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April 6, 2017 | JPMorgan (JPM) boss Jamie Dimon says there’s something wrong with the US economy and he is obviously right. Here’s our short list: * too much public and private debt * too little income and growth * monopolies in banking and other industries * oppressive regulation for all businesses * political muddle and lack of national purpose * confused, irrational monetary policy A couple of weeks before Mr. Dimon was waxing effusive on the state of the American political economy, New York Fed President Bill Dudley told an audience that excessive student debt was holding back the US economy “despite efforts of the Federal Reserve to stimulate economic activity.” Really? We thought that the Fed was engaged in an effort to manipulate asset prices in a desperate attempt to increase consumption. Since economic expansion is a function of population growth and increases in productivity, both of which are basically the flat, the Fed has never had any real bullets when it comes to encouraging growth save orchestrating debt driven asset bubbles. More, unlike the 1970s and 1980s, today simply lowering interest rates has no apparent impact on consumer spending. The past eight years of near-zero interest rates and massive bond purchases by the FOMC has merely put the key issue of debt temporarily on hold while asset bubbles have bloomed around the economy. Which brings us to the ongoing implosion in demand for automobiles. US automakers including Ford (NYSE:F) and General Motors (NYSE:GM) have seen demand for once-popular sedans basically collapse. More, as we noted in a previous post on David Einhorn’s sudden interest in GM, the residual value of used cars is also falling. Key concept: the upward surge in new car purchases was driven by irrational exuberance (aka credit expansion), which in turn was driven by the FOMC’s policies. But apparently the party in less-than prime auto ABS is over. Mark Wakefield of Alix Partners told Bloomberg News he sees volumes falling by at least 300,000 units from the 18 million peak in 2016, but we’d be surprised if the industry can break 17 million units this year given current trends in the industry and, more important, in credit markets. Part of the problem for automakers is that the surge in new credit that enabled consumers to buy cars in part came from captive leasing units and independent auto lessors that are facing growing losses on existing loans and leases. Nearly one in five cars was leased last year and residual valuations are plummeting, especially for passenger cars. The new arrivals in the below prime auto lessor community are going to take a big hit. The next step will be for these smaller leasing firms and banks focused on providing credit to below prime customers to withdraw credit from the system, which will in turn cause auto sales to fall further. Originating and selling prime auto paper has been a break even prospect at best, thus all of the focus of Wall Street was on below-prime originations over the past year or more. Tales of mortgage market in the mid-2000s? Yes. Repeat after we: “Gain on Sale.” Names like AutoNation (NYSE:AN) and CarMax (NASDAQ:KMX) may be able to survive the credit losses likely this year and next, but smaller players in the leasing channel will pull back quickly on risk exposures, reducing the ability of the automakers to move inventory. Needless to say, even as Yellen & Co try to belatedly raise interest rates, the credit cycle has already turned sour. If anything, the Fed should be pondering when to ease. But hold that thought... Bank Earnings Meanwhile in the world of banks, the prospect of Q1 ’17 earnings is hardly causing great joy among Sell Side analysts, especially for the big universal banks with significant securities operations. In Q1 '17 the bond market has again set new records for investment grade (IG) bond issuance, but the economics of debt deals is significantly thinner than for equity offerings. Initial public offerings have dwindled under the social engineering of Janet Yellen and the FOMC. Simply stated, why issue public shares when you can tap private equity or float a bond deal at what are still historically low rates? For those who think that rising short-term interest rates will somehow boost earnings, it is interesting to note that the majority of US banks saw net-interest margins decline in 2016 – this as the yield on the 10-year Treasury was rising following the election of Donald Trump. Only trouble, as we wrote for Kroll Bond Rating Agency at the time, is that IG and even high yield bonds were rallying as the T-bond sold off. Hmmm. Below is our famous chart showing the cash components of NIM for all US banks through year-end 2016, using data from the FDIC. Notice how low that the Fed pushed the cost of funds for US banks in order to keep the zombie girls dancing -- just $11.5 billion in the middle of 2015. The same figure was almost $15 billion as of Q4 ’16. Note that income rose more, but only because of the bank lending spree in 2016 which is now ended. Swelling balance sheets enabled the big zombie banks to pretend that they are making more money on good old fashioned leverage, but if you look at the impact on the return on earning assets, the picture is different. The chart below shows net interest income divided by earning assets, which clearly shows that the past eight years of extraordinary Fed policy have been bad for bank asset returns and income. On a risk-adjusted basis, the large bank sector looks about as cyclical as the large US automakers. And since mid-March, spreads on high-yield debt have been widening as investor confidence in the Trump Bump has started to wane. Credit losses for US banks are starting to rise, albeit from a very low base. As the chart below suggests, loss rates on the $9 plus trillion in US bank loans bottomed in 2015 and are slowly starting to increase as the great asset bubble created by Janet Yellen and the FOMC begins to deflate. Ask yourself a question: Are the C&I and commercial real estate credits on the books of the largest US banks and, in particular, in asset backed securities (ABS), significantly better quality than the growth of auto exposures to consumers over the past half decade? The answer is clearly “no” as evidenced by the fact that the major rating agencies are all starting to walk back their ratings on post-crisis commercial real estate exposures . As we wander into Q1 '17 earnings next week, we can’t help but notice that those generous souls at KBW decided to upgrade Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) on the theory that lighter regulation and rising interest rates will boost earnings. Really?? Read our comment on Citi from last week if you have not already done so. The gross spread on C&I and CRE loans at Citi is so low that cash flows from both of these enormous portfolio components could be wiped out by charge offs in a stressed scenario. We differ on both points used by KBW to justify the upgrades of Citi and WFC. First, any reduction in capital requirements is a medium term exercise, in other words, no impact in 2017. Capital is THE solution of choice for the political class when it comes to avoiding the dreaded specter of “systemic risk,” even among conservative Republicans. Don’t hold your breath for significant changes in capital requirements. Second, a flat yield curve sinks all boats. Without a serious change in mind on the part of the FOMC, rising short-term rates and falling 10s to 30s sure does not look like a winner to us. Indeed, if the FOMC goes forward with three more short-term rate hikes in 2017 without starting to sell MBS from the $4 trillion portfolio, look for NIM for the whole banking industry to take a swan dive. In the latest FOMC minutes we see this important tidbit: “participants agreed that reductions in the Federal Reserve’s securities holdings should be gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings.” This passage from the FOMC minutes illustrates that the members of the Fed’s policy making body clearly do not understand what is happening in the bond market. Agency issuance is down dramatically compared with 2016, like minus 15-20% YOY ($300-400 billion) over the course of 2017. If the FOMC really wants to see long-term yields rise in concert with short-term benchmark rates, then selling at least $50-100 billion per month in MBS from the Fed’s portfolio is entirely necessary. If the FOMC keeps to its current plan, however, the curve will flatten, bank earnings will suffer and the US economy will start to contract. Details aside, it will be called the Yellen recession for a reason. 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. 