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Grand Lake Stream | During our fishing trip to Leen's Lodge last week, there was a lot of discussion about the markets and whether the Fed is going to successfully manage the return to normalcy. Our bet on that question is “no” as we noted in a missive yesterday by Jeff Cox of CNBC: “ The Fed's effort to control the rise of its key interest rate is running into some problems .” Dr. George Selgin of Cato Institute has a timely new paper appropriately entitled "Floored" that discusses this issue of the FOMC using interest on excess reserves as a “floor” for the Federal funds rate. In the paper, Selgin talks about “how the Fed’s floor-system experiment came about, what its intended and actual consequences have been, and why either the Fed itself or Congress should bring the experiment to an end as rapidly as can be done without causing further economic damage.” Instead of reviving the private market for Fed Funds, the FOMC has used Basel III and paying interest on excess reserves or “IOER” to turn the trading of short term funds into a lab experiment. Instead of creating a traditionl “corridor” system for managing short-term rates, with IOER near the bottom of the policy range and the discount window rate at the top, the FOMC opted for a more radical experiment. Selgin notes: “Had [the FOMC] actually employed interest on reserves to establish a proper corridor system, as it planned to do in 2006, and even had it allowed interest to be paid on excess reserves with that aim alone in mind, paying interest on reserves wouldn’t have constituted a radical change. But as we shall see, when the Fed actually put its new tool to work, a corridor system was no longer what it had in mind.” Selgin cites some revealing passages from former Fed Chairman Ben Bernanke, who justifies the need for paying interest on excess reserves to prevent interest rates from falling too low. “[By] setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much [emergency] lending we did,” stated Bernanke in 2015. Was Bernanke’s comment an admission that negative rates are as a general matter undesirable? Perhaps. Selgin notes: “Although they were keen on providing emergency support to particular firms and markets, Fed officials recognized no general liquidity shortage calling for further monetary accommodation. The challenge, as they saw it, was that of extending credit to particular recipients without letting that credit result in any general increase in lending and spending…. for the most part the Fed was counting on IOER to encourage banks to accumulate excess reserves instead of lending them.” So even though the FOMC saw "no general liquidity shortage," they continued with extraordinary measures. Selgin’s paper makes clear that the FOMC had no firm idea how the use of IOER as a floor for interest rates would impact the markets and the US economy. In particular, the idea of using IOER as a way to dissuade banks from lending illustrates the speculative and, indeed, irrational nature of FOMC deliberations. As the renowned physicist Richard Feynman states: “It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong. In that simple statement is the key to science.” But of course economics is not a science, a fact illustrated by the Fed’s decision to pay IOER in combination with massive open market purchases of Treasury paper and mortgage backed securities. There is some support for the idea that the decision by the Fed to use IOER as a floor for interest rates negatively impacted bank lending and economic growth, as shown in the chart below. Source: FDIC There are many factors affecting the growth rate for loan portfolios, but what the data from the FDIC clearly suggests is that the surge in bank deposits seen from 2012 onward was not matched by a commensurate increase in bank lending. Also, as we’ve discussed previously, sales of loans by US banks have declined 10 fold since the mid-2000s. Again, Selgin: “The Fed’s decision to switch to a floor system at a time when equilibrium market interest rates were collapsing, and to do so with the aim of propping-up its policy rate to keep it above the zero lower bound, contributed to the severity of the recession, while limiting the Fed’s options for promoting recovery. Thanks to it, the U.S. economy has been in the grip of an above-zero liquidity trap since the trough of the Great Recession.” Although the impact of the Fed’s policies with respect to paying interest on excess reserves has generated a great deal of debate in the economics community, the other aspect which has received far too little attention is how quantitative easing impacts long-term interest rates. The Federal Open Market Committee was sold a bill of goods by the staff of the Board of Governors and FRBNY chief Bill Dudley. Specifically, we hear that Simon Potter, Head of the Markets Group at the Federal Reserve Bank of New York, (and Dudley) told the FOMC that they could hold any quantity of reserves indefinitely as long as they could do reverse repo operations to set a rate floor to accompany the ceiling rate system (interest on excess reserves or IOER). The Potter-Dudley assertion that short-term REPOS can suffice to manage any amount of excess reserves seems to be refuted by experience, however, especially given the combination of IOER with aggressive open market operations (aka “QE”). “The correct strategy all along would have been for the Committee to pause at 1.5% for Fed funds (2 hikes ago),” notes former Fed researcher officer Walker Todd. “The Fed could then begin to sell off the mortgage backed securities until the resulting long end rate increases began to put upward pressure on the Fed funds rate. Then the Fed would be in the more comfortable situation of following the market upward instead of trying to lead against market résistance, which is what is happening now.” As Chairman Powell and the FOMC raise the interest rate floor, the size of the Fed’s portfolio seemingly prevent long-term interest rates from rising. The securities holdings of the Fed and other global central banks are entirely passive, with no trading or hedging operations to influence long rates to rise, thus the spread between short term rates and longer maturities is shrinking rapidly. Unless the FOMC relents and starts to actively manage longer-term rates by selling securities and/or swaps and futures, the Treasury yield curve is likely to invert by year-end. In the event, the financial markets will react negatively and force the FOMC to delay any further rate hikes until long-term interest rates actually start to rise of their own volition. Until then, the short-term liquidity trap created by the Fed’s misuse of IOER will be a continued obstacle to policy normalization, on the one hand, while the Fed’s massive QE portfolio will act as a cap on long-term bond yields. And the FOMC has yet to admit publicly that they indeed have a problem of their own special creation. http://is.gd/FordMen #GeorgeSelgin #WalkerTodd #CATO #IOER

Boston | Even as the Federal Open Market Committee raised short-term interest rates last week, the Trump Administration doubled down on trade war to gain leverage in the mid-term elections loom. The markets have not reacted well to the bellicose language coming from the White House, with financials in particularly under-performing the markets. But you don’t need to look very far to understand the travails affecting the US banking sector. One reason why banks are selling off is the prospect of significant layoffs and operating losses in the mortgage sector. Rising costs and tight production spreads have driven the mortgage industry into the red this quarter, with many shops not even meeting minimum production levels to achieve break even. Rob Chrisman warned in his weekly comment that he expects to see at least one large bank shedding “thousands” of people this summer because of the combination of tight spreads and the over $8,000 per loan cost of new residential originations. Another, more important reason for fading on the US large cap financials, particularly given the extraordinary run last year, is that the easy growth for the industry is at an end, both in terms of loans and deposits. We had a fascinating conversation last week with Lee Adler, proprietor of The Wall Street Examiner , about the “extinguishment” of reserves as the Fed’s Quantitative Easing treasure trove runs off. Adler contends that the runoff of QE means an end to the easy deposit growth seen by US banks over the past half decade. “Under QE Fed lent money to Treasury in the form of note and bond purchases,” Adler explains. “By redeeming the notes and bonds as they mature, the Fed is effectively calling in those loans at the pace of $30 billion per month now, going to $40 billion in July, and 50 in October. Treasury pays the Fed off with cash it raises in additional note and bond sales. Investors bought the bonds with their bank deposits." "Those deposits are extinguished when they are withdrawn from the investors' accounts, go into Treasury account, then from Treasury account to Fed to pay off the maturing paper," Adler continues. "The asset disappears from the Fed's balance sheet, and so does the bank reserve deposit because the bank's customer used it to buy the new bonds. The new bonds now exist, but the money used to purchase them was extinguished when the Treasury used it to pay off the Fed.” “Deposit growth is slowly grinding to a halt, adds Adler. “It should go negative in the next couple months, especially if ECB makes more cuts in QE. Some of the ECB QE money was flowing instantly to US. Since ECB went from 60 to 30B QE their deposit growth has also slowed and less money flowed to US to buy bonds and stocks.” And sure enough, Alder’s prognosis is confirmed by the data from the FDIC, which shows that bank deposit growth has basically dropped to near zero over the past year. The chart below shows quarterly deposit growth rates going back to the mid-1980s. Notice that even during the years of aggressive Fed asset purchases, bank deposit growth rates were modest after the initial fear surge in non-interest bearing deposits after the 2008 debacle. Source: FDIC Of course, weak loan demand is another reason why deposit growth has been relatively restrained in this cycle. What demand has existed was focused on the hotter metro markets, which are starting to evidence late stage buyers fatigue. And as we’ve noted previously, bank regulators have been tapping the breaks on residential and multifamily credit for several years now. We also are reminded once again that there is no national market for residential real estate in the US. The folks at Weiss Analytics, in fact, confirm that with their latest data. Weiss Analytics reports that red hot metros such as Las Vegas, Seattle-Tacoma and Denver-Aurora are starting to see a decline in the number of transactions with rising home prices. In 2015-2016, these markets were at one stage showing virtually all home sales with rising prices, a measure of the enormous asset price distortions caused by the FOMC in the real estate sector. Just by coincidence, credit costs of the decidedly prime residential loans owned by US banks bottomed in 2015. Performance of first-lien mortgages remained unchanged during the first quarter of 2018 compared with a year earlier, according to the Office of the Comptroller of the Currency’s (OCC) quarterly report on mortgages. But what the data from Weiss Analytics suggest is that the heady sellers market of 2016 is rapidly changing two years later. The table below shows the percentage of sales in different markets where prices were rising. If our colleagues at the Fed and OCC want a list of markets where banks are likely to face credit challenges in the next few years, they could do well to ponder the list above, which features some of the highest price volatility numbers of any residential asset markets in the US. And notice that the exurbs north of Washington DC are in a state of collapse, a sure sign that these recession proof venues are about to flop into a tenants market. We’ll bet dinner at 21 Club that the loss given default (LGD) for these hyperbolic residential markets is close to zero or lower, as is the case currently with bank-owned multifamily exposures. With LGDs nationally for US bank owned residential exposures still in the 20% range vs the long-term average of 65%, it is pretty clear that credit costs in residential will rise in the future as the Fed continues to tighten credit and the US economy slows.

