New York | This week in The Institutional Risk Analyst, contributor Ralph Delguidice ponders the aftermath of the retreat last week by the Federal Open Market Committee following the latest market volatility tantrum. Suffice to say that the FOMC has no stomach for deflation of any duration, thus we see the magical appearance of the "Powell Put" in financial commentaries. But riddle us this: When is easing really tightening? First the Fed backed off further rate hikes, now we are talking about resuming asset purchases for the system open market account or SOMA. Sadly, the impact of renewed “quantitative easing” will be a further tightening of private credit as the FOMC does what is does best, namely caters to the debt issuance needs of the US Treasury. None of these developments are a surprise to readers of The Institutional Risk Analyst and illustrate the growing conflict between prudential rules meant to ensure liquidity in banks and the voracious cash needs of Washington. Last week's events illustrate that the FOMC cannot pursue price stability in the face of $1 trillion annual deficits. A Bigger Balance Sheet? (careful what you wish for) By Ralph Delguidice The credit-cartel-consensus has concluded that the Fed has made up its mind to end the balance sheet roll-off “early;” whatever that means. Chairman Jerome Powell suggested a near term equilibrium where reserves are “plentiful,” and that may indeed mean soon; but on closer examination it may surprise many and turn out to imply TIGHTER credit in the hard money markets where real companies fund and leverage on a secured basis. A larger balance sheet—with all of the associated moving parts like currency demand and the Treasury General Account (TGA)—will mean more reserves for banks to use to satisfy the Liquidity Coverage Ratio (LCR) and Resolution Liquidity Adequacy and Positioning (RLAP) requirements that already see Fed reserves as BY FAR the most efficient of all qualifying assets. In fact, for global systemically important banks (G-SIBs), RLAP is calculated intra-day and that leaves ONLY Fed reserves as effective. With more bank assets tied up in Fed reserves—and more “sponsored REPO” giving Money Market Funds and CCPs direct access to the Fed as a counter-party to REPO sellers-- the supply of credit that can flow into private REPO markets will fall all else equal. This will be coming at the same time that VASTLY increased US Treasury (UST) issuance will need to be cleared into the private bond markets. The Treasury Borrowing Advisory Committee Members (TBAC) report last week was VERY clear that much more US savings were going to be needed go forward as foreign demand for UST could not be counted on. With rates where they are these UST positions will increasingly need to be financed—either by intermediary dealers or end users--, and this turns banks that were SELLERS of REPO into BUYERS of REPO. Yesterday was month end, and we saw UST GC printing at 2.90% Source: Scott Skyrm Yes, it was one day. But the quarter end spikes are higher and last longer, and the Year End is flat out crazy. Remember that this is all the time when then SOMA balance sheet roll-off was intact (it still is, of course) and the Fed was encouraging dealer banks to lend back into the private money markets. AKA: “normalization.” Now stop the run-off music and tell the banks to hold more reserves at the Fed, what do we think happens? Policy honchos need to ponder the conflict of LCR/G-SIB rules with monetary policy. Isn’t that called “macropru”? Bottom line here is that the global money markets are a complex cascade of arbitrage that recent history shows can-- and certainly will —amplify any changes to the Fed footprint in reserve demand in uncertain and sometimes counter-intuitive ways. As BAML said in a recent piece on the possible need for a Fed Backstop the REPO market: “has become increasingly fragile and sensitive to shifting behavior of key market participants, especially banks and dealers, the strategists wrote.” https://www.reuters.com/article/us-usa-repos/u-s-federal-reserve-may-need-to-backstop-repo-market-baml-idUSKCN1P5273 Chris Whalen wrote recently in The IRA that the Fed wanted to “nationalize” the money markets once and for all as a way to ensure financial stability. This rings increasingly true as we get visibility into the eventual size, tenor and composition of the SOMA account, and buyers of financial stocks would do well to remember that structural changes to the money markets that involve a permanent Fed presence may change the REPO alchemy (Hey!! it’s a loan AND a sale!!) that they have taken for granted for all these many years. Just Sayin', #Delguidice #PowellPut

“How did you go bankrupt?” “Two ways. Gradually, then suddenly.” Ernest Hemingway, "The Sun Also Rises" New York | Last week the Federal Open Market Committee under Chairman Jerome Powell blinked, again. Last week, The Wall Street Journal reported what bond traders and the readers of The Institutional Risk Analyst have known for months. Rate hikes are on hold and the FOMC is preparing to end the shrinkage of the Fed’s system open market account (SOMA) portfolio. With the financial economy slowing and housing in a swoon, there may be no rate hikes at all in 2019 and maybe even a resumption of quantitative easing (QE). But no surprise. The post 2008 world has seen the death of many long-held beliefs, in particular the idea that the US central bank is here to fight inflation. Jim Cramer of CNBC hit the proverbial nail on the head last November when he questioned how the Fed can talk about “normal” when things are decidedly not normal at all and largely as a result of FOMC policy actions. Bernanke likes to pretend that he saved the world