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Over the past decade we have periodically talked to our brother Michael Whalen (MW), Emmy award winning composer, film editor, and now agent to a growing list of performers, about the rapidly changing state of the world of content. With theater admissions and revenues flat, the final break in the Old World of Hollywood came several weeks ago with the major studios announcing a new model for releasing content online almost immediately after the theatrical release. Will we even be watching the Academy Awards in 20 years? The IRA: So Michael, the change in the relationship between the movie studios and theaters that you have long predicted has come to pass. The studios have announced that they will be releasing films to online distribution only weeks after the release to the theaters. Talk a little about the economics of making movies today and how the investors/creators are able to cover costs much less make money. MW: The situation facing the movie industry is a classic case of supply and demand. It is so much easier to produce a movie now than 20 years ago. Technology has knocked-down a lot barriers and walls. Also, another factor is state issued tax credits. Localities are tripping over themselves to have even low-end filmmakers use their states. It might sound like a joke but there are people making quality videos and shorts with their iPhones. The IRA: Hey, we’ve been experimenting with new platforms like Collide. Our friend Stacy Herbert shot a TV segment in Central Park with me and Max for The Kaiser Report last year on an iPhone. Looked great. But it sounds like the traditional distribution channels for films are the victims of innovation. MW: Precisely. Trapped inside this rapidly changing economic environment are theatre owners. They charge $12 - $25 a ticket to watch films that I can rent at home for $4. We live in a time where people under the age of 30 have no real need to go to the theatre to see anything. They watch YouTube on their phones. The theatre chains have done little to make the basic experience of going to the theatre compelling for a young audience. It’s a value conversation: you’ll probably get dinner (for 2), gas for the car, tickets and theatre food. It’s $100+ evening. This better be the best movie ever. Seriously, many people today don’t have the disposal income to go to theaters, much less sports events or other types of live entertainment. The IRA: OK, but how about the films themselves? Brent Lang put out a great piece in Variety recently talking about the whole movie business being in trouble. Do you agree? MW: Yes, the finances around film have never been for the faint of heart. These days, beyond the theaters to the world of content the upside is so much less than it used to be even a few years ago. There are hundreds of new platforms and outlets around the world for quality content - however, no one wants to pay for it. Well, to be fair - - they don’t have the upfront dollars to pay for it. Therefore, most licensing deals are some kind of revenue sharing scheme. The IRA: So you need to find investors for a film and the studios bare no risk for the project? How many films actually make money? Is this like people supporting Broadway shows out of passionate devotion or charity? Does not sound like a business any more. MW: The truth is that investors in these schemes often cannot cover their investments. These are breakeven scenarios at best. In the old days, you could release a decent film - breakeven in the theaters and then the foreign licensing and home video would give you a nice multiple. Now, if you’re lucky, you hope your revenue share deal with NetFlix gives you a little income. The IRA: So is the theater channel now a significant contributor to revenue or are we talking about online as the biggest contributor? MW: Being nominated for an Oscar can translate to a VERY big payday for the movie, its stars and those associated with making the film. That said, Best Picture winners typically earn an additional $14 to $15 million in box office revenue. Movies like, The King’s Speech, garnered $138 million in domestic box office – over $100 million more than was expected before it won. That is very unusual. Moonlight (this year’s Best Picture Winner) had only made $22 million before the award. The IRA: Wow, so a critically acclaimed film may not ever break double digits at the box office? MW: Nope. To date, Moonlight has made $55 million. It is also the lowest grossing Best Picture winner in history. In Hollywood, talent agents and managers estimate that their clients will get a 20% boost in pay for their next film if they win the award for Best Actor or Actress. According to Reuters, an Academy Award nomination can boost ticket sales by one-third and cause a jump in the home video sales and streaming of movies no longer in theaters. When you add-up downloads, streaming and cable TV revenues, the monetary rewards from receiving a nomination can be substantial. The IRA: Ok, so is this something that is attractive to investors or just a passionate crapshoot? MW: Most of the movies that made money in the last 2 years are HUGE “tentpole” franchise movies. This is important because these films typically have the movie itself as one platform of 4 or 5 marketing platforms for an entire project. For example, Disney released “Rogue One” the Star Wars standalone movie. According to Box Office Mojo, it has brought-in $1 billion in worldwide theatrical ticket sales against a production budget of at least $200 million and a marketing budget of at least that much. So, despite HUGE numbers being brought-in, the net profit is relatively small. But Disney has ancillary merchandise, video games, toys, TV licensing and a host of streaming options for this material that will add to the bottom line of the movie - - probably in the $400 - $500 million dollar range after all the costs are deducted. The IRA: Sounds like the big names and titles are the only sure bet. Correct? MW: Yes. For investors, the best course in dealing with film or video content is to finance as big a slate as possible (to increase the statistical probability of having a movie that makes money). Or, to look at creating stand-alone outlets for content. For example, comedian Louis CK directed and produced a video of his stand-up from his show at the Beacon Theatre in NYC. He posted the video on his website in 2011. In a month, 800,000 people had spent $5 to download the concert. To date, he has made millions from a production that cost him $220,000. He has given bonuses to the people who helped him make it, contributed to charity and he shattered how such videos are distributed by doing it himself. Then, the video won a Primetime Emmy® for best live comedy performance. This is the paradigm: great content. Low cost. A simple distribution method that can be driven by social media. Link here to the video: https://louisck.net/purchase/live-at-the-beacon-theater The IRA: So is Louis CK the new role model for content? MW: The key to investing in film is to lower your risk through diversifying – which is obvious. What is not obvious is to lower your expectation on possible returns as well. Unless you have a sophisticated multi-platform release where multiple income streams can help recoup your “hard dollars,” you will probably fail. The percentage of movies that break even in 2017 is at its lowest level in history. Even with multiple streams of possible income, we know that film finance is risky at best. However, streaming models work when the actual cost of production is low. So, look for intense downward pressure on costs, more and more supply of content and fewer reliable financial outlets for this content in the United States and in other territories as “winners” and “losers” begin to emerge in the video streaming market. Said another way, do your homework and make sure you understand the distribution deals that you are getting involved with BEFORE you sign. Some investors “roll the dice” with such deals without fully understanding the dynamics. Frankly, there’s not enough financial headroom to mess around like that on a typical deal. The IRA: Sounds like investing in blockchain startups….. MW: Finally, the premium that is paid for “known” talent is ending. In its place we see increased emphasis on content that is compelling and well made. Yes, “A” list actors will continue to command fees for the foreseeable future – however, more and more, those fees will be replaced by rev share models that put that actor’s ability to attract to the test every time out. Don’t be afraid to put those types of deals in place and be ready to reward actors and other “top-line” personnel who bring the most allusive currency of them all: attention. The IRA: Thanks Michael. #content #hollywood #michaelwhalen #theaters

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

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

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

This essay is part of a longer paper on the US banking system that is part of my research for a future book. What makes a bank good or bad? In financial terms, a “bad bank” describes an institution that houses problem assets and is being run-off. The bad bank is legally separate from the “good bank,” which is solvent and presumably able to function normally as a going concern. Beyond mere financial factors, however, in the wake of 2008, the idea of bad banks conjures up bleak images of financial contagion and economic dislocation that are universally shared. Even before 2008, banks as institutions did not enjoy particular popularity in American culture. People seem to love their local banker, but hate banks in general – especially enormous banks located in big cities. Small banks and credit unions have fiercely loyal followings, but large banks have proportionately larger groups of detractors. This skeptical view of banks, especially larger institutions, is hardly new. Going back to the founding of the American republic, banks were seen as speculators and parasites, members of the business elite of large cities who preyed upon small farmers and working people. President John Adams, who believed that the US should have a single public bank to serve the nation, in 1813 damned private banking as a giant swindle, a "sacrifice of public and private interest to a few aristocratical friends and favorites." President Andrew Jackson’s veto of the Second Bank of the United States in 1832 was a blow against a privately owned “central bank.” More than defending financial probity, Jackson objected to the elitism and the power of the larger banks of that time. “Nothing galvanized American political conflict more than banking, currency, and finance,” wrote Daniel Feller of the early days of the US. “In the republic's first half-century, no subject, save foreign relations and war, gave greater vexation to American statesmen or aroused more heated public debate.” From 1832 through the