New York | Dale Hemmerdinger is the consummate New Yorker. He is a real estate executive and active public citizen. He oversees the properties and service subsidiaries of his family real estate company, ATCO , as well as its parent company, The Hemmerdinger Corporation and The Hemmerdinger Foundation. In 2007 Governor Eliot Spitzer nominated Dale to serve as Chairman of New York’s Metropolitan Transportation Authority. He formerly served as Commissioner of the New York City Conciliation and Appeals Board during the Administration of Mayor Ed Koch. Dale is active in many public and private organizations in New York and is known for his honest and incisive perspective on the political economy. The IRA: Dale, thank you for taking the time. Let’s start with your perspective on the New York real estate scene. How do you put the boom of the past decade into perspective? Hemmerdinger: There have been a number of cycles over the years. New York tends to follow the direction of the national economy but it also has its own real estate cycle. Like many other businesses, when times are good the lenders tend to lend and the builders tend to build – often too many buildings all at once for the demand. Demand for any type of real estate at a given moment is difficult to determine. What tends to happen, when there is a real need for office space or residential space, we all tend to build together and therefore we build too much. The IRA: Certainly looks that way. Are landlords actually getting squeezed at the moment and contrary to the popular press? Hemmerdinger: In the 2008 down cycle, we had a squeeze on rents for almost everything in New York. In the financial business, the situation was even worse. The overhang of office space in New York that was no longer needed by banks, insurance companies and financial firms was huge. All of these constituencies were cutting headcount and reducing space. As the economy improved and we started to come out of the slump, there was a presumption that rents were going to rise at a very steep angle, which has been the history of New York real estate. In previous cycles, rents went up fast and higher than before. This time that really didn’t happen. The slope was very gradual if positive at all. The IRA: That certainly does not track with the rising rent narrative in other markets around the U.S. What happened to make New York different? Hemmerdinger: A decade ago the City and New York State changed the law regarding what you could build with how much state subsidy, etc. The threat of further change to things like the 421a exemption for affordable housing caused many developers with buildable plots to decide that this was the moment to build. The combination of this need for space together with a change in the law, these two things coming together, gave us the building boom you see today. All you need do is walk around the city to see the construction activity. And it is not only in Manhattan, but in Long Island City and the other boroughs. There is a huge amount of building for New York at a given time. The IRA: Long Island City is certainly amazing. Multifamily buildings, hotels and even retail along some of the side streets. Does this construction make sense economically in terms of the market for this new space? Hemmerdinger: It costs a lot to build in New York. The problem is whether there are enough people who can afford to move into this new space. There is no question that there is demand for the space, but at what price? That gap between cost to build and the rental market is going to be a big problem in terms of new residential construction. On the commercial side, we started this cycle with double digit vacancy rates already. Anything over 10% vacancy is what I call a renters market. Keep in mind that vacancy rates are determined by estimates from real estate brokers… The IRA: You mean like the way bankers in the City of London used to determine LIBOR? Hemmerdinger: It is an approximate number determined by the major brokerage firms. Thus anything over 10% in terms of published vacancy rates for commercial space is a tenants market. So we started this cycle with 11% vacancy and no surprise there is a lot of pressure on high-end commercial rents. The IRA: Are you referring to the Third Avenue corridor, for example, where there is ample vacancy for office space? Hemmerdinger: Glad you asked. That is one of the myths of real estate. The old buildings are actually terrific. It’s the middle layer of buildings in terms of age that have problems. Older buildings built before the age of air conditioning have high ceilings and windows that open. Very attractive for tenants. There’s a middle layer of buildings from the 1960s and 1970s where the ceilings were very low and are difficult to retrofit. That’s why you see some of the lovely older building around town being renovated. They are really wonderful properties and affordable for the tenants and amenable to modernization. You give me Rockefeller Center, which has high ceilings and beautiful windows, and we can make it as modern and attractive as any new building. The IRA: Agreed. Look at the renovation of the old New York Times building as another example. The location of older properties also tends to be better in terms of proximity to transportation. We started talking the other day about the new developments over on the West Side of Manhattan, which are absolutely beautiful buildings but a hike even from Penn Station. How do you see those properties positioning in an already glutted commercial market? Hemmerdinger: First thing, the public transportation to Hudson Yards is not adequate to make it work. It’s great for the chiefs who have cars or drivers, but it will be very tough for the regular people who go there every day for work. When I was on the MTA Board, I argued with Governor Spitzer that we should demolish the Jacob Javits Convention Center , which is now too small for events, and then redevelop the entire area with more transportation. We should have residential where Javits Center sits today and then a new convention center and business space going east towards Penn Station. But again the construction cost and also the politics intervened. The assumption that the area on Eleventh Avenue will gentrify and attract businesses is going to be very tough to achieve. They are doing a lot of deals to fill the space, but will these deals work over the medium to long-term? The West Side is very different from what Larry Silverstein is building downtown at the Freedom Tower. Everything is there; shops, amenities, transportation. The presentation is fabulous. The IRA: Given the amount of empty storefronts visible in midtown Manhattan, we agree that growing a healthy street level economy on Eleventh Avenue will be a challenge. But what about other areas of the City that are seeing a construction boom? Hemmerdinger: Ultimately it is the peripheral stuff that always has trouble. Its already starting in Long Island City where we have 16,000 new apartments. That is a lot. We are already dealing with an overcrowded subway system coming in from Queens, so there will be a transportation squeeze in Long Island City over time. The IRA: Long Island City is a barren urban landscape. Not much natural pedestrian traffic and the dominating shadow of the Queensboro Bridge. Very much like the West Side and particularly the High Line Park in some respects. There is only so much you can do to beautify Eleventh Avenue or Queens Plaza without a total redevelopment, correct? Hemmerdinger: Most of the most precious public spaces in New York like Central Park have evolved their own support networks over time. There are a lot of rich people who live around Central Park and pay directly though taxes and by donating to the Central Park Conservancy to maintain it. The Conservancy has done a fabulous job. Public fixtures like the High Line have a much smaller base of supporters, but funding from the community and also from real businesses, above and beyond public funds, is needed to make any neighborhood work long-term. The IRA: But why did we see the enormous scale of development in New York over the past 10 years? Even with the legal changes, it seems like the scale of development has soared compared with past cycles. How did the low level of interest rates contribute? Hemmerdinger: The first thing was the legal changes we mentioned before. Owners did not want to take the chance that future laws would be less permissive. Then interest rates were really low when all of these projects started. Also, there was an awareness that you could purchase air rights and create buildings that were really remarkable. The view of Central Park from the 80th floor is fabulous. You’re in the clouds sometime. So they were producing a product that was limited and very desirable. The problem is that you don’t make money selling the penthouse to a Saudi prince. The IRA: No? Hemmerdinger: No. You have to sell the middle of the building as well. Selling the properties that are not so glamorous at premium prices is the key. There is a real question as to whether there are enough people who can afford these new developments, which will likely put downward pressure on rents. My sense is that there has been enormous overbuilding at the price. You can already see the pressure on rents as unsold condo properties go onto the rental market. The IRA: So what is the outlook for New York City high end residential over the next 18-24 months? Our friend Jonathan Miller at Miller Samuel refers to it as “aspirational pricing” in the current market when it comes to offered prices. And he says capitulation could take years. Hemmerdinger: It is not a question of whether there is demand for the space. The question is can you afford to live there given the cost of rent, which is a function of the cost of construction? Building in New York is very expensive. I think things will get worse as more of these new condo projects come on line, are unsold and they end up in the rental market. If you remember three and four years ago, almost half of condominium sales were to out of town buyers. That flow of cash has slowed. Our experience is that the purchase market for high end properties is down about 10% from peaks of two years ago. When these condos don’t sell, the banks will force the developer to put them into the market as rentals. You will see increasing concession to buyers and falling rents for tenants as landlords try to at least fill buildings so they don’t feel like mausoleums. And then we will have a normal recession. The IRA: Nice. So what is coming in the event of rising interest rates and perhaps a slower economy? Do we have a crisis in commercial real estate in New York? Hemmerdinger: For projects that are not yet completed, they will be facing an increasingly hostile financing market. You can’t get out of a construction loan until you have a certificate of occupancy. Hopefully the developer has a take out for the construction loan, but the debt market is going to be very tough if rentals are soft and the purchase market is even softer. When it comes to prices, think of it as a cake. The top part of the market can squish the most while the bottom of the market will barely move. The higher the initial price of the property, the bigger the potential percentage drop in a down market. In the suburbs, for example, there’s a vigorous market up to a million dollars or so, then the volumes drop dramatically. Greenwich has a ten year supply of homes available for sale. But as you know I like to be optimistic, both about the property market and New York in general. The IRA: Thanks Dale #Hemmerdinger #NewYorkCity #realestate

Back in April we published a comment, " Bank Earnings & Financial Repression ," that introduced the concept of the Financial Repression Index. In a related working paper available on SSRN, " The Financial Repression Index: U.S Banking System Since 1984 ," we define the index, which essentially shows the distribution of bank interest income between debt investors and bank shareholders. At the end of Q1 2018, almost 84% of all income earned by banks on leverage went to bank shareholders as a result of the Fed's policy of "Quantitative Easing," while the remainder went to depositors and bond investors. Thirty years ago, that situation was reversed. The secular decline in US interest rates has very clearly been paid for by depositors and debt investors, while the share of interest earnings apportioned to bank equity investors has grown. In the 1980s, almost three quarters of bank earnings on loans and investments flowed to depositors and bond investors. As recently as 2008, the distribution of profits was roughly 50/50. The chart belows shows the Financial Repression Index updated through Q1 '18. Notice that the index has now turned downward after peaking at 90% of bank interest income allocated to equity holders. With bank interest expense growing more than 50% year over year, net interest margin for banks will flatten and eventually turn negative in 18-24 months -- perfect timing for the next recession in the US. The chart below shows the components of net interest income for all US banks through Q1 '18. Source: FDIC Craig Torres of Bloomberg reported last week that former Fed Chairman Ben Bernanke, the father of QE, predicted that the US economy is headed for a recession by 2020 . Thanks Mr. Chairman. #netinterestincome #financialrepressionindex