following 2008, yet in fact he actually sacrificed any notion of Fed credibility with respect to inflation for another experiment with -- wait for it -- the wealth effect. This widely discredited notion remains today the key driver of FOMC policy actions. “While critics may dispute the wealth effect’s magnitude, few have challenged its conceptual soundness,” notes Christopher Casey of Mises Institute. “The wealth effect is but a mantra without merit.” Ben Bernanke noted in 2010 that “higher equity prices will boost consumer wealth and help increase confidence, which can spur spending.” The Fed's fixation with perception rather than data is illustrated by the way in which former Fed Chairs Bernanke and Yellen deliberate chose to inflate the value of financial and real assets to "stimulate" the economy. The WSJ’s Nick Timiraos reported last week: “Former Fed Chairman Ben Bernanke often argued that it was the maturity and risk-profile of the Fed’s holdings, not the overall size of its reserves or securities portfolio, that determined how much it stimulated markets and the economy.” The Fed’s dual mandate from Congress includes full employment and price stability. But to look at recent policy suggests members of the FOMC cannot read federal statute or do simple sums. Causing asset prices to soar by double digit rates is not price stability – it is inflation, plain and simple. Please, Chairman Bernanke, do show us where it says in the Federal Reserve Act that the FOMC is allowed to employ asset price inflation as a policy choice. In the Orwellian newspeak of the Federal Reserve System, inflating the value of stocks, bonds and real estate to absurd levels is a form of economic “stimulus.” Never mind that this vast act of asset price inflation did not help the majority of Americans. Indeed, the biggest impact of the Bernanke/Yellen asset inflation seems to be preventing a whole generation of younger Americans from buying a new home. As you read these words, real estate markets around the US are starting to revert to the mean, suggesting that the great Bernanke experiment with the wealth effect is ending. Mind you, the adjustment in real estate markets is not happening gradually, but all of a sudden to paraphrase Hemingway. Similar to the volatility seen in debt and equity markets, the price discovery pattern visible in many heretofore red hot residential housing markets is similar to recent equity market volatility – huge downward spikes in home price sales volumes. Prices will eventually follow when sellers capitulate. One large market caught in the downdraft is Chicago, a sleepy Midwest MSA that only started to see home price appreciation relatively late in the game. Markets such as Southern California and Florida started to rebound even before 2012, but Chicago was essentially dead until 2013 but then began to climb steadily. Since then, the index value for homes in Chicago has risen 25 points, according to Weiss Analytics (WA) home price index. Note: WGA LLC is a shareholder in WA. In the 12 months through October 2018, residential home prices rose 3.6% and condos by better than 5%. In the past three months, however, prices have begun to collapse in Chicago as volumes have disappeared. So, Chairman Bernanke, is this an example of “price stability?” Nope. Let’s go east to New York City, where prices along Billionaire’s Row on Central Park South are down single digits in the past year after rising 30% over the past decade. Indeed, condo prices along CPS have been falling since 2016. As in Chicago, sales volumes in NYC's more toni areas have dried up as the gap between buyers and sellers has widened. Of note, single family residential homes in the greater New York MSA have barely moved in the past decade, but are expected to increase a couple of percent on average even as prices in New York City’s most desirable areas sag. Of course, housing price charts are great fun, but the truly scary chart is the one that also remains our favorite, namely loss given default (LGD) on the $2.5 trillion in single family mortgages owned in portfolio by US banks. In Q3 2018, the LGD or net credit cost on this portfolio, which represents one quarter of all mortgages in the US, was negative by almost 16%. This means that, on average for every mortgage that defaulted, the bank make a profit after repaying the loan in full. Source: FDIC Think about how much the prices for homes backing the average bank owned mortgage had to rise to generate such a result as shown in the chart above. Again, Chairman Bernanke, is this sort of behavior in asset prices consistent with “price stability?” Nope. Did this enormous skew in home prices caused by QE and “Operation Twist” help Americans create jobs, or build or buy a home? Nope. We generated a lot of real estate commissions, but much of the benefits, at least for now, have gone to the banks and investors who own residential credit risk. As US home prices revert to the long-term mean, the key question that arises in the minds of many risk managers is when will loan default rates start to rise? Even if the FOMC does not raise the target for Federal Funds or ends the runoff of the Fed portfolio earlier than expected by investors, the pace of Treasury debt issuance will continue to drain liquidity from the credit markets and force rates higher. Source: FDIC Indeed, as we’ve stated previously, we full expect the Fed to reverse course entirely, end rate increases and start growing the SOMA portfolio to keep pace with US government debt issuance. But none of these expedients are likely to prevent the repricing of the US housing market, which after half a decade of irrational exuberance c/o the FOMC is falling back to earth due to a lack of