INSIDE ECONOMICS

Mark Zandi:                       Welcome to Inside Economics. I'm Mark Zandi, the chief economist of Moody's Analytics, and I'm joined by my two trustee co-host, Marisa DiNatale and Chris deRitis. Hi guys.

Cris deRitis:                        Hi Mark.

Marisa DiNatale:              Hi Mark.

Mark Zandi:                       How are you guys doing this week?

Marisa DiNatale:              Good. You sound a little congested.

Mark Zandi:                       Yeah. I got a bit of a cold, but I'm feeling better. I took some NyQuil last night, got a good nights rest, so I'm feeling better, but still a little congested.

Cris deRitis:                        Wow. NyQuil. You have new perspectives on the economy after that?

Mark Zandi:                       Really? What do you mean?

Cris deRitis:                        It gives me funny dreams, right?

Marisa DiNatale:              Did you hallucinate?

Mark Zandi:                       Oh, NyQuil does?

Cris deRitis:                        Yeah.

Mark Zandi:                       Oh, I didn't realize.

Cris deRitis:                        Okay. All right.

Mark Zandi:                       Oh, my wife swears by it. Any ailment, NyQuil.

Cris deRitis:                        I see. I see.

Marisa DiNatale:              Because it just knocks you out.

Cris deRitis:                        It does. It does.

Mark Zandi:                       And then she used to tell me, don't take NyQuil during the day. I think she's done that a couple of times. You really don't want to do that, but anyway, thanks for asking. And we have a guest we're going to talk to in a little bit, Chris Whalen. Chris is a great banking analyst, has a great view of the financial system more broadly, mortgage finance in particular, and we'll have a good conversation with him in just a few minutes. But before we go there, I thought we could start our conversation with what's top of mind this past week. What in the world of economics and financial markets caught your attention? And maybe I'll begin with you, Chris, go with you first. What's top of mind for you?

Cris deRitis:                        Yeah. So this week was a little light on economic data and releases, I found, but there was quite a bit of movement there in financial markets. That certainly caught my eye with the 10-year treasury moving up pretty significantly this week. I think that, in part, because of the... We got the minutes from the FOMC, right? Which maybe influenced investors positions as well. So I think there's been a lot of chatter around the tenure, and then also mortgage rates, as a result of that, have also gotten a lot of attention, so that's certainly caught my eyes. Mortgage rates are now firmly above 7%, right? Lots of discussion about whether that's going to slow down home prices significantly, are buyers going to really retreat? I think that feeds into the second part of your discussion here today.

Mark Zandi:                       Yeah, that's exactly where my mind went. That's top of mind. Excuse me. The 10-year treasury yield, I think it got as high as 4.3%, which in the grand historical scheme of things, isn't that high, but...

Cris deRitis:                        No, no.

Mark Zandi:                       I think it's as high as it's been in over 10 years. I mean, you have to go back, I think even longer than that, maybe 15 years.

Cris deRitis:                        I think so. Yeah, 15.

Mark Zandi:                       Right. Well, let me ask you this. I mean, why do you think it's increased? You mentioned the FOMC minutes, that's not it. That can't be it. That's not it. Why do you think?

Cris deRitis:                        Maybe a contributing factor, right? The minutes suggested that perhaps recession risks are no longer there, or certainly reduced, right?

Mark Zandi:                       That's all news, Chris. Come on. I mean, that was minutes from the July meeting. That's not what's going on here. Fundamentally, what do you think is behind the increase in yield? Maybe investors are beginning to fully discount the likelihood that Fed's not going to be easing policy anytime soon. Maybe that-

Cris deRitis:                        Right. That's what I'm-

Mark Zandi:                       That's what you're saying? Okay.

Cris deRitis:                        That's what I'm saying. So yeah, you're right. There was a lot of speculation after the meeting, but this is a bit of a confirmation.

Mark Zandi:                       Yeah, you're saying-

Cris deRitis:                        Is it just coincidence that the tenure went up, and FOMC minutes were released? You don't see any-

Mark Zandi:                       I think it was going up before the FOMC minutes were released. I think it was already up. I mean, my sense is that... I'm sure you're right.

Cris deRitis:                        Contributing factor, but not a...

Mark Zandi:                       Contributing factor. Yeah.

Cris deRitis:                        Primary factor. Okay, fair enough.

