is accurate, then other researchers start to compare their models to the simple model.” “The other reason that the model is still around is that it is free,” Dr. Altman notes. According to its founder, the Altman-Z Score has predicted roughly 80-90% of all non-financial bankruptcies since it was first published. The Z-Score is entirely public source and is used without commercial restriction in business, corporate finance and investing. Needless to say, the Z-Score and its derivatives generate a lot of traffic online at portals such as Bloomberg , Credit Risk Monitor and S&P . “All I wanted was one penny [per hit],” Dr. Altman says of his elegant creation, which is “simple, accurate and free.” Invoking author Malcom Gladwell’s book “Outliers,” Altman says that his work would have been created by another researcher as computers became more wisely available in the 1960s. “It is really important to be in the right place at the right time,” he observed. This confirms our judgment in “Ford Men: From Inspiration to Enterprise that luck is the most important thing in life. Dr. Altman witnessed the birth of the high yield or “junk” bond market in the early 1980s, a market that encompassed the world of sub-investment grade credits. “The market in 1982 was about $10 billion and comprised of fallen angels, companies that were beautiful at birth and investment grade, but like all of us as we get older we get ugly,” says Altman. “We lose our hair, we get wrinkles and we get downgraded.” Since that time, the Z-Score has been incorporated in corporate and bank risk models for corporate default or “mortality” as Dr. Altman likes to say. In particular, the three zones of “safe,” “grey” and “distress” in terms of credit originally defined by Dr. Altman are now widely disseminated and accepted as benchmarks. He explains the evolution of the model and its use: “The guidelines we established back in 1968 were the so-called zones. Above 2.99 the firm was in the safe zone. Below 1.8, in the distressed zone with a highly likely probability of bankruptcy. By the way, above 3.0 and below 1.8 the Z-Score had a 100% accuracy back in 1968. The model was built for manufacturing companies and in those days big companies did not go bankrupt. Things have changed. The zones are enshrined on the Internet, on Google and Wikipedia, but the problem is that they are no longer appropriate. But that doesn’t keep people from using it because its on the Internet and the Internet is always right.” Dr. Altman explains that there has been an incredible migration of risk in the US economy over the past fifty years reflected in the increased debt leverage in the system. He notes that when the high yield debt market was born, the market was measured in single digit billions, but today the total junk debt outstanding is $3 trillion globally and more than half in the US. Likewise leveraged loans did not exist, but today this is a $1 trillion market that fuels much of the total non-investment grade debt issuance. Altman also believes that the fact of global competition and capital markets has led to more, larger bankruptcies. “In a good year there are roughly 50 bankruptcies of companies with assets more than $1 billion, what we call billion dollar babies,” notes Altman. “As a scientist in this area, I love bankruptcies. Already this year, in this benign credit cycle, we’ve had 14 billion dollar bankruptcies.” Altman states that as the amount of debt leverage has increased in the global economy there has been a compression of credit ratings: “How many 'AAA' rated companies in the US? Two. Johnson & Johnson and Microsoft. Two left. Why is it that there are not more 'AAA' rated companies? Leverage.” The migration of companies down to “BBB” ratings simply reflects the fact of more debt and the desire to stay this side of the line of investment grade. “What rating would you like to be as the chief financial officer of a company,” ask Altman. “We did a survey many years ago and the answer was ‘A.’ What is it today? ‘BBB’ The ‘BBB’ category is exploding. That is the preferred rating. Why? Because if you are ‘A’ it means that you are not exploiting low cost debt. If you are ‘BBB,’ it means that you have higher effective returns for your shareholders. This is why over the past fifty years credit risk has migrated from very low to very high. It has exploded into a global debt bubble and this is not just companies. It's governments and households.” Turning back to mortality, Altman spoke about how “life expectancy changes over the life of a person or a company – what we call contingent probability. In financial markets much like real life, promises are made to be broken. How do you break a promise? You default. You don’t pay back as promised. When assessing default probability, we’ve got gorgeous ‘AAA’s, handsome ‘AA’s, decent looking ‘BBB’s, not so good looking ‘BB’s, and downright disgusting ‘CCC’s. And people have been buying those disgusting ‘CCC’ bonds with great frequency over the past five years.” Dr Altman notes that “we are in a benign credit cycle” and that non-financial corporate debt levels vs. GDP are back to 2008 levels, yet default rates remain low – below 2%. Indeed, the Z-Scores for corporate issuers have risen from 4.8 in 2007 to 5.1 in 2017 even as debt levels have grown. He also notes that high recovery rates for bond and loan investors, plus low interest rates and credit spreads, and ample liquidity, are all signs of benign credit cycle “that has gone on, incredibly, for eight years.” And yet Professor Altman is hardly sanguine about the immediate outlook. “We have been in a ‘risk on’ cycle, meaning easy money and brisk buying,” Altman observes. “Risk on means that people forget risk and take a lot more exposure to get higher yields in this low-rate environment. Using a baseball metaphor, we are in extra innings with respect to the benign credit cycle. Investment grade debt has been exploding since 2007 and high yield debt is also up. A lot of this money is being used for corporate stock buybacks.” “Shrinking equity and exploding debt is a disaster waiting to happen – and it will happen if we have another recession,” Altman concludes. “And we will. Its just a matter of when. I’m not a forecaster of economic activity, but surely given the accumulation of debt, if we have a recession then we will have another credit crisis. It may not be as big as 2008, which was more focused on households. This time the risk is more in the corporate area. But unless things change in terms of market discipline, we are going to have some very nasty repercussions in the debt markets.” #ZScore #Altman #Credit #Default