customers. Look for housing credit costs to rise significantly by the 2020 general election. Meanwhile next door in the leverage loan space, the modest rebound in January 2019 has only taken some of the pain away from the slaughter that occurred in November and December, when dozens of loan conduits were caught off base holding loans for collateralized loan obligations (CLOs). The same weakening macro market dynamic that is causing home prices to slum is prompting investors to flee this asset class. The astute folks at TCW describe the carnage: “As risk sold off globally, retail funds recorded record outflows. At the same time, CLO liabilities widened. As CLOs ceased to be manufactured due to liability costs, demand for loans became negative as retail funds were forced to sell positions to raise cash and meet redemptions. There is a unique component of this weakness: Investment bank trading desks have much smaller balance sheets than they had prior to 2009. Therefore, as CLOs stopped buying and retail funds began selling – there were few investors left to take the other side of the trade.” The CLO market, for the record, saw its largest ever issuance in 2018. As in Q1 2016, when China concerns killed the ABS market for six months, the Street is crossing its collective fingers, hoping that spreads will narrow so that some of these deals will get priced. Don’t hold your breath. Institutional new issuance of CLOs declined in December to $3.9 billion, which was the lowest institutional issuance in 2018. The liquidity that has exited the sector since Thanksgiving is unlikely to return. And again, as with residential credit exposures, the key question in the minds of CLO investors is this: When will default rates start to rise significantly? Nobody has the precise answer to that question, but a reasonable assumption is that the volatility of the change in default rates will be markedly higher than in previous credit cycles thanks to QE and "operation twist." Stay tuned. #BenBernanke #Cramer #wealtheffect #housing

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

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

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

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

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

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

March 3, 2018 | Count the numbers of markets and economic indicators currently at extreme valuations and positive correlations. Financial markets showed a glimmer of normality last week when stock prices fell and bonds rose. The surprise expressed by market participants is an illustration of just how long investors have been dealing with a market where all manner of assets are correlated and at multi-year highs. We talked about this last week with our friends at BNN in Toronto in a TV hit from Bloomberg TV in New York. To our readers: We are ending our weekly email notifications via our third-party listserve. If you’d like a reminder from Wix when new items are posted, please register again at www.theinstitutionalriskanalyst.com and you can manage your subscription directly. As before, new items will be posted on Twitter, Google and other social media. Apologies for any inconvenience. – The IRA Markets were abuzz last week over the prospect of a trade war, but we see President Donald Trump’s latest outburst over tariffs as the opening salvo in the 2020 election cycle. Yet a number of observers are openly wondering if the latest upward move in interest rates is essentially finished and if the next leg for the 10-year Treasury is a bull rally back down to the low 2% range in yield. As the chart below illustrates, the 10-year popped to 2.8% yield following the November 2016 election, then re-traced back down just shy of 2% yield on September 8th of last year. Despite the latest upward move in rates, we remain in the bond bull, flattening yield curve camp for the simple reason that there is still far too much liquidity – call them dead presidents -- chasing scarce assets. Even with credit problems emerging around the world following eight years of irrational easing by the Federal Reserve and other central banks, the markets and particularly credit spreads remain remarkably calm – almost too tranquil. It’s as though that last big dose of monetary thorazine from former Fed Chair Janet Yellen still has not quite worn off. Should long-term interest rates continue to rise, however, we think it is fair to ask whether the period of low credit costs and artificially boosted economic activity in the US also is ending. It is clear that the proverbial party is over in autos, with rising credit standards and falling sales incentives more than tapping the brakes on industry volumes. The particularly nasty chart below shows monthly light vehicle sales in the US through January 2018. Default rates on prime auto loans held by banks have essentially doubled since 2015 and now stand at 1%, which is really not a big deal compared with unsecured loans. But the rate of change is notable. The Wall Street Journal reported last week that residual values for cars coming off lease are falling, one reason why dealers and the automakers have pulled back on costly sales incentives. By no coincidence, loss given default (LGD) for auto loans, which is calculated as charge-offs less recoveries divided by charge-offs, has risen 10 points over the past three years to just under 70% of the original loan amount. LGDs are essentially the inverse of asset prices in a given loan category, thus rising LGDs for auto loans is another way of saying that prices for used cars are weakening. Our pals at the Federal Deposit Insurance Corp reported last week that provisions