Mark Zandi:                       Yeah. My guess, is that there's a lot of treasury issuance. The budget deficit is very high for lots of different reasons. Some temporary, some not so much. I mean, we've got a large structural deficit, and so there's a lot of treasury issuance, bond issuance, and I think the treasury increased the size of its auctions to accommodate the large deficit, and that took, I think investors, by some surprise. I think that probably played a role. There was also, interestingly, some speculation that the Japanese Central Bank, the Bank of Japan, didn't end, but kind of tweaked its yield curve control. That they have this policy of buying tenure, JGBs, Japanese government bonds to keep it low. That was a way to help stimulate the economy, and now that their economy is doing better, they've relaxed that buying. And so this raised the whole level of interest rates around the globe, including here, in the United States.

Cris deRitis:                        Japan's Interesting. We should talk about that sometime.

Mark Zandi:                       You mentioned we should get our colleague Stefan Rik on, and we are, he's going to come on and talk to us about Japan. Marisa, any other explanations for the run-up in 10-year treasury yields, that you can think of? What's going on there?

Marisa DiNatale:              I've seen so many articles this week, about how economists are raising their expectations for this so-called soft landing. Inflation's coming in, the job market is slowing, but it's not cratering. We're probably out of the woods, in terms of recession. It's been all over the news, starting from late last week, to this week, and I wonder if bond investors are reacting, finally saying, the Fed's going to pull it off. We don't have to buy 10-year bonds anymore. Maybe we can be in something shorter term, and perhaps riskier, if we're going to avoid a recession.

Mark Zandi:                       Right, right, right. The interesting thing is, 4.3% is not materially different than our expectation for where tenure treasury should be in the long run. In fact, I'll point out, we have had, in our forecast, for a long time, for many years, the 10-year yield ultimately rising to about 4%. The logic being that, that's consistent with the nominal potential growth rate of the economy. Nominal GDP growth. That's 2% real growth, plus 2% inflation. And in the long run, the cost to capital, which is the 10-year yield, needs to be roughly equal to the return on that capital, economy wide, which is the potential growth rate of the economy, so 4%. And actually, empirically, if you go back and look over the last 50 years, at nominal GDP growth, and compare it to the 10-year treasury yield, they're exactly equal to each other, to the basis point.

                                                Now, there's long periods when they could diverge for various reasons. For example, when the Fed was working hard to lift inflation between the financial crisis and the pandemic, it was managing, creating an easy monetary policy. 10-year yields were low, well below nominal potential growth. But generally speaking, that's the case. And so we've always had, in our forecast, that increase in yields up to about four, and we were getting a lot of criticism, Chris, remember? We had clients that were critical of that forecast. It looks like it's right. I mean, it's hard to know when that was going to happen, when it was going to get back to fair value, but within the asset price, it can be high or low, relative to fair value, for long periods of time. We don't know exactly when it gets back to equilibrium, until its long run value, but you know that it will.

Cris deRitis:                        The other thing is, there's volatility here, right?

Mark Zandi:                       Yeah.

Cris deRitis:                        Even today, on Friday, right? It was 4.3. Earlier this week's, four point... It's close to 4.2 today, right?

Mark Zandi:                       Oh, is it? Is it back down to 4.2?

Cris deRitis:                        Or 2.3, something like that.

Mark Zandi:                       Oh, okay.

Cris deRitis:                        Things are still moving around here.

Mark Zandi:                       Yeah.

Cris deRitis:                        Just a couple of days, doesn't mean its equilibrium.

Mark Zandi:                       Yeah, and I don't think 4.3 is different than four.

Cris deRitis:                        Yeah. In the grand scheme of things, right?

Mark Zandi:                       In the greater scheme of things. Yeah. Now let me... Of course, you mentioned mortgage rates. 30 year fixed mortgage rate is now over 7%, so that's the four and a quarter, let's say, 10-year yield, plus some spread, some difference. And here, the spread is very wide. It's about three percentage points, or 300 basis points.

Cris deRitis:                        Yeah.

Mark Zandi:                       Historically, it's about half. The spread is about half the 300 basis points. I guess, do you think we're going to be above seven here for a while? I mean, I think on our forecast, we have it six and a half, to seven, I believe, but maybe we're too low. Do you think we're going to be hanging above seven here for a while?

Cris deRitis:                        I think the 300 basis points spread is going to remain intact.

Mark Zandi:                       Oh, that's going to remain?