creation of the Federal Reserve System in 1913, the US did not have a “central” bank, but it did have thousands of private banking institutions that made loans and issued their own currency. The creation of national banks in 1863 was primarily a means to finance the Civil War, but it also represented another layer of financial leverage for the American economy. National banks were a new source of liquidity in addition to the existing system of state-chartered banks, which largely issued paper money backed by gold or silver. National banks and the new paper money known as “greenbacks,” which were not backed by metal, greatly enlarged the US financial system and financed the Civil War, then helped fuel a remarkable period of economic growth in America. The modern notion of “bad banks” stems partly from the Gilded Age, when large banks and industrial interests amassed monopoly control over whole industries. Businessmen such as J.P. Morgan, John Rockefeller, and Cornelius Vanderbilt consolidated smaller businesses into vast “money trusts” that exercised horizontal and vertical control over much of the US economy and also exerted enormous influence over the American political system. In the muck-raking press of that time, JP Morgan was portrayed as a giant octopus controlling the numerous industries via the tentacles of the money trusts. President Woodrow Wilson said in 1916: “Our system of credit is privately concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled and dominated governments in the civilized world. No longer a government by free opinion, no longer a government by conviction and the vote of the majority, but a government by the opinion and duress of a small group of dominant men." Modern day regulation of financial markets (and everything else) has its roots in the progressive reaction to the political and economic power of the Robber Barons of the Gilded Age. In the late 1800s, elected state court judges and other officials were bought and sold like chattel, causing progressives to complain that seeking social justice through the courts was impossible. The Progressive movement of the late 1800s featured appeals for easy money and free coinage of silver, but there was also strong Calvinist strain that also wanted to use the power of government to stamp out sin. The modern-day reliance upon regulators and economists to guide American economic life stems from the Protestant ideal of seeking earthly perfection by placing limits upon individual freedom. By the time that President Theodore Roosevelt took the oath of office in 1901, the power of the largest banks and corporations had grown to such a degree that it became a national concern for all of the major political parties. Hixon (2005) notes that “by 1914 bankers had virtually complete control of the money-creation process” and JPMorgan was the de facto central bank, an island of liquidity that stood separate from the private clearinghouses of the era. Other banks seeking to transact business with the House of Morgan had to stand in line in the lobby along with the retail customers. Over the next hundred years, the nature of banks and their relationship to the government agencies that charter and enable their activities, changed dramatically. One of the major transformations in public policy during that era was the adoption of the Progressive agenda, specifically a willingness to use government regulation as a means of controlling the power of the great monopolies and the men who controlled them. Glasser and Schleifer (2001) note that “During the Progressive Era at the beginning of the 20th century, the United States replaced litigation with regulation as the principle mechanism of social control of business.” In 1902 President Theodore Roosevelt said of regulating the money trusts: “Good, not harm, normally comes from the upbuilding of such wealth. Probably the greatest harm done by vast wealth is the harm that we of moderate means do ourselves when we let the vices of envy and hatred enter deep into our own natures. But there is other harm; and it is evident that we should try to do away with that. The great corporations which we have grown to speak of rather loosely as trusts are the creatures of the State, and the State not only has the right to control them, but it is in duty bound to control them wherever the need of such control is shown.” Woodrow Wilson defeated Roosevelt in 1912 and delivered on his promise to rein in the money trusts even as he expanded the scope of the federal government. The creation of the Federal Reserve System in 1913, conveniently enough on the eve of the First World War, began the process of turning over control of the US banking markets to government agencies. Wilson enacted tariff reform, passed anti-trust laws and saw the final passage of the 16th Amendment creating a permanent income tax. The evolution of the US from a Constitutional Republic to a corporate state dominated by the federal government and large corporations would accelerate through WWI and the subsequent financial crises and wars of the 20th Century. Through the post-WWI inflation of the early 1920s, the US banking system supported the growing wave of financial speculation in stocks and real estate that would eventually lead to financial busts early in the decade and finally to the Great Crash of 1929. Whereas the US economy healed itself in the Depression of 1920-21, by the 1929 market bust President Herbert Hoover set in motion “an unprecedented program of federal activism to head off the business downturn,” notes author James Grant. The economist John Maynard Keynes led the chorus of approval for government intervention, declaring that we shall finally be “free, at last, to discard” the pursuit of self-interest. Part of the reason that President Herbert Hoover was able to embark upon the vast social engineering experiment known as the “New Deal” was that the behavior of the largest banks was so absurd. Even as real estate prices collapsed in states such as Florida and the markets were roiled by panic selling, the heads of the major banks cautioned calm. Thomas Lamont of JP Morgan, Charles E. Mitchell of The National City Bank and the heads of the other major banks boldly lent millions to support stocks. On the eve of the crash, Mitchell declared that the trouble in the US securities markets was “purely technical” and that “fundamentals remain unipaired.” But Senator Carter Glass of Virginia, who served as Treasury Secretary during WWI, blamed the market problems squarely on Mitchell, head of the one of the largest banks in the country. By October of that year the US financial system collapsed under the weight of bad investments and fraud. Four years later, as President Franklin Delano Roosevelt took office in March of 1933, every bank from Detroit to New York was closed and had been for weeks. This national catastrophe inspired his memorable phrase about “having nothing to fear but fear itself.” Out of the rubble of the Great Depression and then WWII came a banking system that was heavily regulated and organized around a system of government agencies designed to ensure the stability of banks and even markets. The Glass-Steagall banking laws crafted by Senator Glass in the dark days of 1933 to separate banking from commerce were accompanied by broad regulation of the securities and housing markets. In the 1930s, the Federal Deposit Insurance Corp under Leo Crowley and the Reconstruction Finance Corp under Jesse Jones literally restructured the US banking system as well as other sectors of the economy. The dominance of the large banks was replaced by the supremacy of the federal government, which assumed a central role in the money markets that was reinforced by the mobilization for WWII. From VE Day in 1947 through to the end of the 1970s, the US economy was dominated by the partnership between the US government, including various government-sponsored enterprises (GSEs), and the large corporations and large banks which had helped Washington win WWII and later the Cold War. Only in the 1980s did private, non-bank finance separate and apart from the banking system enjoy a brief renaissance in the US, driving the growth of the 1990s and then ending abruptly with the financial crises of that decade. In the late 1990s, regulators reacted to crises in the securities and money market sectors and inadvertently created the present-day large bank/GSE monopoly. The regulatory changes put in place after the collapse of Kidder Peabody (1994) and the failure of Long Term Capital Management four years later curtailed the ability of nonbank companies to finance themselves and thereby handed a monopoly on short-term finance to the largest banks. Non-bank finance was truncated in 1998 when the Securities and Exchange Commission amended Rule 2a-7, which effectively precluded nonbanks from funding themselves outside the banking system via sales of assets to money market funds. Since 1998, the largest banks have enjoyed effective control over short-term funding sources for nonbanks operating in the mortgage and other sectors, while the GSEs dominate the long-term debt markets. This terrible error in public policy led directly to the subprime mortgage market bubble and financial collapse a decade later. Today even supposed “innovations” such as peer-to-peer lending are constrained by the large bank monopoly on short term finance. Smaller banks and nonbank mortgage lenders likewise cannot compete with the large banks and GSEs in the long end of the bond market. The reaction to the 2008 financial crisis only served to confirm the European-style, corporate model of political economy in America, where “big” is considered good when it comes to private enterprises and anything with a government guarantee is even better. No private corporation can compete with a GSE, after all, and today large banks are now fully GSEs. At the apex of the post-WWII credit pyramid and regulatory hierarchy is government debt, followed by securities issued by the various GSEs and then private obligations, in that qualitative ranking. And as in the case of Europe, in America the rights of private investors now are clearly subordinate to the shifting goals of public policy in Washington. 