for future credit losses for all loans and leases have increased nine quarters in a row, albeit from very low levels seen in the trough of 2015. But the key question facing investors is whether the end of the period of extraordinary ease by global central banks will now see a decline in economic activity and an increase in credit costs for US banks and bond investors. The secular increase in asset prices for stocks, bonds and particularly real estate is exhibit number one in this analysis. As we’ve noted in past issues of The Institutional Risk Analyst, the credit metrics coming from US banks in asset classes such as 1-4 family home loans and multi-family real estate are anything but normal and suggest an adjustment down the road. Will home sales and even prices follow the bearish example of autos? It is interesting to see, for example, that past-due 1-4s owned by banks actually rose to 2.7% in Q4 ’17 after falling steadily for the past five years. More thought-provoking, however, is that fact that record low LGDs for bank owned 1-4s have stabilized at just 24% of the original loan balance vs the 25-year average of 65%, as shown below. Is the next leg up? Source: FDIC Like the chart for auto sales above, the LGDs of 1-4 family loans exhibit a large degree of skew from historical norms, something you’d expect to see after years of experimentation by Chair Yellen and her colleagues on the Federal Open Market Committee. The researchers at the San Francisco Fed (hat tip to Rosie) put it very nicely in a January 8th comment: “Current valuation ratios for U.S. equities and household net worth are high relative to historical benchmarks. The cyclically adjusted price-to-earnings ratio reached its third highest level on record recently, and the ratio of household net worth to disposable income, which includes a broad set of household assets, stands at a record high. Such extreme values of these ratios have historically been followed by reversions toward their long-run averages. However, other current factors, such as low interest rates, caution against bearish forecasts.” So if Yellen and company have front loaded a decade of growth into the past five years, what does that say about prices for stocks, bonds and particularly real estate? While the price increases illustrated in the world of 1-4 family loans suggest a considerable deviation from long-term averages, the degree of skew in the world of multifamily real estate is even more pronounced and suggests a proportionately great degree of asset price distortion. The chart below show LGDs for the $400 billion in bank owned loans backed by multifamily residential properties. Like 1-4s, the default rates on this asset class are extremely low – in large part because distressed debtors are often taken out of these exposures short of a formal default. Last quarter, LGDs for bank multifamily exposures fell to minus 109%, meaning in cash terms that recoveries exceeded charge-offs 2:1. Source: FDIC This chart describing relative change in collateral valuations in the multifamily sector suggests that these assets are overvalued and must, eventually, revert to the LT mean. Also, if the weakness in autos suggests a more general slowing of economic activity, particularly among consumers, how much should banks and bond investors expect loss rates – and LGDs – to rise in coming months and years in related asset classes? The good news is that both 1-4s and multifamily assets are quite solid historically, with the 2007-2010 period of extreme losses standing out. Losses on bank owned 1-4s peaked at the end of 2009 at a whole 2.47% for $2.5 trillion in loans. Multifamily loans held by banks saw net charge-offs peak at just 1.77% at the end of 2009. The chart below shows loss and past due rates for both 1-4 family and multifamily loans. Source: FDIC Compared with unsecured consumer loans, the real estate exposures of US banks have performed quite well over the past 25 years. For example, the charge off rate on the $850 billion in credit card receivables held by all US banks at year end was 3.77%. Of course, credit cards are a much more profitable product for banks than making loans on real estate. But the unusual behavior of the credit loss experience of these asset classes today suggest that prices are very toppy indeed. Both the low loss rates and LGDs displayed by real estate portfolios illustrate the high value of the collateral behind these bank credit exposures. The key question for investors and risk mavens is when or even if these valuations actually adjust downward. When you price credit at zero and compress spreads via brute force methods like quantitative easing, it is easy to conceal a lot of sins in credit terms. For example, the dearth of assets engineered by the Fed has also led to a deterioration in credit covenants and other investor protections. Yet even today, few economists inside the Fed system have publicly stated that QE was overdone, that is distorted markets, and has perhaps created the circumstances for the next financial crunch. Fed Chairman Jerome Powell brushed aside a new paper by two Wall Street economists and two academics questioning the effectiveness of QE, but the next couple of years may reveal some significant real world costs of this ultimately speculative policy. The bad news is that the enormous skew in asset prices engineered by the FOMC may hold significant credit risk in the future. The twin shocks of rising interest rates and widening credit spreads could significantly increase loss rates across the board in US and global banks. Looking at the body language of US regulators, it is hard to avoid the conclusion that the supervisory community is bracing for a repricing of risk.