Cris deRitis:                        Right? So are we going to be above seven? It really depends what your 10-year outlook is. If indeed, we stay above four, then yes, I think we'll stick around seven and a half for a while. Probably, based on our forecast, it's until the middle of next year. That's when the yield curve, in our assumption, goes from inversion to more upward sloping, and that could be the sign that you'll start to see those spreads come in.

Mark Zandi:                       Right.

Cris deRitis:                        And then in the meantime, I don't see a lot of movement to bring that spread down significantly.

Mark Zandi:                       So mortgage rates are going to remain high here?

Cris deRitis:                        I think so. And again, 10-year could actually go up a bit more, so there's risk that we get closer to 8%.

Mark Zandi:                       Right, right. Well, that's a good one. The 10-year yield was top of mind. Marisa, if I ask you the same question, what was top of mind for you this week? What would happen?

Marisa DiNatale:              That was going to be my answer.

Mark Zandi:                       Really? Oh my gosh. All three of us are going to say the same thing?

Marisa DiNatale:              Yeah. Yeah. That's the big news, right?

Cris deRitis:                        What about China? It's getting a lot of play.

Mark Zandi:                       Yeah.

Marisa DiNatale:              That's true. Yeah. Chinese real estate market, again, in the news, with a very, very large commercial real estate company, potentially flirting with default.

Mark Zandi:                       Yeah, I mean...

Marisa DiNatale:              The economy in general, right? The Chinese government stopped producing some unemployment statistics, ostensibly because they don't want people to see what they are. So, yeah.

Mark Zandi:                       You're talking about the youth unemployment rate, right?

Marisa DiNatale:              Yeah, yeah.

Mark Zandi:                       They used to... Well, until this past month, they published the unemployment rate for people. I can't remember what their ages were, like 16 to 25 or something, and that had been... It's high, and it's been increasing, and they stopped publishing it this past month. Presumably, I don't know explanation they gave, but it feels like it's because they just don't want that to be the center of attention. Yeah. It's funny, conversation around China gone from... It's a juggernaut, to it's a basket case.

Cris deRitis:                        Yeah. In months, right?

Mark Zandi:                       Yeah. It's just pretty amazing. I mean, it's got its problems. And we've had discussions about China on the podcast before, with Bears. People were pessimistic about China, and I am sympathetic to that, but it feels like this might be a little bit overdone. I'm not sure the pessimism around the Chinese economy. What do you think, Chris?

Cris deRitis:                        I mean, it's still a huge economy, right? Lots of resources at their disposal still, so could be overdone, but also hard to make the... I find it hard to make the bull case, at this point.

Mark Zandi:                       Yeah.

Cris deRitis:                        What turns this around? I don't see that politics are going to improve anytime soon, right? Especially as we go into an election year. So I think they're going to be under pressure for a while, not just between the US and China, but also Europe and China, other countries as well. There seems to be a lot of pressure there, but they are still integral to the supply chains, right? As much as we talk about moving things around, it's China plus one, is the mantra for adjusting supply chains. So it's still very difficult for manufacturers to move away from China. So they're still playing a very important role, but how do we see additional growth, or how do we see them really turning things around in the short term? That's where I'm scratching my head a bit.

Mark Zandi:                       Yeah. No, I hear you. I hear you. There's just a long list of challenges, but I always get worried about this thing called home bias. It's funny, you talk to people around the world about their economies, wherever they're from, and they tend to be more upbeat, optimistic about their own economy. There's a few exceptions. Marisa and Chris, you'll appreciate this, except for the Italians. I find the Italians, they're more pessimistic than they ought to be about the Italian economy. I mean, there's a lot to be nervous about. Growth rates are depressed.

Cris deRitis:                        I think you need to look a little closer, Mark.

Mark Zandi:                       Really?

Cris deRitis:                        Optimistic.

Mark Zandi:                       Well, it's such a wealthy country, right? It's not growing, but on the other hand... But anyway, I digress. I digress.

Cris deRitis:                        Yeah, yeah. I think you're right.

Mark Zandi:                       My broader point, is that there's a kind of a home bias, and I worry that we're guilty of that here, because China is kind of our, in the case of the US, certainly our competitor. I don't want to say foe, but it feels like they're a foe for many American politicians. They get the blame for a lot of our hills. So I just wonder if we're not overstating the case here, whether the economy's not going to be grow like it did, but maybe it's not going to grow quite as not bad as we're making it out to be, at this point in time. I don't know. I just throw that out. I just worry about it. At least I'm self-aware that I could potentially have some bias.