New York – Ever heard of the European Monetary Authority? Hold that thought. For more than a decade now, banks in Europe have been free-riding on sovereign credit support, a fact that has attracted more than a few foreign investors. With the political devolution now underway in Rome, however, Eurobanks have begun to trade again on their intrinsic credit. In an important new paper from The Institute for New Economic Thinking , Professor Ed Kane of Boston College states the problem succinctly using ratings from our friends at Kamakura: “[T]he recovery of European megabanks from the 2008-09 crisis has been incomplete. Creditors of Europe’s giant banks still seem to be relying on implicit guarantees. In particular, credit spreads on the bonds of these banks appear to be relatively insensitive to the level of the issuer’s longer-term probabilities of default. Coupled with the high pairwise correlation that KRIS default probabilities show between major US and European banks, this finding suggests that creditors do not expect the EU’s bail-in requirements to play much of a role in resolving megabank insolvencies during the next crisis.” Even before the 2008 financial crisis, global regulators were moving on a set of proposals that eventually became known as Basel III. When the discussions began in earnest, the ask from the US side was that Europe do something about non-performing loans in the banking system. The Europeans, for their part, insisted that housing assets – particularly evil mortgage servicing rights or MSRs -- be consigned to the bad bucket along with other supposed intangibles such as net loss carry forwards. Below is our discussion last week with Brian Sullivan of CNBC . The final Basel III document focused mostly on liquidity and capital, but neatly skirts the issue of credit quality. The US banking system is particularly strong when it comes to recognizing and liquidating defaulted loans, in large part because US banks generate strong profits and are able to resolve bad debts in reasonable periods. In Europe, however, banks are less profitable and debtors tend to have the upper hand. There are no bankruptcy courts in Europe. As a result, EU banks have tended to extended forbearance to defaulted obligors, particularly those with access to political influence. There are three pillars of the Basel bank supervision approach: (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. Most of these pillars are observed in the omission in Europe. Capital requirements, notably illustrated by the cases of Deutsche Bank AG (DB) and Montepaschi Group, are largely a fiction. Supervision is fragmented among the 28 EU member states. And market discipline in the EU is largely prohibited via explicit legal limits on short-selling and official “guidance” to banks, rating agencies and large investment firms. Since 2010 when the Basel III rules were announced, there has been a steady but painfully slow recognition by the Europeans that something needs to be done about credit quality and therefore bank solvency. In March of 2018, the European Central Bank announced that bank loans that become non-performing after January 1, 2018 must be adequately reserved, but left aside the issue of non-performing loans recognized prior to this year. The seemingly absurd ECB announcement about reserving loans that go bad from January 1st of this year is part of a larger political dance. The ECB is trying to perform damage control among and between member states that still control bank supervision at the national level while at the same time paying lip service to capital and Basel III. There is no mechanism for supervising EU banks on a unified basis, nor any agreement on loss sharing or even a retail deposit insurance safety net. And the biggest obstacle to moving forward with these initiatives is the enormous public antipathy toward banks. In Italy the government has managed to move significant amounts of bad loans off the books via securitizations with government guarantees on the senior tranches. “Huge volumes of NPLs (€37bn in 2016 and over €47bn in 2017, according to consultancy Deloitte, have been sold by banks, often to specialist American hedge funds like Cerberus Capital Management or Fortress Investment,” the Economist reports. The European Commission has agreed that these securitizations of bad loans do not constitute state aid “as the guarantee will be priced at market levels.” The latest official figure on bank NPLs from the Bank of Italy is 11 percent of total loans, an enormous figure but better than the mid-teens number reported in 2016. Banca Monte dei Paschi, for example, reported 14 percent NPLs at the end of Q1 ’18. By comparison, a bit over 1 percent of loans held by US banks are currently marked as past due. The peak of US NPLs was 5.5. percent in Q4 2009, when the US banking industry charged off $60 billion in bad credits in a single quarter. Such an act of financial housecleaning is impossible in Europe. Investors may gain some comfort from the upbeat views of consultancies such as Deloitte, who noted in a 2016 report on the early efforts to securitize Italian NPLs: “While these reforms may not be the all-encompassing panacea that is needed, any moves to cleanse bank balance sheets of distressed debt has to be welcomed.” But as we’ve told any number of investors over the past few years, there is no practical way to estimate loss resolution timelines or recoveries on non-performing commercial assets in Europe. Of course, auditors like Deloitte and the other major firms must operate in the world of stated financials and prudential regulation as it exists in Europe today. Because of issues with both the definitions behind and presentation of financial disclosure in Europe, particularly when it comes to credit, we still view the official numbers on NPLs in Italy and the rest of southern Europe as being deliberately understated. In Italy, for example, prudent investors proceed on the assumption that total NPLs are probably twice the official levels. Italian banks, owing to political and financial realities, are not prepared to bring their level of asset quality and disclosure to the levels of their US counterparts. When the new ECB rules on NPLs go into effect in 2021, it will be interesting to see if Italy and other Southern European nations actually comply. If you are doing business with a bank anywhere in Europe, the reality is that a foreign investor or ratings analyst or banker or regulator will never know if a given bank is sound or not. There is no culture of disclosure in the EU when it comes to banks. There is no SEC Edgar system for public banks, no FDIC and FFIEC for all US depositories. The disclosure by Monte dei Paschi of its bad loans is contained in a single table. Click here to see the Bank Holding Company Performance Report for Deutsche Bank Trust Corp, the top-tier unit of DB in the US that was recently red flagged by the Fed for operational issues. There is no similar public source of information in Europe for DB or any other depository. Instead in the EU there is a private network of data dissemination based upon 28 national accounting rules and national regulatory regimes. Your only indicators of risk are prices for a bank’s debt and equity and the relevant sovereign benchmarks. Since as Professor Kane observes many EU banks have been trading like quasi sovereign credits, recent market volatility begs the question as to both bond spreads and equity market valuations. Of note, the guarantee pricing mechanism for the Italian NPL securitizations depends upon the pricing for credit default swaps (CDS) for a basket of Italian issuers as well as the credit support of the Italian government. With the rise of the explicitly anti-euro coalition in Rome, the practical value of that Italian state guarantee certainly comes into question. One aspect of this situation that deserves attention from investors is the precarious nature of funding in the EU banking system. In the Euro zone, German banks make the system go by carrying over €900 billion euros of float in the form of unsettled credits for the rest of the system. This means that German banks enable payments by banks in Italy, Spain, Portugal, and Greece, notes former Fed counsel and researcher Walker Todd. Todd explains that the US Federal Reserve System avoids the buildup of large inter-district debit and credit balances by settling accounts systemwide on a weekly basis. “In the old days, that is why $10,000 notes existed -- to facilitate the clearings,” Todd avers. For whatever reason, when the euro was established in 1997, no provision for periodic intercountry clearing and settlement was included. This has led inexorably over time to the strongest member country extending a great deal of unintended credit to the rest of the EU system, especially the weakest countries' banking systems. As the M5S/Lega coalition engages with the other EU member states, they would do well to remember that the Germans ultimately are financing short-term borrowings via the ECB. Of note for investors in Italian banks, German chancellor Angela Merkel rejects any debt forgiveness schemes for Italy – one of the early demands from the M5S/Legal government that was apparently dropped – at least for now. Merkel stated flatly that solidarity among euro area members should not lead to "a debt union” – a concept that would spell political suicide for Merkel and her coalition. Yet it is some measure of the dire situation in Europe that the German leader leaves open the possibility of a bailout for Italy. French President Emmanuel Macron advocates the creation of a specific budget for the euro area, with the appointment of a finance minister, and the transformation of the European Stability Mechanism (ESM). ) into a European Monetary Fund (EMF). Merkel apparently agrees. "If the entire eurozone is in danger, the EMF must be able to provide long-term credit to help countries, Merkel said last week. “Such credits could be spread over 30 years and granted on the condition that the beneficiaries undertake structural reforms." The reality in Europe is that structural reforms never occur in large member states, only in the subordinate states such as Ireland, Greece and Spain. Italy, as Europe’s largest debtor state, lacks the political will to get its banks and fiscal situation in order. Thus Merkel seems to be preparing the way for a bailout for Italy if for no other reason than to protect German banks. Think of it as a larger version of the Greek project. The M5S/Lega coalition has explicitly threatened sovereign debt default, an explicit act of extortion focused on Germany and Angela Merkel. Is an EU bailout bullish for Italian banks? Maybe in the near term. But ultimately we think that Italy’s fiscal disarray will destroy the EU and lead to an Italian exit and currency devaluation with the reintroduction of the lira. In the event, banks in Italy and throughout the euro area will be severely impacted. #AngelaMerkel #DeutscheBank #EdKane #WalkerTodd #MontepaschiGroup #BaselIII #ECB #NPLs #BancaMontedeiPaschi

New York – Happy Memorial Day. "Let us have peace." Grant's Tomb The Mortgage Bankers Association Secondary Expo is always one of the more important events of the year for the housing finance industry and 2018 was no exception. MBA Chief Economist Mike Fratantoni delivered the expected bad news that the industry slipped into net loss on new loan origination for the first time since 2014. Soaring regulatory costs and shrinking spreads are the culprits. But the industry remains upbeat. Rob Chrisman summed it up: “I know many owners and CEOs of residential lenders… and would never bet against their success. They represent a very savvy, entrepreneurial, and street-smart group of individuals but are faced with many risks, with LO comp, technology, housing inventory, and shrinking margins in the forefront.” We could not help but be impressed by the innovation on display at the MBA event. A number of mortgage lenders are getting into new areas of credit such as “business lending” (aka funding fix n flip strategies) and other short-term credits. Reverse mortgage lenders are getting into forward jumbo lending, while jumbo shops now want to do reverses. REITs are buying lenders and old mortgage bankers are spawning new REITs. And there is even talk of non-bank construction and development (C&D) lending. The fact that the likes of Goldman Sachs (GS), Zillow and Redfin are in the market for financing fix-and-flip projects and single-family rentals gives some investors confidence. And yes, the market has grown significantly. But we worry the Bernanke-Yellen monetary joy juice known as "QE," which has pushed up home prices by multiples of the supposed PCE inflation rate, is behind this surge in demand for home improvement loans. Cool off the home price appreciation and this new credit market chills out as well. To give you an idea of the level of frenzy in bank C&D lending, in Q1 '18 US banks reported a negative cost of credit for this $350 billion asset class. Somehow we can’t see the opportunistic diversification into business lending ending well. And the fact that GS has decided to add fix n flip to crypto currencies in its portfolio of BIG IDEAS is most definitely a concern. Lending on collateral like a residential home is a far better of a business than unsecured lending to small, often unincorporated businesses focused on home flipping. Some shops will lend 90% on the purchase of the spec home and then fund 100% of the improvements on the asset as well. As and when home prices stabilize in high value MSAs, the rationale behind this business will evaporate. There are certainly signs that the credit market for residential exposures had matured. With the collateral under the residential mortgage sector showing continued signs of being “too good to be true,” loss rates actually rose in Q1 ’18 to 27% after falling into the twenties a year ago. This rate of loss given default (LGD) is still among the lowest levels seen in almost half a century for bank owned residential loans, as shown in the chart below. The average LGD for bank RESI loans going back to the early 1980s is 66%, of note. Source: FDIC Gillian Tett of the FT last week became the latest financial writer to call US housing a bubble. Tett confirms that the Federal Open Market Committee has manipulated US real estate prices to the point where a messy correction is inevitable. The downward skew in loss rates over the past several years certainly supports that view, but nobody on the FOMC seems to want to talk about real estate prices and how racing valuations have outrun conventional measures of inflation much less potential home