"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. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.