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The term mortgage servicing right or "MSR" generally describes a party's contractual rights with respect to servicing or controlling the servicing of a pool of mortgage loans owned by others, including the entitlement to receive servicing compensation. There are a number of risks involved with investing in MSRs, including accurately estimating the prepayment rates of the underlying mortgages and managing the related swings in valuation due to movements in benchmark securities such as the 10-year Treasury. For example, in October 2007 Countrywide recorded a write-down of nearly $1 billion on its MSR which at the time had a book value of $18 billion on a balance sheet of $200 billion in assets, meaning that virtually the bank’s entire capital position was essentially represented by the mortgage servicing asset. The largest risk facing an investor in MSRs and/or a creditor holding exposure to MSRs as collateral, however, is that the ownership of the asset may be “terminated” by a government agency or investor. This risk is binary for the parties at interest and can be particularly significant in the case of non-bank lenders and loan servicers (“seller/servicers”), because as asset managers for loans owned by third parties, the MSR frequently is the only significant asset on the company’s balance sheet. While the academic literature regarding MSRs is limited, those sources that are available most often focus on the risk to the borrower or home owner in the event of interruption. From a credit and business perspective, however, the prospect of an interruption or involuntary termination of servicing rights raises potentially catastrophic risks to counterparties and investors. This idiosyncratic risk of servicing termination is a function of both quantitative factors such as the financial performance of the seller/servicer and qualitative factors such as management, internal systems and controls, compliance and operations. Indeed, in many cases the human resources function of a seller/servicer is one of the most important internal functions in the entire enterprise. All of the federal housing agencies, including government sponsored entities such as Fannie Mae (FNMA), Freddie Mac (FHLMC), and Ginnie Mae (GNMA), have the unilateral right to transfer the servicing of loans and/or securities they guarantee. The GSEs and GNMA also have approval rights over the transfer of MSRs, again associated with securities that these entities guarantee. All three agencies have established review procedures for transfers of MSRs since the 2008 financial crisis. FNMA, for example, has published a Servicing Transfers Overview that sets forth criteria for the approval of MSR transfers. In addition, investors have consent rights to servicing sales and transfers for non-agency mortgages, but the requirements of private transfers of servicing are onerous. “As a condition to providing the consent,” notes a 2015 report by the Federal Reserve Board and other bank regulatory agencies, “investors have historically required that the buyer of the MSAs assume direct recourse liability for origination and servicing defects, regardless of whether that buyer, as the new servicer, originated the loan or caused the servicing defect.” In general, the reasons for an involuntary termination of servicing rights primarily turn on quantitative factors, in particular the financial soundness of the servicer. Virtually all of the servicing transfers seen in recent years have occurred because of financial difficulties at the seller/servicer, but the reasons for a transfer vary. In the case of GNMA, transfers are usually initiated out of concern that the seller/servicer has liquidity problems and cannot either 1) maintain timely payments to bond holders and/or 2) repurchase defaulted mortgages out of GNMA pools. In the case of FNMA and FHLMC, on the other hand, servicing transfers have been far more rare and are usually motivated by concerns about the ability of the seller/servicer to service the loans and engage in effective loss mitigation of loan defaults. It is important to understand that GNMA guarantees only the pass-through payments to security-holders, not the credit performance of the underlying loans. The loans which underlie a GNMA security are guaranteed by the Federal Housing Administration (FHA), Veterans Administration (VA) or US Department of Agriculture (USDA). But unlike the GSEs, GNMA has no balance sheet with which to fund advances to bond holders in the event that a seller/servicer suffers liquidity problems. More, GNMA cannot purchase troubled loans or MSRs, and thus the agency tends to be very proactive when it determines that a seller/servicer is in financial distress. Another reason for the GSEs or GNMA to initiate a servicing transfer is reputational risk. Negative publicity with respect to a seller/servicer can lead to reputational harm, which can have adverse effects on other lines of business, the availability of funding from counterparties and on a firm's MSR portfolio itself. Potential borrowers may be less likely to originate a loan with a firm that has had servicing issues, and in some instances reputational harm may have led some bank and non-bank institutions to leave or divest of their mortgage servicing activities. For example, in the case of Ocwen Financial (NYSE:OCN), publicity related to its operational problems and related action by the states of New York and California led to “voluntary” servicing transfers of GSE and GNMA MSRs in 2015 to other entities including Nationstar (NYSE:NSM) and JPMorgan Chase (NYSE:JPM). These transfers were actively encouraged by regulators and subject to approval by FNMA and the Federal Housing Finance Agency (FHFA). In a 2015 comment letter from the American Bankers Association to the MSR Task Force of State Bank Supervisors, the trade group noted: “If a non-bank servicer were to fail, significant questions could arise regarding the capacity of the market to financially absorb and operationalize the transfer of an unprecedented number of servicing rights. We are also concerned about the potential gaps in borrower service and borrower confusion that could occur in this situation.” The Risks of Servicing Transfers First and foremost, the involuntary termination of servicing can result in a total loss to the owner of the MSR and also cause losses to any creditors with a security interest in the intangible asset or the underlying loans. In the event of an involuntary termination initiated by one of the federal housing agencies, the MSR asset essentially disappears from the balance sheet of the former servicer, who receives no compensation from the new servicer. This potential for a total, binary loss with respect to the MSR due to a termination and involuntary transfer has negatively colored the view of these assets within the mortgage finance and credit communities. As discussed below, uncertainty as to how such a transfer process would work in the event of default of a servicer has historically made lenders reluctant to lend against MSRs or loan collateral tied to an MSR, especially for GNMA exposures. This situation has improved recently, however, with changes made by GNMA in its acknowledgement agreement. The new agreement provides some comfort to investors and lenders that GNMA “won't interfere with financiers' rights to servicing,” reports National Mortgage News, “so long as Ginnie is given all the information it needs to be sure the bond payments that the agency insures flow through to investors.” The changes to the GNMA acknowledgement agreement made at the end of 2016 have had a tangible and positive impact on how investors and lenders view GNMA MSRs. Whereas a year ago, lenders were reluctant to lend more that 50% against GNMA MSRs or advances for distressed loan servicing, today the loan rates vs GNMA MSRs and loan collateral advance rates have climbed into the 70s vs 90% for FNMA and FHLMC exposures. In the first quarter of 2017, asset-backed securities transactions using GNMA MSRs as collateral have been completed by PennyMac Mortgage Investment Trust (NYSE:PMT) and Freedom Mortgage. Involuntary termination of servicing have been extremely rare and have usually involved smaller banks and nonbank servicers that have experienced financial difficulties or failed. There have been few forced transfers of mortgage servicing by the FNMA, FHLMC or GNMA involving a mortgage servicer that was still in operation. In cases where the loan servicer encounters financial problems, however, the risk of termination rises dramatically. The Federal Reserve Board noted in a report to Congress: “Mortgage servicing is governed by regulations and contracts that can pose significant legal and compliance risks. Various federal and state agencies' rules and regulations address mortgage servicing standards, including consumer protections. In addition, the GSEs and Ginnie Mae require servicers to comply with guidelines to service loans guaranteed by those entities, while separate contractual provisions govern the servicing of loans in private-label MBS. Mistakes or omissions by servicers can lead to lawsuits, fines, and loss of income. Use of subservicers or other contractors can compound this risk. In addition, when a servicer does not comply with the standards established by the GSEs or Ginnie Mae, these entities can confiscate the servicing, forcing the servicer to charge off the value of the