buyers. National Association of Realtors (NAR) released a summary of existing-home sales data showing that housing market activity this April fell 2.5 percent from last month and dropped 1.4 percent from last year. The MBA has total loan origination flows basically flat at $1.6 trillion annually through 2020. In markets such as New York, Austin and San Francisco, volumes in high end properties are softening. Luxury prices in New York actually peaked several years ago. Tett writes: “But estate agents say that sales volumes in the first quarter of 2018 were at their lowest level for six years. Meanwhile the median price per square foot was 18 per cent lower than a year earlier, according to some reports. That leaves Manhattan estate agents nervously gossiping about the local outlook. However, it should prompt investors and policymakers to ask a bigger question: could New York’s jitters herald declines in other non-US real estate markets too?” Ditto Gillian. In fact, the increase in loss rates on 1-4 family loan defaults is not yet mirrored in actual rates of default and delinquency. Past due bank owned loans at 2.5% is at the lowest level since Q4 ’07, an unfortunate yet accurate historical coincidence. A decade ago as today, credit seemed to have no cost and banks were reporting negative rates of loss. That situation pertains in the $400 billion portfolio of bank owned multifamily loans, where recoveries continue to exceed cash losses due to the huge price increases in this popular asset class. The rates of delinquency and charge offs are near zero for bank owned multifamily loans, as shown in the chart below. Source: FDIC Most of the operators we polled think that the low profit margin environment in residential lending will persist for years, even as sales volumes flatten out. Of interest, the MBA has purchase mortgages growing steadily in its loan production estimates, while mortgage refinancing volumes steadily fall. Obviously mortgage refinancing is less attractive in a rising rate environment, But will home purchase transactions continue to grow in the post-QE world? This is the key question that will validate – or not -- expectations for businesses operating in the world of mortgage finance. No surprise then that yields for both conventional and government-insured mortgage servicing assets are trading briskly in single digits. During our discussion of mortgage servicing rights (MSRs), one of the panelists wondered if it would not be possible to see mortgage prepayments drop even below current low levels. From left, Phil Laren of MCTrade, Charles Clark of Everbank, RC Whalen, Seth Sprague of Phoenix Capital & Mark Garland of Mountain View. The upward movement in prices for MSRs over the past year has been striking, with cash flow multiples for conventional MSRs north of five times annual cash flow and new issue GNMA MSRs in the mid-threes compared to half that level twelve months ago. This year marks five years running that yields on MSRs have fallen, a process now accelerating due to rising interest rates. Seth Sprague of Phoenix Capital told the audience that institutional cash focused on the MSR market has surged over the past year. “Liquidity has basically doubled along with the number of buyers compared to a year ago,” he noted and added that rising interest rates are making the escrow balances associated with MSRs increasingly valuable along with the expectation of low prepayment speeds. Mark Garland from Mountain View said that “We’ve all talked a lot about non-banks growing market share. We are starting to see the banks coming back to the MSR market. Banks are being very competitive. And we’ve seen new shops come to the marketplace. We traded a deal recently where the 30 year [cash flow] multiple went above 5.5 times. That would have been unimaginable six months ago.” As the mortgage industry struggles with the “benefits” of quantitative easing and ultra-low interest rates, current and former Fed officials travel around the country congratulating themselves on their cleverness and engaging in chest pounding demonstrations over the profits earned via QE -- profits that should have gone to private investors but instead were remitted back to the Treasury. Sadly for Bernanke, now the FOMC's System bond portfolio is badly under water to the tune of tens of billions of dollars. In fact, QE resulted in the transfer of trillions of dollars in income from private investors to the state and created grotesque distortions in asset prices like stocks and real estate. The acceleration in MRS valuations over the past year is as much about rising interest rates as it is due to Fed market manipulations. Instead of boosting job growth and home affordability, the good citizens at the Federal Reserve have through excessive regulation and QE engineered scarcity of homes and a declining market for mortgage finance – precisely the opposite of the goals they pretend to pursue. One thing that is pretty clear though is that over the past five years the cost of buying a home has soared faster than the official inflation rate, a fact that is likely to result in thousands of job losses in the mortgage sector over the next year and more. Consolidation is the name of the game in the world of mortgage banking, driven by sharply increased operating costs, falling loan origination profits and rising interest expenses. The concern of course is what happens when home prices inevitably weaken. Martin Feldstein, writing in the Wall Street Journal , warns similarly for stocks but would likely also add a bubble in housing to the list of FOMC accomplishments: “Year after year, the stock market has roared ahead, driven by the Federal Reserve’s excessively easy monetary policy. The result is a fragile financial situation—and potentially a steep drop somewhere up ahead.” Next week, the Institutional Risk Analyst will release the new edition of the Bank Book, including a discussion of current banking industry trends in credit and operating performance, and profiles of the top US banks. #BenBernanke #JanetYellen #inflationQE #MortgageBankersAssociation

New York – This week The IRA will be at the MBA Secondary Market Conference & Expo , as always held at the Marriott Marquis in Times Square. The 8th floor reception and bar is where folks generally hang out. Attendees should not miss the panel on mortgage servicing rights at 3:00 PM Monday. We’ll give our impressions of this important conference in the next edition of The Institutional Risk Analyst . Three takeaways from our meetings last week in Paris: First, we heard Banque de France Governor Villeroy de Galhau confirm that the European Central Bank intends to continue reinvesting its portfolio of securities indefinitely. This means continued low interest rates in Europe and, significantly, increasing monetary policy divergence between the EU and the US. Second and following from the first point, the banking system in Europe remains extremely fragile, this despite happy talk from various bankers we met during the trip. The fact of sustained quantitative easing by the ECB, however, is a tacit admission that the state must continue to tax savings in order to transfer value to debtors such as banks. Overall, the ECB clearly does not believe that economic growth has reached sufficiently robust levels such that extraordinary policy steps should end. Italian banks, for example, admit to bad loans equal to 14.5 percent of total loans. Double that number to capture the economic reality under so-called international accounting rules. Italian banks have packaged and securitized non-performing loans (NPLs) to sell them to investors, supported by Italian government guarantees on senior tranches. These NPL deals are said to be popular with foreign hedge funds, yet this explicit state bailout of the banks illustrates the core fiscal problem facing Italy. And third, the fact of agreement between the opposition parties in Italy means that the days of the Eurozone as we know it today may be numbered. The accord between the Five Star Movement (M5S) and the far-right League Party (Lega) of Silvio Berlusconi marks a deterioration in the commitment to fiscal discipline in Europe. Specifically, the M5S/Lega coalition wants EU assent to increased spending and cutting taxes – an explicit embrace of the Trumpian economic model operating in the US. The M5S/Lega coalition is essentially asking (or rather blackmailing) the EU into waiving the community’s fiscal rules as a concession to keep Italy in the Union. The M5S/Lega coalition manifesto, entitled appropriately “Government for Change,” suggests plans have been made for Italy to leave the single currency, calls for sanctions against Russia to be scrapped and reveals plans to ask the European Central Bank to forgive all of the Italian debt the ECB purchased as part of QE. John Dizard, writing in the Financial Times on Friday , notes the new spending in Italy will be funded via “mini-BoTs,” referring to Italian T-bills. The M5S/Lega coalition apparently wishes to issue small (euro) denomination, non-interest-bearing Treasury bills. The paper would be in the form of bearer securities that would be secured by Italian state tax revenues. Dizard notes that the logical conclusion of the Italian scheme, which allows the printing of a de facto fiat currency in the form of bearer bonds, will result in either Germany or Italy leaving the EU. The Italian evolution suggests that Ben Bernanke, Mario Draghi and their counterparts in Japan, by embracing mass purchases of securities via Quantitative Easing, have opened Pandora’s Box when it comes to sovereign debt forgiveness. We especially like the fact that mini-BOTs will be in physical form, printed like lottery tickets. The spread on Italy is now trading 1.65 percent over German Bunds vs 1.5 percent last week and is likely to widen further. Among the biggest challenges facing Italy’s new government and all EU heads of state is the growing economic policy divergence between the US and Europe. Again, to repeat point two above, the Europeans have no intention of raising interest rates anytime soon and, to this end, will continue to reinvest returns of principal from the ECB’s securities portfolio. Given the Fed’s focus on raising interest rates in 2018, it seems reasonable to assume that the euro is headed lower vs the dollar. The assumption on the Federal Open Market Committee, of course, is that US inflation is near 2 percent, giving us a real interest rate measured against LIBOR at 3 percent, for example, of one hundred basis points. But what if the FOMC is wrong about inflation and, particularly, if the favorite inflation measure used by American economists is overstated? Is the ​broadly defined ​personal consumption expenditure (PCE) index, which the FOMC relies upon for​ assessing economic conditions and fiscal policy, inflation, and employment​, really the best measure of price change? And is the FOMC currently making a rather gigantic mistake in raising interest rates further? Our friend Brian Barnier at Fed Dashboard has done some interesting work on this question over the past several years, including his May 10, 2018 missive (“ Concentrated price changes mean less control for the Fed ”). The chart below from Fed Dashboard shows the components of PCE. The chart illustrates how difficult it is to discern a central tendency in the bundle of data that goes into inflation indicators such as PCE. As Barnier writes: “’Inflation is back’ has been a big headline. Is that true? Yes, if ‘inflation’ means the weighted-average price change of products No, if ‘inflation’ means price increases caused by monetary factors or widespread price increases.” The San Francisco Fed has also done some great work on this issue of "PCE diffusion." If you are indeed a data dependent monetary agency, the idea of using the center point average of the diverse factors in PCE as a bellwether for monetary inflation is a bit odd. Notice, for example, that increases in the cost of financial services such as banks, auto insurance and financial advice are among the biggest positive factors in the PCE index. Increases in interest paid on excess reserves (IOER) by the Fed also positively impacts PCE, Barnier tells The IRA . Important for Europe, the Fed’s use of PCE is leading to rising interest rates, which in turn is driving up dollar borrowing costs in Europe, as shown in the FRED chart below of three month LIBOR vs three month Treasury bills. The FOMC’s view of inflation also is supporting a rally in the much battered dollar. But what if the Fed’s favorite indicator, namely PCE, is overstating the actual rate of price change? Economists on both sides of the Atlantic like to neatly separate “real-world” indicators like interest rates and debt from supposed monetary factors such as PCE. But the divergence of monetary policy in the US and Europe suggests this is difficult in practice. There seems to be a basic conflict in how inflation is perceived in Washington and Brussels. This conflict of visions promises to be increasingly problematic in the weeks and months ahead with a stronger dollar and higher US interest rates pressuring emerging nations. The big risk we see both for Europe is that the narrative being followed by the FOMC assumes that inflation is rising, at least as measured by PCE, when in fact deflation driven by excessive debt may still be the central tendency of aggregate price change. If PCE is overstating monetary price change, then the FOMC should not raise rates further. So the good news is that Europe is showing some signs of life in terms of economic growth. A weaker euro may help in the near term. The bad news is that the EU’s banks remain largely crippled by non-performing loans accumulated during previous economic slumps. And the level of debt held by nations such as Italy is growing steadily. With the UK already headed for the door, the latest political developments in Italy may presage the end of the EU as it stands today. How the Germans and other euro nations deal with the new government in Italy will tell the tale.