Cris deRitis:                        Yeah.

Mark Zandi:                       Yeah. So I worry about that. Okay. Well, why don't we play the statistics game? The game, is that we each come forward with a statistic. The rest of the group tries to figure it out through questions, deductive reasoning and clues. The best statistic is one that's not so easy, we get it immediately, and one that's not so hard, we never get it. And then if it's apropos to the topic at hand, and I'm not sure what the topic of hand is here. We are going to talk about banking with Chris Whalen soon, but that's the game. So tradition has it, we begin with Marisa. Marisa, what's your statistic of the week?

Marisa DiNatale:              Well, my statistic was going to be 7.62%, which is the...

Mark Zandi:                       Oh, it's not the fixed mortgage rate.

Marisa DiNatale:              It is. It's the average 30-year fixed today.

Mark Zandi:                       Where are you looking?

Cris deRitis:                        Which index? Yeah.

Mark Zandi:                       Yeah.

Marisa DiNatale:              I'm looking on bank rate.

Mark Zandi:                       Oh, I think that may be... Really? Okay. We'll look at Mortgage Daily News, right Chris?

Cris deRitis:                        Yes. Mortgage news daily, right?

Mark Zandi:                       Sorry? Mortgage news daily. Yeah. What does that say?

Cris deRitis:                        7.37?

Mark Zandi:                       Yeah, that's more like it. Yeah, but I don't know. Okay, fair enough. We thought we would know that right off the hand. Right offhand.

Cris deRitis:                        It's high. It's high.

Mark Zandi:                       That's high. That is high.

Cris deRitis:                        Right. It's higher than what the MBA, or the Freddie Mac reports.

Mark Zandi:                       Certainly what Freddie says. Yeah. Right. But anyway, that's-

Marisa DiNatale:              The point is, my statistic is now out of date, because of our conversation about what was top of mind. That was going to be my statistics. I've got another one for you.

Cris deRitis:                        Okay, give us another.

Mark Zandi:                       Give us another

Marisa DiNatale:              5.2%.

Mark Zandi:                       5.2%. It was a statistic that came out this week?

Marisa DiNatale:              Yes.

Mark Zandi:                       Was it a government statistic?

Marisa DiNatale:              Yes.

Mark Zandi:                       Oh, okay. What do you think, Chris?

Cris deRitis:                        Housing related, we had permits and starts. No?

Marisa DiNatale:              No, It's not housing related.

Cris deRitis:                        All right. I didn't think so. Retail sales came out.

Mark Zandi:                       Retail sales. Is it retail sales related?

Marisa DiNatale:              It's not, no.

Mark Zandi:                       I think we got industrial production, didn't we? Is it IP related?

Cris deRitis:                        That came-

Marisa DiNatale:              It's IP related. Yes.

Mark Zandi:                       Oh, 5.2. It's something like utilities output or something, in the month. No. Mining output.

Marisa DiNatale:              No.

Mark Zandi:                       Utilities output.

Marisa DiNatale:              No.

Mark Zandi:                       Vehicle manufacturing output.

Marisa DiNatale:              Yes.

Cris deRitis:                        Nicely done.

Mark Zandi:                       Oh boy, that's digging deep baby.

Marisa DiNatale:              It's the motor vehicles and parts, month over month, industrial. The production change in auto is 5.2%. It's up 10.3% year over year. It's on the rise. And the reason I bring this, isn't really germane to what we were talking about this week. I was kind of digging deep into the stats.

Mark Zandi:                       That's okay.

Marisa DiNatale:              We've been talking a lot about auto production, and how it is coming back. It's been contributing quite strongly to getting more cars out there, has caused prices to come down in the vehicle market, which has been important for inflation, month over month. So we're starting to see the auto market normalize. Supply chain disruptions largely work their way through. The auto supply, worldwide, is coming back online. We are watching the UAW strike, which could be a problem here in the US, but it's a big part of manufacturing, so that's why I mentioned it.

Mark Zandi:                       Well, and manufacturing's held up pretty well. I think IP, year over year, is basically flat, isn't it? I mean, industrial production has gone nowhere over the past year.