MSA.” “Moreover, negative publicity can lead to reputational harm, which can have adverse effects on other lines of business and on a firm's MSA portfolio itself. Potential borrowers may be less likely to originate a loan with a firm that has had servicing issues, and in some instances reputational harm may have led some banking institutions to leave or divest from their mortgage servicing activities.” With all of these caveats enumerated, however, it is important to remember that most mortgage servicing portfolios have enormous stability and considerable intrinsic value, primarily because when managed properly they throw off large amounts of cash and can thus be readily transferred in the event such action is required. Case Study: Taylor Bean Whittaker In 2002, FNMA terminated Taylor Bean Whittaker’s (TBW) status as an approved seller/servicer after discovering significant fraud in the company’s loan origination and sales practices. FNMA, however, did not formally advise Freddie Mac, its regulator, the FHA or other interested entities about TBW's termination or the reasons for the action. Indeed, FNMA instead entered into an non-disclosure agreement with TBW and then took active steps to conceal the reasons for the termination. Following its termination by FNMA, TBW dramatically increased the volume of its business with FHLMC and GNMA. By 2009 when it filed for bankruptcy protection, TBW serviced a mortgage portfolio of approximately 512,000 loans with an aggregated unpaid principal balance (UPB) exceeding $80 billion. The 2009 bankruptcy of TBW resulted in the confiscation by GNMA of an MSR representing $26 billion in unpaid principal balance (UPB) of loans. The reason for the action was that the financial failure of the entity placed GNMA at risk of default on its insured securities. In a September 2014 report, the Inspector General of GNMA noted: “The ultimate failure, of course, is the inability of an issuer to pass through payments to security-holders or to otherwise demonstrate a lack of compliance so significant as to render it unfit to maintain its nominal ownership of the MSRs. Historically, such failures have resulted in Ginnie Mae’s declaration of a default, with the accompanying extinguishment of an issuer’s rights to the MSRs and termination of approval status. In such cases, the MSRs become government property and are serviced on behalf of Ginnie Mae by a third party subservicer.” On August 14, 2009, Colonial Bank, Montgomery, AL, TBW’s insured depository, was closed by the Alabama State Banking Department. The Federal Deposit Insurance Corporation (FDIC) was named Receiver and sold the bank’s branches to BB&T (NYSE:BBT), but the FDIC insurance fund ultimately took a roughly $3 billion loss. Also, Deutsche Bank (NYSE:DB) and BNP Paribas (NYSE:BNP) together lost over $1.5 billion, due to the fraud related to TBW’s bogus commercial paper operations, which were conducted out of a non-bank subsidiary of the group. In 2010, GNMA bought over $4 billion of non-performing TBW loans out of its guaranteed MBS pools and increased its applicable reserve for losses by $720 million to prepare for anticipated losses. The Federal Housing Administration (FHA) and GNMA Mae eventually lost hundreds of millions on defective loans placed in MBS pools that were guaranteed by FHA. FHLMC lost over a billion dollars on defective loans that TBW sold it, after TBW's frauds were uncovered and the firm ceased operations. Voluntary Servicing Transfers The failure of TBW was an extreme event that involved deliberate acts of fraud, acts which ultimately saw the head of the company prosecuted criminally. The losses due to TBW, however, were actually exacerbated because FNMA did not take active steps to see that the bank’s fraudulent operations were promptly shut down by prudential regulators. In the case of the bankruptcies of both TBW and ResCap, however, the loan servicing operations that remained continued to operate in due course post-filing and, indeed, under the protection of the Bankruptcy Court, which rightly saw the MSRs and whole loans as valuable assets of the bankruptcy estate that warranted protection. Even though the housing agencies suffered losses due to the fraud at TBW, the GNMA servicing assets were eventually sold voluntarily. All of the FHA, VA and Rural Housing Services loans that were current were transferred to Bank of America (NYSE:BAC). Delinquent loans were transferred to either Saxon or Ocwen. In other cases where a seller/servicer merely encounters financial difficulties, it seems reasonable to expect based upon past experience that FNMA, FHLMC and GNMA Mae would likely acquiesce in the voluntary transfer of servicing, as in the case of Ocwen in 2015. Again, the key question in the case of GNMA is whether or not the seller/servicer was able to continue 1) making payments to bond holders and/or 2) fund the repurchase of defaulted loans. With the GSEs, the issue is a more general concern about liquidity in the context of loss mitigation activities on defaulted loans. Both the 2009 bankruptcy of TBW and the 2012 ResCap bankruptcy resulted in the orderly transfer of mortgage servicing and loan portfolios with the consideration flowing to the respective estates. Ocwen Financial Corp and Walter Investment Management Corp (NYSE:WAC) ultimately prevailed in a bankruptcy auction for the ResCap mortgage business with a $3 billion bid that topped rival Nationstar Mortgage Holdings (NYSE:NSM). Ironically, the acquisition of the ResCap MSR caused significant operational problems for Ocwen three years later. Neither the bankruptcy of TBW nor ResCap created a financial panic or broader problems in the financial markets. In both cases, the successful use of bankruptcy suggests that mortgage servicing is inherently stable and that FNMA, FHLMC and Ginnie Mae will acquiesce in a voluntary restructuring of a seller/servicer so long as 1) creditors are kept at bay via an orderly bankruptcy or receivership process and 2) the servicers have sufficient liquidity to maintain in process payments to bond holders and other creditors, in the case of GNMA, and to fund loss mitigation activities, in the case of both GNMA and the GSEs. Conclusion While the potential risk of termination of a mortgage servicing portfolio is very real, in reality the chances of such an occurrence seem to be relatively small. A big part of the reason for the remoteness of involuntary mortgage transfers seems to be the fact that all of the housing agencies carefully monitor the financial stability of the seller/servicers operating in the markets in which they operate. Also, financial problems at a seller/servicer that result in the involuntary termination of servicing rights can cause significant problems for consumers and thus has become a major area of concern for federal regulators. Preserving the value of the MSR is a key consideration in any situation where the liquidity or financial strength of the seller/servicer is in question. As a result, all of the housing agencies tend to take a very proactive approach to surveillance of seller/servicers and require voluntary transfers when necessary, especially for smaller seller/servicers. In the rare cases where a servicer has filed bankruptcy, both the courts, the federal housing agencies and federal bank regulators have worked together to achieve a smooth and voluntary transfer of servicing with consideration paid to the original MSR holder. Despite the ugly details around both bankruptcies, the cases of TBW and ResCap illustrate the fact that a loan servicing business is stable and can operate in bankruptcy. The fact that the MSR is often the most valuable asset of a seller/servicer seems to have made the federal courts and corporate creditors willing to work to achieve an orderly resolution in the event of a bankruptcy by a seller/servicer. In general, when assessing the potential risk of the involuntary transfer of mortgage servicing, it seems obvious that investors, analysts and regulators should pay close attention to quantitative factors such as the financial soundness and sources of liquidity of the seller/servicer. Another area of interest should be the management team and its ability to assess and control risks to the enterprise. Any evidence of operational problems at a seller/servicer are obviously a red flag for investors and counterparties. But perhaps the biggest issue in assessing a mortgage servicer is operational, namely whether the seller/servicer can effectively manage the compliance, training and human resources challenges in servicing residential loans. As we have seen with Ocwen and other large legacy seller/servicers including banks and nonbanks, failure to effectively manage the loan servicing process can result in fines and sanctions, public censure and reputational risk, and a cascade of events that can even threaten the ability of the enterprise to remain a going concern. The bottom line is that the most egregious example of termination of mortgage servicing rights, TBW, involved deliberate acts of fraud and criminality. Most of the other events shown in the table of GNMA terminations of mortgage servicing involved smaller banks and nonbank servicers that encountered financial difficulty and subsequently failed or were sold. In those cases where a large seller/servicer has filed bankruptcy, the transfer process for MSRs has been smooth and the rights of creditors have been protected, suggesting that outside of cases where fraud is present the overall risk to investors and creditors is relatively manageable given a surveillance program that follows the criteria outlined above. A version of this commentary with footnotes and appendices can be found on SSRN https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2936422