Paris | Why is economic growth so modest in the United States given the low levels of interest rates? Or as Jim Glassman of JPMorganChase (JPM) wrote last week: "According to popular theory, Treasury yields should be much higher than they are, given the current rate of GDP growth." Remember when regulators talked about a nonsense called "macroprudential" policy? The short answer to the riddle of growth vs interest rates posed by Jim Glassman is excessive regulation. Sadly when we hear from a number central bank officials and economists tomorrow at the Banque de France, there won’t be any discussion from the assembled expertsof a conflict between monetary policy and regulation. Perhaps the single most oppressive factor in the US economy today is the Federal Open Market Committee. Since the 2008 financial crisis, the FOMC has subsidized the US banking systems to the tune of about half a trillion dollars per year, yet the committee members insist that their policies are intended to promote job creation and economic expansion. Most of the benefit of lower interest rates have flowed to the largest banks and leveraged investors while the US economy has largely healed itself. Do the math: $100 billion per quarter in subsidies to banks in terms of low deposit rates and bond yields, plus billions more per month paid by the Fed risk free in interest on excess reserves (IOER). Bank net interest margins shrank dramatically in the past year as market rates have risen, yet the subsidies continue to flow because deposit rates have barely moved. And the sad part is that, even as the FOMC effectively competes with the US Treasury by paying IOER, it is also encouraging banks not to lend to support real economic activity. We illustrated the mathematics of financial repression in The IRA last month (“ Bank Earnings & Financial Repression” ). The dirty little secret kept by the FOMC is that were it to actually stop paying IOER tomorrow, the Fed funds rate would probably be cut in half. That would not fit into the macroprudential fantasy that justifies the actions of the Fed over the past decade. Within the strange, neo-Keynesian logic that operates within the US central bank, the FOMC believes that it must use IOER to manage interest rates upward to prepare for the next recession. But by pushing up short-term interest rates when there is so little real demand for credit, the FOMC may actually cause the next recession. So why does the central bank feel compelled to force short-term interest rates higher? Didn’t the FOMC buy $4 trillion in Treasury debt and mortgage backed securities in order to promote risk taking and investment to boost employment? Well, sort of yes and sort of no. The fact is that demand for short term credit is much weaker than the FOMC is willing to admit. And as we have discussed previously, the FOMC refuses to take losses on the System portfolio by actually selling bonds. Thus, to Glassman's point, there is an effective cap on long-term interest rates. Even as the Fed was manipulating credit spreads and credit markets via quantitative easing, prudential regulators were increasing capital requirements for banks and discouraging lenders from taking risk. Specifically, bank capital levels have basically doubled since 2008, which leaves less of the bank balance sheet available for lending. We discussed this asset allocation issue with Dennis Santiago of Total Bank Solutions a couple of weeks back (“ The Interview: Dennis Santiago on Banks, Blockchain and the Goddess of NIM ”). More important, the supervisory guidance to banks from prudential regulators, in particular the officials at the Federal Reserve Board and the Office of the Comptroller of the Currency, has been to avoid risk taking. Hard ceilings have been placed on all manner of bank loan exposures, from commercial and industrial loans to construction finance and multifamily and residential real estate. As with the increased capital levels, the guidance from US regulators makes it effectively impossible for banks to maintain levels of credit needed to fuel higher economic growth. In addition to limiting overall bank loan exposures for much of the US economy, federal regulators have specifically limited lending to consumers, particularly the bottom third or so of Americans in terms of credit scores. Roughly one third of all Americans who can actually qualify for a FICO score have score below 650. This puts them out of reach for most bank lenders, especially the largest banks. Even as the overall credit quality of US consumers has been rising over the past decade, banks have effectively been told to only lend to consumers with credit scores north of 680-700. According to the company formerly known as Fair, Isaac & Co, the average FICO score rose to over 700 last year. The chart below from FICO Blog shows the distribution of FICO scores through 2017 and is republished with permission. The reason that non-banks have come to control more than half of the US mortgage market is that the depositories were told to avoid any default and/or reputational risks involving US consumers, who are viewed by federal regulators as being toxic. This guidance is not written down anywhere the public may see it, but the effect on credit availability from banks is stifling economic expansion and arguably offsets much of the positive benefit from the FOMC’s manipulation of interest rates. If all of this seems a little bit crazy, it is. The folks on the FOMC bend the rules of monetary mechanics and more, but prudential regulators have put in place guidelines and unpublished rules that effectively freeze out millions of Americans from getting loans for their new business or to buy a home. If you think that the 2010 Dodd-Frank law was meant to protect consumers, then you’re right. It protects them from gaining access to credit on reasonable terms from federally insured banks. Of course you’re probably thinking that the non-bank lenders are picking up the slack with less affluent Americans, but not really. Banks may be levered 10-15 times on equity, but non-banks lever their capital just 1-3 times -- if they want to access the investment grade sector of the capital markets. So even if non-banks are willing to lend to borrowers with inferior credit, their ability to support lending volumes is constrained by limited balance sheets. One reason why lending volumes for the US residential mortgage market have fallen for the past three years is that there simply is not enough capacity to support these less attractive borrowers. More, the Fed’s manipulation of asset prices has pushed the cost of a home beyond the reach of many American families. Meanwhile, the competition among banks and non-banks for loans to more affluent borrowers has driven loan spreads for assets such as mortgages and auto loans down to all-time lows or even negative. So what is to be done? In simple terms, we need to moderate the oppressive bank regulatory environment to allow banks to lend on reasonable terms to creditworthy borrowers. At the same time, the FOMC needs to realize that pushing up short-term rates much above current levels in the near term is going to be counterproductive and could lead the US down the path to a recession. There is simply not enough leverage available in the US economy to support higher growth at today's interest rates – especially given the regulatory restrictions placed upon banks when it comes to capital and lending. If we proceed with the FOMC’s planned rate hikes, the proverbial aircraft runs the risk of stalling at the end of the runway rather than taking off. Until we can somehow harmonize regulation of private credit with public monetary policy, this conflict of visions between the FOMC and federal bank regulators poses a serious risk to the US economy.