Marisa DiNatale:              Yeah. It actually perked up quite a bit this past month. It was up 1%, which is the largest month on month gain that we've seen in, I think since January.

Mark Zandi:                       And I do think utility output, mining output were up a lot. That's why I said those first.

Marisa DiNatale:              They were, and they're pretty volatile, so I don't [inaudible]

Mark Zandi:                       I wouldn't read too much into it. But it is pretty amazing that manufacturing is held up as well as it's held up, right? It's, outside of housing, the most rate sensitive sector of the economy, and it's navigated through reasonably very, very well. If IP is flat, that's pretty good. Okay. That was a good one. Chris, you want to go next?

Cris deRitis:                        Sure. My original statistic was going to be blank, but we already covered that with the...

Mark Zandi:                       Blank?

Cris deRitis:                        Yes. That was the Chinese youth unemployment rate.

Mark Zandi:                       Oh. What is the Chinese youth unemployment rate? I can't remember.

Cris deRitis:                        Well, we don't know. NA.

Mark Zandi:                       Oh, I see. I mean, last month it was what? 22% or something?

Cris deRitis:                        Oh yeah, it was in the twenties.

Mark Zandi:                       In the twenties. Right.

Cris deRitis:                        Close to a quarter, I think. But my statistic is 12.

Mark Zandi:                       I know what it is.

Marisa DiNatale:              Philly Fed.

Mark Zandi:                       It's your favorite.

Cris deRitis:                        Yeah. Yeah, yeah.

Mark Zandi:                       Yeah. We are digging deep here. So the Philly Fed Index went to 12. You want to explain?

Cris deRitis:                        Yeah. So that's a manufacturing business survey, right? So a positive number of 12. It was minus 10 the previous month. Actually, it's the first positive since August of 2022. So indicating it is very similar to Marisa's statistic there, that manufacturing is picking up. In the Philadelphia region, shipments up, new orders are up. Positive as well. Certainly more optimism when it comes to manufacturing. So kind of consistent with that, more positive vibe, I would say. I will say, qualify, it is one number, one month, right?

Mark Zandi:                       Yeah.

Cris deRitis:                        So you don't want to read too much into it, but certainly it's moving in a more positive direction.

Mark Zandi:                       I think the Philly Fed Index, historically, has been a very good, accurate, prescient predictor of recession, hasn't it? I mean, I think it's particularly good. I mean, I've seen different studies trying to find indicators that predict recessions, and it's not the same as the yield curve, but it's pretty good.

Marisa DiNatale:              It does track... Of all the Fed District manufacturing surveys, it's one of the one that tracks the national ISM composite index, the best.

Mark Zandi:                       Oh, is that right?

Marisa DiNatale:              Yeah.

Mark Zandi:                       Yeah. And it was firmly negative, and now it's positive again. So another reason to think, maybe no recession. It's behind us.

Cris deRitis:                        No recession next month. Let's go with it.

Mark Zandi:                       No recession next month. Okay.

Marisa DiNatale:              Or there wasn't a recession last month.

Cris deRitis:                        That's right. A bit of a lag too.

Mark Zandi:                       Okay. You ready for mine?

Cris deRitis:                        Yeah.

Mark Zandi:                       $1.7 trillion.

Cris deRitis:                        Dollars?

Mark Zandi:                       I'm sorry. Yeah, $1.7 trillion.

Marisa DiNatale:              Is this part of the Fed's balance sheet?

Mark Zandi:                       No, no. I don't want to mislead you. It could be somewhat related, I guess, but no.

Cris deRitis:                        Is this CRE related?

Mark Zandi:                       CRE, commercial real estate? No.

Cris deRitis:                        Yeah. No.

Marisa DiNatale:              Is it housing, residential housing related?

Mark Zandi:                       No, no. We did talk about it in the context of the 10-year treasury yield for the increase in the yield. So think about the reasons for the rise.

Cris deRitis:                        So increase in government debt issuance, is that it?

Mark Zandi:                       Or just the deficit.

Cris deRitis:                        The deficit itself. Okay. Fair enough.

Mark Zandi:                       Yeah, 12 month moving sum. We get the size of the deficit every month from the US Treasury. I think the last data point is for July. So I think that's right. For the 12 months ending in July, the deficit is 1.7 trillion. So not inconsequential, starting and rising. Well, good. All right. Well, before we move on and get Chris here, talking with us, just very quickly, probabilities of recession. Marisa, you were at one third of a probability for recession.