February 13, 2026 | The latest edition of “The Wrap” features our view of the key events in Washington and on Wall Street over the past week. Don’t forget to watch “The Wrap” on The Julia LaRoche Show  every Saturday on YouTube to catch our discussion of what’s hot and what’s not in the world of finance and investing. Below for our Premium Service subscribers is a replay of yesterday’s quarterly update and some other content. AI Hype Stalls Large-cap tech stocks experienced the worst week since November, causing a split market where value-oriented stocks are gaining attention, while tech stocks and crypto tokens are being liquidated. Equity managers are rotating out of tech and into everything else, creating a cosmic imbalance that is difficult for the non-tech equity market to absorb. Virtually every stock in our fintech-heavy finance company group, for example, is down for the year and we expect the selloff to continue.  Charlie McElligott  at Nomura (NMR) summed it up from his options market perspective: The risk hence is a day like today, where a lot of “Lazy Longs” in Equities and Metals have enjoyed extremely high Sharpe “smooth glide,” which then risks a “Profit-Take” spilling-over into a larger “Risk Management Exercise” of forced selling into “Skinny Exits” Likewise the bank group is also in retreat, with all of the large cap names in the WGA Bank Top 50 now pushed out of the top 25 rankings. Sector leader JPMorgan (JPM)  now ranks 87th in our group based upon the 200 day moving average, a striking setback for the House of Morgan. Shed no tears, because JPM’s price to book value is still around 2.5x, but it has lost considerable ground vs other, mostly smaller names.  Source: YahooFinance (02/12/26) As stocks have retreated, the Treasury market has rallied, with the 10-year T-note moving down towards 4% and related issues in the corporate and mortgage markets rallying as well. The average coupon of all T-notes is 3%, of note, illustrating just how far out of the money is the population of notes below the average.   Adding to the gloom is the crypto sector, where bitcoin and other speculative vehicles are being routed in a way not seen since before COVID. Whereas the environment of speculative frenzy that prevailed in 2025 boosted the value of banks, credit, bitcoin and other opportunities, the more critical atmosphere that prevails today is causing a selloff in most crypto tokens and an exodus of liquidity from this ersatz market.  Housing & the Economy Fannie Mae and Freddie Mac released earnings this past week and the GSEs are profitable with rising volumes. The only problem is that most of the growth is in refinance transactions rather than purchase mortgages. And the average loan coupon of $14 trillion in residential mortgages is still below 4%.  As we noted earlier this week (“ Santander + Webster = ? | Affordability: Accelerate Treasury Debt Repurchases ”), the weight of low-coupon Treasury bonds and MBS issued during COVID is essentially negating the purchases by the GSEs, which are concentrated in current coupons. For the same reason, the bond purchases of the GSEs are unlikely to push down mortgage rates, especially with Fannie/Freddie buying current coupons. Fannie Mae If FHFA Director Bill Pulte  was really smart, he'd repackage the MBS bought by the GSEs into CMOs and bury the troublesome duration in the insurance market. Then he'd go buy more low coupons and restructure those. Yet a selloff in equities accompanied by a flight to quality in risk-free assets such as Treasuries and MBS may do the trick in the short-term. During comments to our Premium Service  readers yesterday in our quarterly update, we reflected our view that the mortgage market is likely to have a rough year. There is a dearth of quality leads in the agency market and, not surprisingly, some lenders are behaving very badly in order to win business.  When a broker partner of a major lender you don’t know calls after you close a mortgage and offers to immediately beat your rate, that is illegal. As our dear departed friend David Stevens  liked to say, the mortgage industry is one big RESPA violation. The growth of the jumbo, non-QM loan market is driven by slow business in the agency world. Strike Two: PennyMac Buys Cenlar During the quarterly call, we repeated our view that PennyMac Financial (PFSI)  is relatively cheap following their disastrous earnings announcement last week, but the flow of comments coming in from various observers makes us reconsider that view. Why? Because in the increasingly desperate search for new loans and mortgage servicing rights (MSRs), some lenders are making bad decisions. This week PennyMac announced the purchase of industry servicing giant Cenlar FSB . The deal ends a long narrative in the mortgage industry. The Trenton NJ specialty sub-servicer operated inside a grandfathered thrift but with a severely and deliberately constrained business model. Our assumption has always been that Cenlar was unsalable. The OCC will probably be happy to see this relic of the final days of the Office of Thrift Supervision go into the history books.  We see a couple of issues for PFSI. First, PFSI has agreed to acquire the subservicing business of Cenlar Capital Corporation for a total of $257.5 million. The deal consists of an upfront cash payment of $172.5 million and up to $85 million in contingent payments based on performance over three years. The acquisition is expected to close in the second half of 2026. Here's the obvious question: What is PFSI buying? Inside Mortgage Finance  reports correctly that "Pennymac noted that some $307.0 billion of the portfolio is in the process of leaving Cenlar or has provisions allowing a move to a different subservicer if Cenlar is sold."   Since the very political 2021 consent order with the OCC, servicing has been leaving Cenlar. United Wholesale Mortgage (UWMC)  transitioned away from Cenlar for servicing, opting instead to bring its loan servicing in-house using technology from ICE.  Ally Financial Inc. (ALLY)  has also announced a transfer to servicing to the bank. Many other banks are retaining originated mortgage servicing rights (OMSRs), reducing natural customers for subservicing. One of the odd things about the Cenlar model is their basic decision not to compete with lenders or even primary servicers. Cenlar explicitly subordinated itself to the interests of the MSR owner in all respects. The bank did not even control escrow deposits, a major difference with other bank subservicing models such as JPM and the pre-NYCB Flagstar. Indeed, the Cenlar bank has been shrinking. Cenlar FSB (12/31/25) Source: FDIC/BankRegData Another aspect of the Cenlar model is that they did not solicit borrowers. Under PennMac ownership, will they mine the portfolio for recapture? Of course, but how big will the portfolio be in a year? What about other firms involved with subserviced assets? We can see this sale process getting very complicated and potentially causing even more migration of MSRs. You can be sure every Cenlar servicing customer is getting calls from the competition. As one industry maven wrote: "It's all about getting access to borrowers before your competitors. Gotta own the comms channels. The best use of AI in mortgage lending might actually be an agent that blocks your competitor's robocallers."  In this regard, Fannie Mae's results show how refinance volumes are growing while purchases are falling as shown in the chart above.  It will be interesting to see if this transaction helps the PFSI stock price, but our fear – which is shared by a number of operators in the industry – is that PennyMac has made a second serious mistake in as many weeks buying Cenlar. The economics of the subservicing business is very thin and depends upon maintaining the good will of the owner of the MSR. If the subservicing business runs off to other subservicers like Loan Care or Dovenmuehle, then PFSI could end up losing money on this transaction, even if the performance fees are not triggered. Let’s say they ultimately buy $300 billion in subservicing. Is that worth $172 million, assuming no performance payments? Say a million loans x $6-8 per performing loan per month annually?  But frankly, the whole book could move. Cenlar does not own the MSR. The mortgage equity group we track has also sold off in recent weeks.  Market leader PFSI is down at the bottom of the list with poor performers like Zillow (Z) and Blend (BLND) . For the sake of the mortgage sector, we hope PFSI rebounds soon and that we avoid more surprises, but frankly the Cenlar acquisition looks like it may actually take the valuation of PennyMac lower in the near term. Our mortgage surveillance group is available to subscribers to our Premium Service below.

February 11, 2026  | Today the The Institutional Risk Analyst  publishes a new feature for subscribers to our Premium Service , The WGA Precious Metals Top 25 . Over the past year, we have assembled an eclectic list of miners, producers and ETFs that provide our readers with ways to create exposure to gold and silver markets. As with our WGA Bank Top 50, we provide our full surveillance group for the information of our readers. We created the Precious Metals Top 25 through our own research and discussions with veteran asset managers around the world. Our goal was to create a representative list of stocks that can give our readers exposure to gold and other precious metals. We think of the list as a point of departure for investor research and also a benchmark for market movements in precious metals. With the sharp move upward in gold and silver prices, and growing concerns about the stability of the dollar and US financial markets, investor interest in precious metals is increasing dramatically. Despite the big price movements seen in 2025, we believe that the appreciation of gold against the fiat currencies and worthless crypto tokens is in the early stages.