"Al", retired Wells Fargo stagecoach pony New York | Wall Street more than bounced last week as the secular shortage of stocks quickly snapped investors out of their collective funk. But one once stellar performer in the large cap financials, Wells Fargo & Co (NYSE:WFC), hung back from the surging crowd. In years gone by, Wells was the quiet exemplar of operating efficiency among large banks, but no more. Today WFC is the bank that everyone loves to hate. But while WFC may be the object of scorn, its operations continue pretty much as before. As we told SquawkBox a week ago, having WFC trading at a discount to JPMorgan (NYSE:JPM) is not a normal state of affairs. The former has better nominal as well as risk adjusted returns than JPM on most days, but of late WFC senior management has been slicing off figurative fingers and toes in a stunning display of reputational self-destruction. With WFC up just single digits for the year following the perfunctory sanctions from Chair Janet Yellen and the Federal Reserve Board, and its large bank peers up 3x this amount, the question many investors ask naturally is whether Warren Buffett’s favorite bank is good value compared with JPM and other peers. The short answer is “Yes” – but only if you believe that WFC, sans problemas, ought to be trading at 2x book value. With JPM at 1.7x book, WFC in normal times should be trading at a 20-25% premium to the House of Morgan. But these are hardly normal times. It seems more than ironic that at a time when financials are trading at all time highs, one of the more dependable large banks has managed to put itself into the penalty box with progressive politicians and federal regulators. Ron Lieber of The New York Times last week listed the long bill of particulars against WFC: “Any one of the sins that Wells Fargo committed against consumers would have been bad enough. There was the unnecessary auto insurance it forced auto loan borrowers to buy. And the data breach where scores of the bank’s wealthiest clients woke up to the news that a lawyer for the company had handed over their personal information to an adversary. Plus accusations of unauthorized changes to people’s mortgages. And those fake accounts — numbering in seven figures — that employees created in customers’ names.” Lieber then goes on to bemoan the fact that he cannot pull all of his business from WFC, including the operationally challenged world of loan servicing. WFC has $1.7 trillion in loans it manages as a loan servicer. In the consumer centric world of financial journalism, it may seem entirely appropriate for borrowers to have the option – nay, the right – to decide who services their mortgage. But in fact it is the investor in the mortgage note, frequently Uncle Sam, who ultimately makes that decision. For the past two decades, WFC has built a huge business originating and servicing residential and commercial mortgages. By default, when investors purchase a mortgage backed security (MBS) issued by a large universal bank such as Wells, they also select the loan servicer. WFC originates or buys the billions of dollars per year in residential mortgage loans, packages them into securities, and then issues MBS while retaining the right to service the loans, what is known as mortgage servicing rights or “MSRs.” Servicing rights such as MSRs are naturally occuring negative duration assets, the opposite in technical terms to a loan portfolio or a Treasury bond. This invaluable quality makes MSRs perform well in a rising interest rate environment as we see today. But most Sell Side analysts neither know nor care about such details when it comes to following mortgage focused banks and non-banks such as WFC. And only a few members of the mainstream financial press such as John Dizard at the FT dare to write about MSRs. The total carrying value of WFC’s residential and commercial MSRs was $14.7 billion at September 30, 2017, and $14.4 billion at December 31, 2016, or a bit less than one percent of the $1.7 trillion in total outstanding principal balance of mortgage paper that Wells services. The nation’s largest loan servicing portfolio (WFC owns about one third of all bank owned MSRs) generates significant income for the bank, but is also perhaps the most problematic business for WFC due to the consumer facing risks that arise in the mortgage world every single day. You can argue that the large financials are overvalued, as we did on CNBC's Halftime Report the other day, but don’t fight the Fed, ECB and Bank of Japan all at once. The path to “normal” as defined in the Gospel according to St Janet will take years longer than the Federal Open Market Committee admits publicly. Note, for example, that the estimated timing of prepayments on the Fed’s portfolio of RMBS is clustered in the mid-2020s, at least for now. Like Sell Side bank earnings estimates, the FOMC numbers on monthly portfolio runoff rates will change over the course of 2018. The beauty of MSRs is sadly called “extension risk.” Rates rise, bond prices fall, prepayments decrease, duration and IRR increase, and the fair value of your MSR magically grows. Kidder Peabody (1986)? Long Term Capital Management (1998)? Citigroup (2008)? All of these firms died due to extension risk on various types of pass through securities, one reason why the SEC effectively banned non-banks from issuing their own MBS in 1998. By amending Rule 2a-7, the SEC not only may have killed LTCM, but it made it impossible for nonbanks to issue their own paper. The SEC under Chairman Arthur Levitt handed the largest banks a monopoly in making and servicing home mortgages. It is hard to ignore the superior performance of WFC vs other large banks, even if you assume no balance sheet growth due to the Fed sanctions and the risk of its many consumer facing businesses. WFC has equity returns that are two points better than its assets peers and with similar risk adjusted returns on capital (RAROC). The only name in the top five banks with even close to WFCs’ equity returns is USB, which deliberately manages