New York | We were in the car last week heading to Washington for the gala celebration for The American Conservative’s 15 years in existence. During the trip, we heard former auto industry executive Bob Lutz take down Tesla’s (TSLA) economic model live on CNBC . Talking to Carl Quintanilla, Lutz – who worked in senior management for all three US automakers – basically made two interesting points: that Tesla spends too much for its larger batteries and that the company’s labor costs are six times the industry average. Lutz repeated his view that examination of the company’s financials by “anybody who knows anything about the automobile business” must lead to the conclusion that “this cannot possibly work” with reference to TSLA’s costs and revenues. He predicted bankruptcy for the company. “[Musk] doesn’t want to talk about the numbers, which are a disaster,” former GM Vice Chairman Lutz told CNBC (“ Elon's costs are way higher than his revenues: Bob Lutz ”). He says let’s talk about the future… He wants to talk about anything but the disastrous business.” Suffice to say that Lutz generates a LOT of controversy, both from the supporters of Tesla and its charismatic CEO Elon Musk and from auto industry aficionados, as we discovered on our twitter thread upon posting his interview. But Musk does not cut a very impressive figure as a corporate CEO, behaving like a cranky child a la Facebook’s (FB) Mark Zuckerberg. He either needs to play the role as CEO of a public company or stand down. Come to think of it, Musk reminds us a lot of Henry Ford, a difficult man who had a vision and largely kept his own counsel. Ford was not known for his patience with mere mortals, preferring the company of other visionaries like Thomas Edison, Harvey Firestone and Charles Lindbergh. In fact, Henry Ford was an appalling manager who was not even an officer when Ford Motor Co was started. He would have failed for a third time in business but for his partners like James Couzens, Horace Dodge and Charles Sorenson. What we can definitely say about autos having researched Ford Men: From Inspiration to Enterprise over many years is that manufacturing passenger vehicles in the 21st Century is a very tough, often times irrational business with modest and frequently negative equity returns. Watching Ford Motor (F) decide last week to stop making “cars” is a reflection of this economic reality. Ford and all the global automakers must follow the evolving preferences of consumers when it comes to product design and discard products that don’t fit that target. Green is good, but consumer preferences for SUVs are really about utility, a trend Ford itself helped shape by introducing truck-based passenger vehicles like the Bronco and Explorer several decades ago. When Toyota responded in 1998 with the Lexus RX300, that marked a key step in the evolution and feminization of luxury sports utility vehicles. The 2000 model year Ford Explorer was still a big, dangerous truck, but the Lexus RX was a round, beautifully finished, if underpowered, passenger vehicle that rode high, had a big cabin, rear hatch and great visibility. The Lexus also had good gas mileage. The fact that TSLA has embraced traditional sedans rather than some sleek kind of vision for the hybrid SUV is notable. As we discussed with Bloomberg Intelligence auto analyst Kevin Tynan in February in The IRA (" The Interview: Kevin Tynan on Autos and Mobility " ), the global industry is headed towards a mix of SUVs and true trucks with traditional passenger cars getting a rapidly declining share of the production pie. Makers like Tesla and Audi, for example, are atypical in their continued focus on passenger cars vs SUVs of varying shades. Tynan said in February: “A decade ago most SUVs were being built on a truck platform, but that is not the case at all today. These were full frame vehicles. Today there are very few SUVs that are built on the same platform as the pickups.” Or to put it another way, Ford still makes “cars” that look like SUVs on the outside. And please don’t take your Audi Q-7 off-road in Maine or even off pavement during the June Camp Kotok fishing trip (there are a couple of spots left, BTW). Take the Ford F-250 Super Duty with the double cab and short bed to tow the grand lake canoe (see below). Toma Stream Tynan also noted that SUVs and trucks tend to be more profitable than cars, but here is where the problem comes for TSLA. According to Lutz, the delivered price for the Tesla Model 3 is in the $50k range as opposed to original price tag of $30k. That big delta in terms of the delivered price for a Tesla Model 3 will take out a lot of demand for the vehicle, Lutz concludes. More important, at that $50k price point, Tesla is up against Toyota, Audi, BMW and Daimler Benz, all of whom have full electric and hybrid offerings that can be reasonably profitable today. And the rest of the auto industry is right behind the premium marques in terms of features at lower price points. Elon Musk has achieved two huge goals: First, he validated the concept of electric cars in the public mind and with the auto industry. The entire global auto industry is desperately chasing Tesla’s vision of the electric future of personal transportation. Second, Musk has created a premium brand in Tesla, but this brand needs to be managed to be competitive. As Tynan noted: “Tesla is valued as a tech company, but as a car maker they are in precisely the wrong place in terms of consumer who want a higher ride and other attributes of a truck or crossover… Tesla could at least build a car that consumers want.” To us, Musk needs to declare victory and move on to his real passion, namely selling the future, space travel, shuttle to Neptune, whatever. Making cars of whichever propulsion type is about today and those few global designer/assembler/marketers that can compete for market share. Like Henry Ford, Musk’s considerable talent as a visionary and salesman may not be matched by his operating skills. He should just admit as much and put Tesla up for sale. Tesla ought to hold an auction among the top global automakers and pick a partner to build TSLA autos and especially small and mid-size hybrid Tesla SUVs. The continuing surfeit of global capital may still enable Musk to extract himself whole from the Tesla project and avoid facing the fate of some previous automotive entrepreneurs. We’re thinking not so much about the habitually conservative Henry Ford as much as William Durant of General Motors (GM) fame. One of the greatest speculators of a century ago, Durant built GM into the largest corporation in history during the first decade of the auto industry. Ford, GM and the Dodge Brothers were all fabulously successful and profitable businesses in the 1900s with returns to shareholders measured in the thousands of percent annually. Durant brought Buick, Oldsmobile, Pontiac, Cadillac, Champion ignition, AC spark plug and other companies into GM, sales soared, but earnings lagged. By 1910, however, Durant became over-extended and lost control of GM to the creditor banks led by JPMorgan (JPM). Durant was ousted by the bankers as his company sank into bankruptcy. By 1915, aided by the du Pont family and other investors, Durant regained control of GM and began “an enormous program of expansion,” to quote Earl Sparling’s 1930 classic, “Mystery Men of Wall Street.” The E.I du Pont Nemours Powder Company put $50 million of war profits into GM to support Durant. In the Spring of 1920, Durant tried to float $64 million in new stock to finance the excess of expenses over revenue at GM. The stock was trading at $38.50, but new investors were coming in at half that valuation – just $20 per share. The situation went from bad to disaster quickly, when several large stockholders, concerned about the misalignment of costs and revenue, threatened to sell, forcing Durant to personally support the stock. By June 1920, Durant had been buying GM stock through intermediaries for more than a month, but to no avail. The stock broke to $20 in public trading when a 100,000 share block was offered, Sparling reports. GM reached $12 per share by the end of the month. The value of GM continued to fall along with his fortune. Durant spent his entire cash reserve -- $90 million – to allow some of his personal friends and associates to exit the stock. By the end of 1920, JPMorgan stepped in once again and along with the du Ponts took charge of GM for the second time in two decades. They paid Durant $40 million for his stake, of note. More important, Du Pont controlled GM until the Administration of President Dwight D. Eisenhower forced the divestiture. It seems to us that Elon Musk has a choice. He can either magically cut the cash burn rate of TSLA down to nothing and start delivering cars on time or he can look for an exit strategy. Musk has created an awful lot of value in TSLA, but the better part of valor may be for this American icon to partner with a global automaker and move on to personal aircraft, for example. Otherwise TSLA will continue to burn cash and, eventually, must go back to the markets for more. And if TSLA is unsuccessful in raising new cash, then like GM in 1920 the great endeavor will be finished – unless Musk is prepared to fund the venture out of his own pocket. The bond holders and other creditors are, of course, ultimately the true owners of TSLA. Thus a sale may be the best outcome for this valuable brand, but how to get Musk to accept such an outcome? Trouble is, Musk may not be able to fund his project until it becomes at least as competitive as the rest of the industry. And between today and that operational goal, TSLA will be valued more and more as a car company as opposed to a technology play. Ponder Audi AG valued at $34 billion vs TSLA at $49 billion. The markets will resolve the question soon enough. One might apply the judgment of Sparling on the persistent Durant to the personality of Musk: “[I]t isn’t money nor even power that this man has striven for all his years, but achievement, a role in the play of life that might turn that comedy and farce into the kind of drama it would be had a surer playwright written it.” #ElonMusk #Tesla #Ford #GM #Audi #CNBC

New York | In this issue of The Institutional Risk Analyst , we talk with Dennis Santiago, co-founder of Institutional Risk Analytics and the author of the Bank Monitor safety and rating system. The Bank Monitor was acquired by Total Financial Solutions of Hackensack, NJ in 2014. Dennis is a rare analyst who combines a high-level understanding of operations analysis and business process with an equally sophisticated understanding of technology. He is an involved public citizen and political commentator published on platforms such as the Huffington Post and America Out Loud . His personal blog at www.pickingnits.com focuses on global risk and national policy. We spoke to Dennis at his office in Los Angeles. The IRA: Dennis thanks for taking the time to catch up. Let’s start off by talking a little about how you are using the Bank Monitor ratings engine and specifically the use case developed for the State of Ohio at TBS. How are they using the Bank Monitor to screen the risk of the banks that are participating in their state-level deposit insurance program for banks? Dennis: The Ohio case is a fascinating study in action and reaction dynamics of federal regulation. As the market has gone beyond the 2008 crisis, new business cases for safety and soundness testing have emerged. This one stems from how the increased capital requirements at the federal level have constrained capital flexibility for local markets, reducing the amount of credit available to these communities. As a result of capital and liquidity requirements imposed at the federal level, banks are compelled to over-collateralize loans. The driving rule behind public depositor overcollateralization was the implementation of the US version of Basel III’s Liquidity Coverage Rule (LCR). It was structured such that a bank gained no operational liquidity for taking municipal deposits. Roughly, every muni deposit dollar had to be collateralized with a low yield high quality liquid asset. The net net interest margin (NIM) for the silo is zero. The IRA: That’s very interesting and something we’ve never heard about in the financial industry media. What approach did Ohio take ultimately? Santiago: The regulatory answer was to allow the pooling of collateral by a guarantor so as to generate headroom to engage in higher yielding assets. This created conditions for generating economical NIM’s off these exposures. Ohio enacted a law that created a way for the state to pool the collateral. They created a vehicle to guarantee a portion of the collateralization requirement at the federal level for in-state banks are deemed to be safe and sound using acceptance criteria more strenuous than federal requirements. The collateral relief is significant thus enabling banking services to Ohio municipalities. To enable this, what Ohio did was use a customized version of the Bank Monitor safety and soundness monitoring solution that not only looked beyond FDIC insured deposits regime analysis but went further and assessed the overall quality