February 9, 2026  | Last week, Adam Josephson  published an interesting comment about the Treasury program to repurchase existing government securities . Why is the Treasury buying back existing notes and bonds, and issuing new debt, sometimes at a higher cost? For the same reason that caused the stock of PennyMac Financial (PFSI) to crater  last week thanks to the MBS purchases by the GSEs, namely duration . Few people in finance actually understand the bond market much less geeky subjects like option-adjusted duration (OAD), a key concept in the mortgage and asset management communities. You need to have friends like Alan Boyce , Fred Feldkamp , Lee Adler and Adam Quinones to beat you about the head and shoulders until you "get it." The famous Boyce napkin illustrating the value of mortgage servicing rights (MSRs) is below. The Federal Open Market Committee under Chairman Jerome Powell  frantically began to push interest rates down in January 2019 and began to buy trillions in low-coupon Treasury debt. By doing this, the Fed drained duration out of the market and thereby caused interest rates to fall. This also created a massive interest rate ghetto for dealers, banks and bond investors. The Fed’s ill-considered actions distorted the financial markets and also forced home prices up double digits.  Simply stated: The low-coupon bonds issued during COVID have a longer duration  than current coupons with higher yields, making the Treasury market more volatile. A T-bill maturing tomorrow has a duration of one day, for example, but a 30-year zero coupon Treasury bond has a duration of 30-years and far greater volatility. Think of duration as a weight, pushing down on bond prices and raising bond market yields. A new 30-year Treasury bond maturing in November 2055 with a 4.625% coupon, has a Macaulay duration  of approximately 15 to 17 years. The 10-year Treasury note has a still high sensitivity to interest rate changes, aka volatility, but far less than the 30-year zero coupon Treasury debt or a mortgage-backed security with variable duration . The variability of duration in MBS caused Silicon Valley Bank to fail. Dealers paying SOFR at 3.75% plus say 1-2% are not interested in holding Treasury debt or agency MBS or loans with coupons below 5%. While Treasury has purchased premium securities with higher coupons  as part of repurchase operations, today the priority ought to be retiring COVID-era Treasury debt. Bonds with higher coupons trading at a premium to the market are more stable. The chart below from the FRBNY shows SOFR through last week. Source: FRBNY Generally the Treasury’s repurchase of existing debt is limited by available cash. But when the Treasury repurchases a low-coupon bond issued during COVID at a discount and then issues a new bond at current rates, the agency actually generates net cash in the short-term but has a higher total cost over the life of the bond. Yet the bond market, investors and the Treasury itself benefit far more from repurchases of low coupon debt in terms of lower market volatility.  By repurchasing the low coupon securities, the Treasury also reverses the damage of the FOMC under Chairman Powell. As we’ve noted previously, the actions of the Powell FOMC merely continued the equally confused thinking of the Fed under Chair Janet Yellen (2014-2018). Yellen, Powell and their colleagues on the FOMC apparently thought that the central bank could control the long end of the yield curve.  Wrong. Of interest, the restart of net T-bill purchases by the FOMC for the system open market account (SOMA) in December is reducing the need for the Treasury to issue T-bills to the public. John Comiskey  notes in Reverse Engineering Finance : “Not only did Treasury leave the coupons alone this QRA but their forward guidance indicates continuing to do so for “at least the next several quarters”. Their mention of the SOMA Treasury bill purchases is also noteworthy. Treasury understands that those purchases will soon enough reduce Treasury’s need to issue bills (or coupons) to the rest of the public. The Fed indicated these purchases would slow down after April. How much they slow it will likely be a significant input to Treasury’s coupon levels calculus late this year.” In The Wrap this past week (“ The Wrap: Pulte Crushes PennyMac; Kevin Warsh's Conflict of Visions “), we noted that when the Fed’s balance sheet grows via open market purchases, bank deposits grow dollar-for-dollar, indirectly pushing up asset prices and inflation. Yet the political attraction of the Fed purchasing government is unavoidable, one reason we think that Warsh’s statements about shrinking the Fed balance sheet will ultimately be unrealized.  Treasury Debt as Tax Assets The Treasury can accelerate the retirement of low-coupon, COVID era debt by taking a page from Argentina and treating all government obligations as tax assets. Last April we asked whether the Treasury ought to accept debt in payment of tariffs and/or taxes (“ Should Treasury Accept Debt for Tax Payments? Bank OZK Update ”).   Accepting tenders of Treasury debt at face amount for tariff or tax payments will supercharge the buyback process so as to eliminate all of the discount coupons in the government debt market. Doing so would lower market volatility and incentivize dealers and investors to hold the remaining paper, pushing market yields down. We wrote: “High interest rates are a problem, but so too are low rate securities left over from COVID. Back in 2024, the US Treasury began a program to repurchase low coupon bonds in the open market in order to improve market liquidity. If you are a small dealer or fund paying SOFR +1% for money from your friendly neighborhood bank, you don’t want to own a Treasury note paying 0.125% per annum.  More than half of the Treasury note market is more than 10 points under water at todays yields and therefore illiquid.”  It may seem counter-intuitive, but by removing the low coupon, high duration bonds from circulation, the Treasury can reduce the average duration of all public debt and thereby encourage LT interest rates to fall . Bonds with high coupons will be sought after by dealers and LT investors alike, pushing down Treasury yields and also interest rates for corporate debt and residential mortgages. Indeed, we think that the Treasury should adopt a standing policy to encourage investors to buy and redeem discount notes and bonds for tariff and/or tax payments.   The chart below shows the 323 issues of Treasury notes outstanding by coupon rate. The unweighted average coupon is 3% and the median coupon is ~ 3.5%.  Yet the duration of the bonds below 3% coupons is much, much larger than the half of Treasury notes above 3% average coupon. The weight of the duration, if we think of it in physical terms depresses bond prices and forces yields higher. Source: US Treasury Fannie Mae and Freddie Mac have been repurchasing current coupons, for example, but they ought to focus their open market operations on low-coupon MBS. Trouble is, holding MBS with 2 and 3 percent coupons in portfolio will generate significant losses for the GSEs. The Fed could to take all the $2 trillion in MBS in the SOMA and repackage the debt into collateralized mortgage obligations (CMOs). The Street can easily sell the Fed CMO bonds to insurers and pensions, and bury the duration forever. Doing so would actually help LT interest rates to fall. Indeed, the GSEs ought to do the same with MBS purchased to date. Issue CMOs, bury the duration. Bottom line is that if President Trump wants LT interest rates and especially residential mortgage rates to fall, he should ramp up Treasury repurchases of low coupon government notes and bonds currently trading at a discount.  Also, President Trump should direct FHFA Director Bill Pulte to restructure MBS purchased by the GSEs into CMOs of different maturities.   Banco Santander SA + Webster Bank = ? Banco Santander SA (SAN)  announced an agreement to acquire Webster Financial Corporation (WBS) , the parent company of Webster Bank, in a deal announced on February 3, 2026. The transaction is valued at approximately $12.3 billion, a ~ 10% premium to WBS market cap prior to the announcement. The deal is expected to close in the second half of 2026, subject to regulatory and shareholder approvals. We suspect this deal will get approved quickly, one reason that you're likely to see more M&A transactions this year. SAN is a dominant retail bank in the EU with over 178 million customers, although it ranks behind BNP Paribas and Crédit Agricole in terms of total assets. In the US, SAN operates through $175 billion asset Santander Holdings USA (SH USA) , which owns $104 billion asset Santander Bank, N.A. (SBNA) and Santander Consumer USA (SC). Below we provide our specific thoughts on the transaction for subscribers to our " Premium Service. "