its size at below half a trillion in total assets. Source: TBS Bank Monitor Q3 2017 Could smaller mean higher ROEs at WFC?? An intriguing possibility. The travails of WFC are a blissful situation, however, compared to the life and death situation that confronts many non-bank mortgage firms as the first quarter of 2018 heads to a close. Indeed, market pressures are seemingly driving a renewed focus on M&A. Nationstar Mortgage (NYSE: NSM) last Tuesday announced a nearly $4 billion merger with WMIH Corp. (NASDAQ: WMIH), the successor company to mortgage originator Washington Mutual. After 2008, WFC and other large banks sold problematic mortgages to non-banks such as NSM. Firms such as Countrywide and Washington Mutual, though technically commercial banks, operated as non-banks in the secondary market for home loans and funded themselves mostly with short-term money. Let’s walk down memory lane. In September 2008, readers of The IRA will doubtless recall, JPMorgan Chase acquired the banking operations of Washington Mutual Bank in a transaction facilitated by the Federal Deposit Insurance Corporation. JPMorgan Chase acquired the assets, assumed the qualified financial contracts and made a payment of $1.9 billion to the FDIC. Claims by equity, subordinated and senior debt holders of WMIH were not acquired and ended up in bankruptcy in Delaware. "For all depositors and other customers of Washington Mutual Bank, this is simply a combination of two banks," FDIC Chairman Sheila C. Bair said that fateful day. "WaMu's balance sheet and the payment paid by JPMorgan Chase allowed a transaction in which neither the uninsured depositors nor the insurance fund absorbed any losses," Bair added significantly. Of course, when the FDIC seized the bank and sold it to JPM, it left the controlling financial investor, Texas Pacific Group, high and dry. From bankruptcy, the predecessors of WMIH commenced nearly a decade of litigation with the FDIC and other parties over disputed assets of the failed bank. When WMIH won a $2 billion judgment against FDIC, the bank insurance agency then turned around and sued the officers and directors of WaMu for the now $2 billion deficiency in the FDIC fund. God does have a sense of humor. WMIH’s merger with NSM marks a new page in the firm’s corporate history. With a decade of litigation behind it, WMIH now boasts a couple hundred million in capital and $6 billion in usable net operating loss (NOL) carryforwards. WMIH also has a new private equity sponsor, KKR, who is joined by Texas Teacher Retirement Fund and Greywolf Capital. The NSM transaction also may mark the start of a consolidation in the world of mortgage finance and servicing, where over-capacity is hurting profitability as loan volumes and servicing assets steadily fall. But don’t look for any large banks to be buyers of large non-bank mortgage firms. WFC is one of the few large banks that remain in the market for government-guaranteed FHA loans and Ginnie Mae securities. As non-bank seller servicers exit the GNMA market, banks such as WFC and Flagstar (NYSE:FBC) will be under pressure from regulators to pick up the slack or even acquire insolvent non-banks, but likely that door is closed for the largest banks. Thanks to Dodd-Frank and the CFPB, federal bank regulators consider consumer facing businesses toxic for the large banks. They have effectively told WFC et al to avoid reputation risk at all costs. Even if WFC is not allowed to grow its assets for the next several years, we expect the bank to eventually return to a slight premium to JPM. We see two possibilities. Either a) WFC is going to slowly rise to 2x book value vs JPM’s 1.7x multiple or b) JPM and the other larger banks will slowly adjust downward as the full weight of securities issuance descends upon the major banks in the post-QE world. Just for the record, we are betting on the latter scenario as Wall Street desperately seeks a reasonable explanation for current market valuations. Just remember that reaching “normal” and adjusting asset prices accordingly will take years thanks to the over-generosity of Chair Yellen and the FOMC. #WellFargo #JanetYellen #FOMC #WFC #JPM #NSM #WMIH #FBC

February 12, 2018 | In this issue of The Institutional Risk Analyst, we turn our attention to the auto sector. Kevin Tynan is the Senior Automotive Analyst at Bloomberg Intelligence and has been covering the industry for decades. We first met Kevin during the research for "Ford Men: From Inspiration to Enterprise" and value his insights on the automakers and the macro trends that impact this particularly American industry sector. We spoke to Kevin last week at his office in Princeton. The IRA: Ford just reported lackluster earnings, making more money per unit on lower sales. How do you assess the situation facing the US automakers? Is this a case of the industry shrinking or is there a more nuanced explanation for the competitive situation is facing the US automakers? Tynan: Those issues are really Ford specific. They are caught between this smallish product portfolio that is very dependent upon one nameplate, namely the F-series pickup truck, and the lack of other products. Lincoln only did sales of about 100,000 units last year. The market in the US is just about to touch 70 percent trucks overall and Ford is about 76%. But Fiat-Chrysler was 90 percent trucks in January or nine out of ten units sold were some form of truck. GM was about 80% trucks and SUVs in January, but they have a much broader portfolio. They have GMC which is only trucks and Silverado under the Chevrolet brand and all the trucks in Buick and even Escalade in Cadillac. The IRA: Wow. It gives us a feeling of déjà vu when you describe the industry. Nothing has really changed, has it? For much of the 20th Century Ford was only ever compared to Chevrolet because it was so much smaller that the colossus of General Motors built by Alfred Sloan. Ford never had a move-up offering for its customers from the basic Ford models and now is dependent upon a premium truck line. Tynan: Just looking at the statistics it may seem so, but under the surface it is really different. If you go back to pre-bankruptcy days for GM and Chrysler, one thing that is different is the definition of a truck. When gas was $4.50 per gallon you really saw the consumer shop on the car side of the dealership. You don’t see that today. 