of depository institutions at the uninsured deposits layer. Municipal deposits tend to be well above FDIC insurance limits. The IRA: We had no idea the State of Ohio was doing this. To be clear, the state is using public funds guarantee mechanisms to provide collateral cover for uninsured deposits of municipalities at prime banks? And this is being done to give capital relief to banks in Ohio? Santiago: That is correct. Banks that operate within state lines can follow state law and are able to take advantage of this facility. The bank must have a physical branch in the state of Ohio. It’s a very innovative solution. More importantly from a fiscal policy perspective, it illustrates agency theory in action between federal and state actors. The IRA: Talk about this dynamic between state and federal regulation. How have the new capital and liquidity rules constrained credit? Santiago: The constraint is because of the need to put up additional capital and reserves against different types of risk exposures. The higher capital levels and the new risk weighting for different assets penalizes banks for selecting higher yielding asset types. We are essentially removing capital that the bank would use to lend from the business operating equation. The IRA: And less effective leverage? Santiago: Yes, yes. The banks look great and have lots of capital, but the business volumes are flat and down vs 2015-2016. The banks don’t have any capital allocation left to lend. Volume is constrained by the Dodd-Frank capital rules; that’s why investors are skittish about bank valuations today. The IRA: Agreed. In the great continuum of risk and public policy, where are we now? Are we too restrictive on banks? Santiago: We may have gone a bit too far in terms of restrictive policy on banks, thus causing new forms of behavior to emerge. You’re seeing regulations that are effectively encouraging the growth of non-bank companies, which are the customers of banks. The banks lend the marginal dollars out to non-bank firms at relatively high spreads compared to real estate lending, for example. If banks have to keep more funds sequestered in capital and reserves, then the growth in non-bank lending is a way to boost NIM. What you have is higher capital balanced by riskier operations to get to the same returns. It begs the question, is this really the center lane path we want to see our financial system following? The IRA: Probably not. The banks do look better, but the pre-tax asset and equity returns are clearly lower than prior to 2008. The after-tax results look better thanks to the tax legislation last year. Santiago: We have lots of money in the piggy bank and lots of risky stuff, creating a barbell of risk at most banks. It’s like the barbell on the cover of Nassim Taleb’s new book “Skin in the Game,” with one tiny end and one grotesquely large end. The banks look under-risked because of the huge reserves they are required to hold. And it causes problems and costs. What we are seeing years after Dodd-Frank is a reaction by proactive states like OH to adjust their own bank regulation to maintain economic activity in the face of restrictive federal regulations. States like OH eventually adapted and passed laws leading to new filtering methodologies for tracking the performance of prime banks. This was a reaction to the negative impact on the OH economy as a consequence and effect of federal regulation. The IRA: We have a banking system that is under-levered and over-reserved. But we also have a system where the Fed has manipulated credit spreads and risk pricing. How much risk is hidden under the comfortable blanket of Fed open market operations? Santiago: Loss rates are clearly headed higher. In order to achieve the returns that investors expect, banks have taken on increasingly more risk in terms of asset participations. NIM is not a forgiving number. You make it or you don’t. The IRA: And NIM is extremely unforgiving when the cost of funds for banks is rising 3x the rate of asset returns. In the most recent earnings cycle, Goldman Sachs (GS) was the only large bank that actually grew interest income faster than interest expense. The great rubber band has clearly snapped. But you won’t hear anybody in the economics profession talking about this on CNBC. The narrative still says higher rates are good for banks. Santiago: Correct. And in the world of bank balance sheets, we have a capital squeeze in addition to a NIM squeeze. The rate of adjustment in terms of NIM is going to depend upon the inflation rate and how fast the Fed adjusts. Banks are already being forced to stretch in terms of asset returns and credit risk. Basically the Fed has flooded the room with liquidity for the past eight years. Banks have to keep their head above water in terms of earning positive returns. But the abundance of liquidity makes finding acceptable returns very challenging. In order to survive, the banks move their asset allocation decisions to less safe, especially when volumes are constrained by capital rules. The IRA: Bankers want bonuses. Where is your big worry bead for the future of the US banking industry? Santiago: Clearly the big transition in the banking industry in terms of asset-liability management (ALM) is going to be managing the shift from liability sensitive strategies to asset focused strategies. One of the big aspects of the 2008 crisis and the recovery was liability management by banks… The IRA: And by the Federal Open Market Committee, which protected bank NIM from 2009 onward by killing depositors and bond holders. Santiago: Now the focus is going to shift over the managing asset returns and related risks. How do you manage yield? In an environment where prices are constrained by the Fed and volumes are constrained by capital regulation, how do you placate the Goddess of NIM? I repeat, NIM is a unforgiving goddess. She does not care how. So if you are short on price and volumes, you turn up the risk on credit participations. All NIM wants to know is that you made your nut last quarter. The IRA: Speaking of assorted nuts, you’ve had some prescient things to say about bitcoin and the so-called blockchain tech that enables it. Haven’t we seen this movie before?? Santiago: Crypto is a really interesting phenomenon. It’s not the tech, it’s how the tech affects the landscape of money. It has grayed the line between people who live on the network and people who don’t. The blending of the two worlds of barter and above board enterprises is like oil and water. As a rule, they do not mix. The way a barter community exchanges value is totally antithetical to the tax paying world. The world of “Hawala” with two sets of books allows for the transfer of value without money actually changing hands. We note the exchanges in a “cross-ledger.” This stuff has been going on for hundred of years in parallel with other forms of finance. The IRA: So crypto has enabled the ancient barter system and outside of the established network. The barter participants don’t pay taxes. OK, we get it. Is that all there is, to paraphrase Peggy Lee? Santiago: We have not really thought through the implications of enabling barter via electronic multiple ledger bookkeeping on a global scale. The IRA: The true participants in the barter world would never trade bitcoin via an exchange. They exchange the numbers and report the transaction to the collective. Our friends in places like Russia and Lebanon use crypto to live, pay bills, outside of the formal system. It is a binary choice. Santiago: Exactly. Trading cryptos via electronic means defeats the point of trust in the barter world. The compact in the barter world is that your net value trade is zero. There’s no taxes or excise or fees. It’s currency-free economics. Crypto imposes itself upon this barter market. The thing about this is that taxes, excise and fees attempting to extract their due won’t be far behind. That’s just the way of things. The IRA: Fair enough on cryptos, but how about blockchain? This is definitely a movie we’ve seen before. It was an electric KoolAid XML taxonomy building party hosted by Chairman Chris Cox at the Securities and Exchange Commission. Eventually led to public companies filing their financials in a dialect of XML. Is there anything here with blockchain? Santiago: As a technologist, I have to admit that there are moments when blockchain bemuses me. If you listen to the pundits, about half say it is a solution in search of a problem and the other half says it’s the greatest thing since sliced bread. I’m a bit more pragmatic about tech having been around since before people started calling it FinTech. To me, the shared ledger technology that seems to get everybody exited is just the latest version of SOAP XML, which is also the basis of a ledgering system. This technology was designed about 30 years ago and eventually trickled down into areas like financial reporting at the SEC as you noted. The FDIC CALL Report data warehouse is another massive implementation of XML based technology to gather, screen and publish bank financial statement data. The transfer of data between banks and other financial institutions is based upon APIs that sit atop XML constructs that are ancient in technology terms. The growth of global trade, manufacturing and logistics is a massive and universal example of XML-based ledgering technology. The IRA: So there is nothing really new here in terms of basic functionality? Santiago: Blockchain is an alternative ledgering system architecture. It is replacing something that is working well. More non-ICO solutions are presently deployed than blockchain ones. Don’t get me wrong. For some use cases, it’s the perfect fit. As with all tools, knowing when and where it’s the best option, and when it’s not, is the key. But people also confuse blockchain as a ledgering system with blockchain as a cyber security system, which it is not. The cases of theft of bitcoin and derivative cryptos have shown the technology still has vulnerability as manifested by incidents of cyber theft poking holes in the tech. We have nerds stealing money from the other nerds in scenarios lifted right out of movies and novels, which is pretty funny. The IRA: Ha. How does this end up? Santiago: What I think is going to happen with blockchain is that people will eventually realize that it is first a foremost a ledgering system that competes with existing systems, some of which are technical, others structural. The question becomes, why is a blockchain-based solution the more efficient solution? When is cost and latency attractive because it provides improved trust or transparency? In a flat internet where everyone is a stranger and are trying to hack you all the time the answer may go one way. In closed universes of known senders where per message mechanistic send/receive confirmation is mitigated, the most efficient transmission and ledgering systems will win out. The pragmatic odds probably favor innovative hybrids still hatching in laboratories. In the end, once we are done with falling in love with the toys, then we will wake up. And people are already starting to wake up to the reality that there’s more than one use-case and implementation design solution in this phenomenon. It’s not a one size fits all discovery. These are savvy folks. They are asking the obvious questions. Stay tuned. The IRA: Thanks Dennis #dennissantiago #blockchain #banks #TotalBankSolutions