Marisa DiNatale:              Are we talking about the next, what? Year?

Mark Zandi:                       12 months. Yeah, next 12 months. Next year. This time next year. Are you still at one third?

Marisa DiNatale:              Yeah.

Mark Zandi:                       Yeah. Okay. I am as well. I'm still at one third. Still relatively optimistic. You, Chris? You were at 45%.

Cris deRitis:                        I'm going to stick there.

Mark Zandi:                       Okay.

Cris deRitis:                        The fact that everyone else is marking down their odds, makes me even more nervous.

Mark Zandi:                       Yeah, I hear you. I hear you. Yeah. Okay, very good. Anything else? Anything else that we should have covered, that we didn't, before we move on? Marisa?

Marisa DiNatale:              I have a question, and want your opinion. Chris, with the mortgage rate above 7%, do you have any different outlook for the housing market? I mean, what do you... Seem to have been bottoming, house prices even rising a little bit. Does this change anything in your mind?

Mark Zandi:                       Chris, go ahead.

Cris deRitis:                        Yeah. I'd say we have about a four and a half percent decline from the peak, in our house price forecast. And that's perhaps already quite bearish, relative to other forecasters. I would stick to that. I think that there's certainly still a lot of demand out there. We see investors still playing a role, and there's very limited supply of housing. So certainly, that has kept prices up. But 7%, we're really starting to dig in even further into the affordability. And so I remain convinced that we'll see some weakness here. I just don't see how we can continue to power forward, even with rates rising above 7%.

Mark Zandi:                       Yeah, I agree. I think rates will come back below seven. I do think the 10-year will hang around four. Of course, forecasting interest rates, forecasting anything is pretty intrepid. Forecasting interest rates in the near term, is downright crazy to try to do, but okay, we have to do it. So I have rates coming back down to six point and a half percent-ish, to seven maybe. And if that's the case, then I think we get down, four or 5%, peak to trough. If we're above seven and we hang above seven for 3, 6, 9 months, it can do more damage, for sure.

Cris deRitis:                        Yeah.

Mark Zandi:                       It feels like the market's very interest rate sensitive, as you would anticipate, given the high house prices. So if you're at seven plus, really weak. Six and lower starts to come back to life. So I think if we're actually going to be above seven for a while, market's going to take it on the chin. Home sales are going to get hit, and I do expect some more meaningful house price declines, but I think that's coming. Okay.

Cris deRitis:                        It does increase the lock-in effect even more though, right?

Mark Zandi:                       It does. Well, I guess, but we're all locked in. Does it really matter if it's six and a half, or seven? I guess.

Cris deRitis:                        Probably not.

Mark Zandi:                       Probably not. Because the average coupon, the average mortgage... The mortgage rate on the average... The rate on the average mortgage outstanding, is about three and a half percent, something like that.

Cris deRitis:                        Yeah.

Mark Zandi:                       Yeah. Okay. All right, very good. Well, thank you. And we're going to move on to the next part of the podcast. I'd like to welcome Chris Whalen to the podcast. Chris, hey, good to see you.

Chris Whalen:                   Good morning, Mark. Always a pleasure.

Mark Zandi:                       Where are you hailing from?

Chris Whalen:                   I am in Westchester County, New York. We moved up to Briarcliff a couple of years ago. I've got a Fannie three, by the way, which I'll never get rid of. And what's interesting is, this is an affluent area, but we cut our expenses more than half, leaving the city. So what does that say about affordability?

Mark Zandi:                       That's interesting. By half, I mean...

Chris Whalen:                   Yeah, half, easy.

Mark Zandi:                       Really?

Chris Whalen:                   Yeah, the city is just prohibitively expensive. I think we should relocate people, frankly.

Mark Zandi:                       Well, Briarcliff is a beautiful spot. My brother lives in Chappaqua, so I got out there quite a bit.

Chris Whalen:                   God's country. The Whalens have been here for 270 years.

Mark Zandi:                       Okay. Congratulations. So your ancestors were friends with Alexander Hamilton?

Chris Whalen:                   No, these were the Irish. We were building the railroads and the tunnels.

Mark Zandi:                       Oh, I see.

Chris Whalen:                   Yeah, we were [inaudible] thank you very much. And railroad people. My name was railroad engineer and civil war hero.