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. The IRA: What we call trucks in the data are really passenger cars, is that the point? Tynan: Yes. Fuel efficiency has improved so dramatically compared with 2008 that the price of gasoline is no longer an issue for consumers. Even if there was a spike in gasoline prices, consumers would be buying smaller trucks not go back to the car side. The IRA: So is it really fair to say that the industry is 80% trucks or has the definition of a truck now become blended with a passenger car into the now ubiquitous crossover? Tynan: It is just a different type of truck. Look at the Ford Explorer, which was really the first mass produced SUV and was built on a truck chassis. Now the Explorer is built on the same platform as the Taurus. Nissan Pathfinder shares a platform with the Altima. There are a lot of crossovers out there that look like trucks but are built on passenger car platforms. They have the driving dynamics and efficiency of cars. There are a couple of automakers who are really too car heavy and they are scrambling to move to trucks. VW, BMW and Tesla are all upside down in terms of the focus on cars. 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. The IRA: Don’t get us started on Tesla. It’s a toy. Tesla is a beautiful model slot car built by a guy who thinks he’s Tony Stark. Elon Musk is clearly a genius, but he should stick to building rockets. He just spent a couple of billion dollars to put a Tesla into orbit on the Falcon Heavy rocket. Maybe Tesla could build a flying car to cut the commute to JFK? Tynan: Well, Tesla could at least build a car that consumers want. The IRA: We spent a couple of weeks in Uruguay over the holiday and there were a number of brand new Maserati SUVs in Punta del Este. With the taxes that is a very expensive car, but the ladies love them. My spouse has a passion for the Porsche Cayenne – not a 911. She wants the SUV, but then again, she also thinks the new F-250 Super Duty is pretty cool. Tynan: What you are seeing with the premium brands – Jaguar, Lamborghini, Porsche and BMW – are lower, wider SUV crossovers. I was joking with somebody the other day that we may eventually see the return of wagons for people who don’t want that high, floating feeling and want to sit low but want the utility of a truck. The wave of the future may be a return to wagons in the guise of a crossover. The IRA: I drove a Lexus LX 300 for many years. That was the first round, stylish SUV that really appealed to women. It was dependable and great on gas. But most men seem to prefer sedans. Look at the Audi A-3 mini wagon, which unfortunately became a sedan. Tynan: Have a look at the Volvo V-90, absolutely gorgeous wagon. It is beautifully designed and they just came out with the Cross Country version which is a legitimate wagon you can take off road. All wheel drive, all you need. The IRA: Let’s talk about mobility. Has the panic over mobility subsided or are all of the automakers still chasing this threat/opportunity? Tynan: There is a lot of capital being wasted on mobility. It feels strange. Automakers are trying to reinvent themselves by getting into things they have never done before. The automakers are chasing relevance. There is a lot of money being spent with no ROI attached to it, but what is interesting is that this is what is driving valuations in the market right now. The IRA: Yes, it's called the Amazon model. Go out and spend as much as possible and grab market share and pretend that you are Jeff Bezos. Or look at Uber, a car service with Internet enablement that has no comparative advantage long term. Uber is burning capital to subsidize a car service for urban millennials who may never own a car. There seems to be a massive misallocation of capital in the mobility space on an almost Chinese scale. Is this too harsh? Tynan: The fascinating thing about Uber is the idea of level five self-driving. If you take the cost of the driver out of the equation, let’s say its mid-five figures, that becomes interesting. You can amortize the cost over five years for a car that runs 24x7. Can we ever get to level five? Will the government ever support the investment required? I don’t know. Robo taxis everywhere. If the current model does not make money, then you take out the most expensive part of the model which is the driver, then maybe you have a shot at profitability. The IRA: Well, we see it in the movies so it must be true. The 1973 Woody Allen film “Sleeper” is the first self-driving car we can recall. That is going to take some time. New highways with the guidance systems embedded in the pavement. But more to the point, who is going to insure the operation of these passenger vehicles? Tynan: Correct. We are legitimately at level two now and some manufacturers with large corporate parents will maybe get to level three in a few years, but nobody ever talks about the cost. It is challenging today to put $1,800 options in passenger vehicles. The cost of a driverless car is going to be enormous compared with the price of today’s vehicles. Frankly, the auto industry is not going to get to level five for consumers anytime soon. The IRA: To that point, doesn’t it make more sense for the first autonomous vehicles to be trucks or busses? Issues like safety and liability almost force the first roll-out of driverless vehicles to come in use cases other than passenger cars. Tynan: Think about congestion. There are valid applications for cars to operate autonomously and, say, drop you off at work and then carry other passengers while you are at work. But I am not sure that this really addresses congestion in urban areas. The IRA: More to the point, think about the current