New York | Sometimes simple images are the most powerful. The chart below from FRED shows US real GDP change vs. the effective rate for Federal funds over the past five years. Just imagine around Election Day in the US this November, if the Fed funds rate is above the last print in real GDP and the gap between two year Treasury notes and ten year T-bonds is just about nada. Bad for stocks, yeah. But then maybe we see a bond market bull rally because the Street remains so painfully short quality duration. As major central banks turn off the Electric Kool Aid drip, we’ll find out soon enough whether the promise of growth is real in a world with equally real interest rates. This question of just how fast the US economy can grow without near-zero short term rates is really the first order of business when assessing macro market risk. If you believe the dot-plots from the Federal Open Market Committee, we are almost assured to see the convergence of GDP growth rates and Fed funds. Question to Chairman Powell: Are you prepared to start explicit sales of securities from the System portfolio? The chart below shows the painfully slow decline in the amount of Treasury bonds and mortgage backed securities behind the Fed’s $4 trillion in excess reserves. The consensus on the Street seems to be lower growth and higher inflation, but with little upward pressure on interest rates. The Mortgage Bankers Association, for example, has projected real GDP change slowly trending below 2 percent by 2020. If we do two more quarter point increases in Fed funds this year, then we get perfect stagnation with rising inflation, right? Fact is, global growth is not particularly strong, as witnessed by the slow attrition of Sell Side firms over the past decade. UBS, HSBC, BNP, Merrill Lynch, Morgan Stanley (MS) and other second tier transactional players fled to the safety of wealth management after the 2008 crisis, but folks like Deutsche Bank (DB) pretended that 2008 did not happen. This lack of response by management eventually crippled Deutsche financially and led to the current situation, where one of the biggest banks in Europe may require state aid. Last week, we saw Deutsche Bank retreat from the world of deal making and derivatives trading, and going back to an imaginary European commercial banking business. We saw former Goldman Sachs banker and now European Central Bank chief Mario “Whatever it Takes” Draghi make noises about possibly continuing with the ECBs disastrous experiment in “quantitative easing.” Then we ended the week with German Chancellor Angela Merkel holding hands with Donald Trump at the White House. One observer commented to The IRA last week that perhaps Merkel was at the White House to discuss “Plan B” for Deutsche Bank, but this of course assumes that there was Plan A. It seems pretty clear that there has never been a real design for dealing with Deutsche at the corporate level. Years of QE in Europe has decimated DB and other European universal banks. Just as in the US, the ECB’s bond purchases have suppressed bank earnings and loan pricing, and basically killed secondary market trading. Each day we hear further doubts raised about the prospects of synchronized global growth, if for no other reason than the level of indebtedness globally is growing faster than the underlying economy. Global debt is now at $164 trillion, or 225% of GDP, the International Monetary Fund warns. The world is now 12% of GDP deeper in debt than it was at a peak debt cycle during the financial crisis in 2009, hitting a whopping $164 trillion, according to the International Monetary Fund. Our friend David Rosenberg from Gluskin Sheff + Associates in Toronto likes to remind us that the growth of the past five years – both in terms of stock prices and GDP – has come to us c/o the Fed, ECB and Bank of Japan. Why this fact is not obvious to more people working in the equity markets is a source of wonderment to us. Our collective inner neo-Keynesian cheers for the impact of low rates on debtors, but forgets that banks and pensions and even individuals are savers as well. It is pretty clear that the much anticipated surge in cash from tax cuts has not caused an upward surge in corporate investment. The Street has been trimming GDP estimates since January, which in turn “trickle down” into earnings models. And the economic prognostication chorus has certainly turned bearish in the last few weeks. Indeed, Rosenberg told the gathered audience at the most recent Grant’s Interest Rate Observer conference that upcoming market adjustments would lead to a resurgence of religious faith. One place we can assure you there is no lack of tearful prayers is the world of financial institution treasury, where the prospect of a flat yield curve is seen as truly dreadful. Look at the US bank unit of DB, for example, and the gross spread on the half of the lending book deployed in real estate loans is a whole 311 basis points (bp). The same measure at JPMorgan (JPM) is 361 bp. Wells Fargo (WFC) real estate loans? 391 bp. Bank of America (BAC)? 364 bp. Do you want to even hear Citigroup? A whole 263 bp gross spread on real estate loans according to the FDIC. With inflation currently at 2 percent, less funding costs, these banks are giving money away for nothing. If you look at the real estate loan book at US Bancorp (USB), suddenly we are near 5 percent gross yield. How about Bank of the Ozarks (OZRK) at 554 bp? BBT Corporation at 432 bp? Get the idea ? The smaller banks have more pricing power for originating assets, but net loan yields overall are still constrained and barely positive in inflation-adjusted terms. So here’s the big question we face: Has the FOMC effectively capped financial asset returns for the foreseeable future? That is, do all savers face years ahead where yields on securities are better than say the lows of 2012-2015, but not much higher than today? And do banks now face competition from the bond market even as pricing for loans and securities show little real upward pressure? Our best guess is that the attempt by the Fed, ECB and BOJ to stoke inflation by stealing duration from the markets via QE has had the reverse impact, namely constrained asset returns and income – that is, carry – from the global investment book. We’ve discussed the impact of curve flattening on net-interest margins previously in The IRA (" Bank Earnings and Financial Repression "). If GDP slows as the FOMC continues to literally force short-term rates higher, market sentiment toward the weaker financials such as DB could become very dicey indeed. But the more important concern is how global equity investors react to the idea that inflation may be higher than GDP in the years ahead -- the classic definition of stagflation. #deflation #FRED #GDP #duration #DeutscheBank #AngelaMerkel #DonaldTrump

New York | Watching the related financial dramas of China’s HNA Group and Germany’s Deutsche Bank AG (DB), we are reminded of Timothy Dickinson, who reminded us that the image of purposeful design and order imposed from above by experts and regulators is largely an illusion. The world is filled with ill-considered people and strategies, and no realm more than the intersection of public policy and corporate governance. The Federal Open Market Committee is raising short-term interest rates as though it matters, yet in fact Fed policy remains relatively easy in terms of the cost of credit -- the duration . The problem comes because of the scarcity of assets, one reason why high-yield credit spreads have been tightening even as short term funding rates have risen. And the fat part of the Fed’s passive portfolio runoff is in the mid-2020s and thereafter. The chart below shows "AAA," "BBB" and high yield bond spreads. Of course, everybody is so excited by the move of the 10 year Treasury bond to a three percent yield. The move of the short end has been even more pronounced, however, one reason why so many banks are reporting shrinkage in net margins even as shareholder payouts of capital surge. The FRED chart below shows Federal funds, Treasury 2s and 10s. Imagine Fed funds at 2% and Treasury 10s still shy of 3.5 percent yields. The alarm bells in Washington will be ringing. As we note in an upcoming conversation with Dennis Santiago, banks are constrained by the dual impact of restrictions on lending due to regulation and a dearth of duration due to the Fed, ECB, BOJ and “quantitative easing.” In an already difficult market environment, the less well managed institutions get into trouble more readily. We’ve already described the comic behavior of HNA in previous comments, but needless to say there is always more grist for the mill. Most recently, Lucy Hornby in Beijing and Hudson Lockett of the Financial Times described some of the structural aspects of the HNA investment in DB , including a suggestion of a rather complex leverage structure above the investment in the bank. “The sharp fall in the bank’s share price has forced HNA either to sell part of its stake, or pay cash to cover a derivatives arrangement that was used to acquire the shares,” they report. Although it is very common for financial investors to apply leverage high up the capital stack, bank regulators tend to frown on double leverage – especially when it is not adequately disclosed. Double digit ownership of voting shares certainly is a threshold most competent regulators set as requiring active assent for any bank investment. Ultimately, diligent bank regulators generally need to know who is investing in a bank in a significant way. And a key requirement in that approval process is the ability to be a stable investor and potentially a source of strength to the bank should more capital be required. Readers of The IRA will recall that DB searched for years and in vain for a new shareholder prior to the arrival of HNA. When the shadowy Chinese group started to accumulate DB shares in February 2017, the situation at the bank was grave – and had been for years. The board and management of DB has been unable to articulate a strategy for the business going back a decade. While much attention has been focused on the procession of CEOs that have moved through the DB CSUITE, the blame ultimately rests with the board and chairman Paul Achleitner. Like most supervisory bodies in Europe, the board of DB has proven remarkably inert in recent years, basically a reflection of the lax governance of banks more generally in the EU. For example, the FT reported on April 19, 2018, “ Deutsche Bank, HNA, and the GAR chase ” that their investigation into the provenance of the HNA investment in DB suggests the possibility “of an additional undisclosed shareholder behind one of the HNA entities.” This is a remarkable revelation (kudos to Cynthia O'Murchu and Robert Smith at FT ), yet note that prudential regulators on both sides of the Atlantic have taken no action – at least in public – for fear or toppling over the sagging Deutsche Bank. Normally when you hide the identity of the beneficial owner of a US bank, the primary regulator begins an enforcement action and sends out cheery referrals to the US Attorney and other law enforcement agencies. The parties involved start thinking about jail time. Yet in the strange case of DB and HNA, exactly nothing is happening. The regulatory community has been caught completely off base over the past year and more, but can do nothing for fear of ragin contagion. Indeed, the festering mess at DB shows that “took big to fail” is alive and well and global regulators are powerless. The key issue for investors is to understand that precisely no one is in charge when it comes to the twin systemic risks posed by DB and HNA. If as seems likely HNA is forced to unwind its leveraged investment in DB, then the German bank will be worse off than before. DB will have wasted more than a year engaged with a surreal investor who has disappeared into the mist like a character in a bad Chinese martial arts film. Who then will step forward to rescue DB? After a $50 billion deal spree, much of it fueled with leverage, HNA has cut a wide swath of value destruction through the world of banking, aviation, lodging, real estate and other sectors. Just how did HNA get the approval of EU regulators for this investment? Nobody knows and nobody is talking. But the aftermath of this celebration of global incompetence could create significant dangers for the financial markets. When the government of New Zealand shot-down an HNA Group investment in a bank, this provided an indication of big problems. The Overseas Investment Office (OIO) blocked an attempt by China’s HNA Group to buy a vehicle finance firm in part due to doubts about the debt-saddled conglomerate’s financial stability, Reuters reports. The OIO apparently disliked the HNA practice of pledging equity investments in group companies as collateral on loans. “The information provided about ownership and control interests was not sufficient or adequate for the OIO to determine who the relevant overseas persons are for [HNA’s] application to acquire UDC,” said Lisa Barrett, the office’s deputy chief executive for policy and overseas investment. “We were therefore not satisfied that the investor test in section 18 of the Overseas Investment Act 2005 was met.” Were US regulators consulted or even aware of the HNA share purchases in DB last year? DB operates a mostly securities business in the US, but the German bank does have a $55 billion trust company in New York. Deutsche Bank Trust Corporation is regulated by the Fed and the State of New York, and is a significant player in the market for commercial mortgage backed securities (CMBS). Of note, one possible permutation of the DB saga back in Germany is the sale of the US banking business. JP Morgan weighed in on the DB debate several weeks back with the publication of a research report for clients that said Deutsche should shrink its U.S. business “to create shareholder value.” But since German Chancellor Angela Merkel threw the German bank under the bus several years ago, the remaining value of DB is questionable. Reports that former Merrill Lynch CEO John Thain is being nominated to the supervisory board of DB is certainly good news. Thain is a veteran operator, but sadly he is not CEO. More than anything else, DB needs to tell investors and regulators why this bank should continue to exist. If in fact DB moves forward with the sale of its US unit, then the entire business could be in play. But should the bank stumble in a way that surprises Europe’s distracted politicians, look for a very hastily planned merger. Our candidate for the first zombie merger of the 21st Century: DB plus Citigroup (C). Neither bank has a particularly strong domestic banking business or funding base, but there are some interesting asymmetries. Financially it would be a disaster for shareholders, but politically it makes all the sense in the world -- especially if you are Angela Merkel or Donald Trump. #HNA #DeutscheBank #Citigroup