February 6, 2026 | This edition of “The Wrap” features our view of the key events in Washington and on Wall Street over the past week. Don’t forget to watch the podcast of “The Wrap” on The Julia LaRoche Show  every Saturday. Our discussion of what’s hot and what’s not in the world of finance and investing is not to be missed! Bill Pulte Crushes PennyMac The big theme this week in the markets is risk off as asset classes from precious metals to AI software stocks took a drubbing. We described the carnage at market leader PennyMac Financial (PFSI)  for our Premium Service  subscribers. Is it really possible that PFSI’s retention of prepayments off of its servicing book were below 30%? Yup. But PennyMac may not be to blame. (See “ PennyMac: Hedging Costs & Residential Loan Recapture Crater the Stock ”).  We hear that the PennyMac fiasco was largely caused by FHFA Director Bill Pulte and the Trump Administration. Most people in the markets don't realize that the GSEs already bought a ton of mortgage-backed securities (MBS) in Q4 of last year. This market manipulation in Q4 was not announced publicly and tightened mortgage spreads 15-20bps. The GSE purchases of MBS increased assumptions of mortgage prepayment speeds without a corresponding offset from hedges in the Treasury market. This set up PennyMac and other mortgage lenders for a disaster. Buyers of excess I/O strips are pretty unhappy as well. Since the January 8, 2026, announcement, when President Donald Trump directed Fannie Mae and Freddie Mac to purchase an additional $200 billion of their own MBS, spreads have tightened an additional 10bps. Trump’s order was aimed at lowering high mortgage rates and boosting housing affordability, but instead he caused significant losses for some mortgage lenders and investors. As Peter Wallison of American Enterprise Institute wrote this week: " Our leaders are not serious people. " Specifically, the MBS purchases by Fannie Mae and Freddie Mac increased demand for bonds, which helped decrease mortgage rates – but only for a brief time.  The appreciation of MBS crushed buyers of interest-only securities (IOs), as model speeds for prepayments are now faster and option-adjusted spread (OAS) values lower. How is this helpful? The members of the trial bar investigating the Q4 earnings release of PennyMac ought to be interviewing FHFA Director Pulte. AI, Silver and Crypto Sink Another casualty of dashed earnings expectations was PayPal Holdings, Inc. (PYPL) , which has lost half of its market cap in the past year.  The sharp sell-off was driven by a miss on quarterly expectations, a weak 2026 earnings outlook, and a sudden leadership change that suggests deeper issues with the fintech issuer. We’ve been concerned about PYPL’s vulnerability to competition from the myriad of new payments platforms since last year (“ Fear & Loathing in Credit; Update: PayPal Holdings ”).  Spot silver retreated by more than a third from an all-time high last week, answering the question from several readers about why we prefer gold to silver.  As we discuss at length in “ Inflated: Money, Debt and the American Dream ,” silver is no longer a monetary asset and has not be used as money since the latter part of the 19th Century. Gold, on the other hand, is being restored as the chief monetary asset held by central banks. We continue to view silver as primarily a speculative commercial commodity and gold as a monetary asset supported by central bank buying.    AI Goes Into Space? Meanwhile, Elon Musk’s  SpaceX acquired his artificial-intelligence startup xAI in a record-setting deal that unifies Musk's AI and space ambitions by combining the rocket-and-satellite company with the maker of the Grok chatbot. The deal, first reported by Reuters , represents one of the most audacious tie-ups in the technology sector but may also reflect the growing weakness in investor support for AI.  As Yahoo Finance noted this week: “ AI is starting to eat its own.” Meanwhile, this week Musk stated that space-based AI is "obviously the only way to scale" to meet the growing demand for computing power. Following the merger of his AI company xAI with SpaceX, Musk outlined a strategy to move large-scale AI computing from Earth to orbit in order to use solar power for AI development. Since political opposition to AI-based power facilities is growing around the world, Musk's statement may be both practical and also a death knell for other AI ventures dependent upon terrestrial power generation. If Musk is able to put his space-based AI architecture into action, other AI ventures may no longer be viable financially or technically. The only question: How to put advanced computer chips into the harsh environment of space? Kevin Warsh’s Conflicted Vision The conversation continues around the appointment by President Trump of Kevin Warsh to be the next Fed chair, a decision we heartily support. The big question, however, is whether Warsh can actually cut the target for federal funds without causing the long end of the yield curve to rise given the Treasury’s massive need for cash. Every time the Treasury completes a new refunding, long-term interest rates rise. The other big question for Warsh given the Treasury’s deficit is his desire to further reduce the size of the Fed’s balance sheet.  As readers of The Institutional Risk Analyst know very well (“ Logan Riffs on SOMA; XYZ and SYF Say No Recession Yet ”), when a Treasury security matures on the Fed’s balance sheet, the Treasury must refinance this liability immediately. This dynamic illustrates why the size of the Fed’s balance sheet is directly related to the size of Treasury indebtedness, the banking system and thus inflation of asset prices. If the Fed is not replacing securities that run off the SOMA portfolio, then the Treasury must sell the new debt to a private investor and a bank deposit disappears. When the Fed is a net buyer of Treasury securities, primary dealers sell securities to the Federal Reserve Bank of New York and the Fed credits their master account, creating a new bank deposit. When the Fed grows its balance sheet, the size of the US banking system increases, asset prices rise and inflationary pressures grow.  Now President Trump has indicated that he wants home prices to remain high, a goal that is directly in conflict with Warsh’s stated desire to see the Fed’s balance sheet shrink. While we continue to expect a home price correction ~ 2028 due to changing market dynamics, a resumption of “quantitative tightening” or QT by the Federal Reserve Board is likely to accelerate a downtown in the housing market. Should Warsh win confirmation, its is not clear to us that there is a majority on the Board of Governors to resume QT. One big reason is that conditions in the US repo market are currently tight, characterized by increased volatility, elevated borrowing costs, and, as of late 2025/early 2026, unusual Federal Reserve intervention.  The Secured Overnight Financing Rate (SOFR) has occasionally risen above the interest paid on bank reserves (IORB), signaling, at times, exceptional demand for cash and limited liquidity.  It's interesting to note, for example, that Morgan Stanley (MS) reported paying 45% for REPO funding last year. The table below comes from Page 77 of the MS Q4 Form 10-Q. If a future Chairman Warsh pushes the Fed to resume shrinking the balance sheet, then he may repeat the mistake made by Jerome Powell in Q4 2018 (“ The Martyrdom of Jerome Powell ”). 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. 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February 3, 2026  | Updated | Last week the financial markets were roiled when PennyMac Financial (PFSI) , the #2 aggregator nationally in residential mortgage loans, badly missed the Street’s earnings targets. PFSI EPS fell short of expectations at $1.97 compared to the forecasted $3.12 per share in Q4 2025.  Revenue also disappointed the Street's admittedly inflated expectations, coming in at $538 million against an impossible forecast of $637.49 million, but the Street estimate was never even remotely realistic. Sometimes stock analysts are misled by rising equity market valuations and this is a case in point. But as we noted in our last comment, 2025 was the year of aspiration and hype. This year is shaping up to be very different. More important than illusory Street expectations, however, was market conditions and that dangerous buzzword "affordability." Analysts assumed an improvement in the firm’s hedging results – a considerable stretch – which caused more than a few investors and analysts to lean into the stock.  But the key factor that generated investor angst was under-performance in terms of loan recapture, an illustration of the hyper-competitive market in residential mortgages. True retention = Retained fundings divided by total run off. On that basis, we figure that PFSI retained less than 1/3 of mortgages that prepaid in Q4 2025. After touching $160 in late January, PFSI closed yesterday below $95 per share and pulled down other mortgage names as well.   Source: Google Finance