trends in housing. Less affluent populations are being forced out of the center cities into the suburbs. These people are going to need transportation to get to work, to school, to shop, etc. The demographics are compelling. Tynan: I’d be happy if we could fix the potholes. I have an eight mile commute on Route 206 towards Princeton in the morning and the roads are a mess. We don’t invest enough in infrastructure. The idea that we are going to wire the entire country or wireless the entire country so that autonomous vehicles can drive at 80 mph eight inches from each other seems a bit of a stretch. The IRA: Sounds like the sales pitch for Blockchain. So talk about the auto sector going forward. The auto sector went from death and destruction in 2010 to an amazing rebound through 2016. What should we expect over the next decade in terms of auto sales? Tynan: We hear a lot of analysts talking about “peak auto.” In 2016 we saw a record at 17.5 million units and then sales fell a bit in 2017. In fact, 2014 was “peak car” but on the truck side of the business demand is still increasing. Hard as it may be to believe, approaching 70% trucks for the industry as a whole is still not yet a peak. Those two categories – compact car and midsize car – really dwindled as crossovers and compact crossovers specifically surged. Compact crossover is the largest segment in the industry now. But as sales volumes for smaller car segments fell, trucks and SUVs simply could not grow fast enough to meet demand. Investors look at US auto sales and say “they’ve peaked, they’re plateauing.” But in fact car sales have fallen so fast that truck sales are struggling to keep up – but making a valiant effort at it. The IRA: So what should investors be focused on with the automakers? Tynan: The profits from truck sales are so much better than cars - automakers are actively deemphasizing their car offerings or at least the smart manufacturers are doing so. The IRA: Tastes have clearly changed. Going back to the Model T Ford, the car was essentially a wagon with a gasoline engine. Then we evolved large, enclosed passenger cars and trucks were really meant for commercial use. It took years for engineers at Ford to convince Henry Ford to make a Model T truck. And even then, you had to buy most of the parts for your Model T from the Sears catalog. But now consumers seem to embrace the crossover as the ideal design. Based on your comments, it sounds like the crossover is the design archetype for the future. Tynan: The higher ride height is clearly in favor, especially as more and more people buy SUVs. The fact that you can seat six people is also a big attraction. The utility of a truck and the ride dynamics and gas mileage of a car is a very compelling combination. There is no way back to the pre-2008 days, even if gas prices spike. On the luxury side of the business, big sedans are no longer the sweet spot for consumers. The IRA: What percentage of F-150 owners are women? Do you have any idea? Tynan: I’m not sure about that, but the percentage of people who drive a truck and never use it for work is soaring. The new pickups are very nicely appointed and can compete in terms of features and comfort with any passenger car. The mid-size trucks are nice too, Ford is getting back into smaller trucks with the new Ranger. The IRA: What in the world happened with Ford? How did they ever decide that people did not want a small truck? They left the entire mid-size segment in the US to the Japanese. Bill Ford is all twisted in a knot over mobility, but then Ford abandoned an important product segment in a category they should dominate. Tynan: They were printing money with the F-150. I’ve spoke to Ford a number of times about this decision. They’re feeling was that the smaller truck would have to be 25 percent more fuel efficient and be 25 percent cheaper to not cannibalize F-150 sales. When GM got back into the segment with Canyon and Colorado, they took market share but not from Toyota Tacoma or other manufacturers. The whole segment just grew. That small truck segment that was 300,000 units a few years ago was almost half a million units last year, but growth has also slowed. Ford and Fiat-Chrysler with the Jeep pickup missed the opportunity. I think that horse has left the barn. Today the Toyota Tacoma is half the segment, while GM is about a third. And the thing is that Ford sells Ranger all over the world. They just weren’t bringing it here. The IRA: As you said Kevin, trucks have not peaked. The Toyota Tacoma is a beautiful vehicle. Tynan: While the US automakers dominate the large truck segment, until GM got back into smaller trucks Toyota owned that segment almost entirely. So it's not about brand loyalty as much as it is about producing a product that consumer want to buy. Some people want to have a pickup that can fit into their garage. They don’t need a full size pickup. So there is roughly half a million buyers for that size vehicle. The IRA: So last question, let’s bring it back to Ford. What is your assessment of Bill Ford and the situation with “his” company in the wake of Alan Mulally and the departure of Mark Fields last year? Bill Ford periodically feels the need to demonstrate his “leadership” with new ideas, but had to retreat entirely a decade ago and was rescued by Mulally. Tynan: The message from Ford has been tough to decipher. Analysts are wondering if Ford is really about cars and trucks or is it about mobility and smart cities? They have been talking about things that have nothing to do with the basic business of making cars and trucks. The message coming from Ford is not as clear as say GM, which is all about making vehicles even while working on new technologies. Mark Fields had been with the company for 25 years, but then was let go after three years as CEO. It seemed a little bit strange to have Fields in the organization for that long and to be that wrong about his leadership ability. The IRA: Tales of Henry the Deuce. Thanks Kevin. 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