Mark Zandi:                       Well, thanks for coming on. We've known each other for many, many years, but maybe you can take a few minutes and just describe to the folks out there, what you're up to and how you got to where you are.

Chris Whalen:                   Indeed. Well, my name is Christopher Whalen, and I'm a banker, but I'm also a banker that writes. My entire career as an investment banker and a member of FINRA, I've also been a credentialed journalist. So I write a blog called the Institutional Risk Analyst, and I've been doing that for a long time. In fact, I owned it when I was at Kroll Bond ratings, and then I resurrected it after I left in 2017. Basically, I work in the capital markets. I'm affiliated with a broker dealer affiliate of co-owning company in New York. We finance loans, we trade TBAs. So I have a ground level view of the world of mortgage finance. And at the same time, I grew up in Washington. My dad was a serious mocker in politics, under Nixon and Reagan, and just passed away, by the way. Read his obit in the New York Times.

Mark Zandi:                       Oh, sorry.

Chris Whalen:                   No, he was a great guy and he played a great outfield too, by the way. Went to Queens College. And I grew up in a political household, so everybody always looks at me and goes, "Chris, where did you learn to write about this stuff?" And I'd say, "My dad, and hanging out with members of the cabinet, and Fed Chairman, and everybody else who was in our [inaudible]" My mother was the greatest entertainer in Washington during that year of the seventies and the eighties. If you didn't have a Christmas invite to Joan's house, there was something wrong with you. And so that's how I got to be who I am, and I feel very fortunate and really blessed to have had this kind of a life. I've done a lot of stuff, but mostly fixed income capital markets

Mark Zandi:                       And the Institutional Risk Investor, how long have you been writing that?

Chris Whalen:                   Oh, the Institutional Risk Analyst?

Mark Zandi:                       Oh, sorry.

Chris Whalen:                   Yeah. That goes back to 2003, when I worked with my dear friend Dennis Santiago. I may actually be working with him again, on an index product. And we built a model for doing, essentially a public data camel's rating of banks. And this model's actually still used by the SEC, in Corp fin, for looking for outliers. Our model is very accusatory. We turned it up a lot for the SEC. But mostly, it's just a census of the banks. It says, how did you do this quarter? You would like it, I think the way it was constructed. And essentially, we index five factors that are in a camel rating, and we array the entire population against the index. In the old days, Mark, the center line for bank performance was 1995, but today, you would really have to recalibrate that model, given what's happened since the data has changed. This is the problem with time series data, it changes over time. So if you're not cognizant of that, you're looking at the wrong thing. Yeah, that's the short version.

Mark Zandi:                       Very good. Well, it's good to have you on, and I guess there's a lot of different directions we can go here, but maybe just start with the banking crisis that hit back in March. Do you think the crisis is over, or there's another shoot of fall here?

Chris Whalen:                   No, I think the crisis is ongoing. The Fed responded with liquidity. We also had a bond market rally of sorts, between last year this time, say Q3, when the mark to market was really ugly. It was almost a trillion dollars just on held to maturity securities, and available for sales securities. We weren't even talking about loans. So since then, we had a bit of a bond rally. But now the 10-years are before. And if you think of the 10-year treasury as your benchmark for paying on bank balance sheets, in terms of mark to market, it could be considerably worse this quarter. Q1 of this year was really just about interest rate moves that banks did not anticipate. You look at Silicon Valley Bank, with 40% of assets in mortgage backed securities, which was four times the average, by the way. And that's the problem.

                                                They were betting the bank on an interest rate drop. Very simple, Mark. And the scary part is, I don't know that management realized, from a duration perspective, just how deep in the hole they were by, say the middle of 2022. Because the book that they owned, that 40% of total assets, was prepaying 50% a year. So they were buying more. They were buying more every quarter, and the coupons were falling, and the duration of that book was falling. So when the Fed decided to raise interest rates, they were basically dead on arrival. So that's what happened. The other banks all had, I would call, idiosyncratic outlier business models that made them vulnerable. Even Western Alliance, which is one of my favorite banks, but they were in the loan sales business. Same thing with Pacwest. They were in the loan sales business and they had to sell that business.

                                                They got out. So I think during... If you go back to 2008 until today, very low interest rates, and banks put more sail up on the sailboat to try and compensate. They took more risk. Think of it as spinnaker on a boat, running free, right, on a beautiful sunny. But then when interest rates started to rise, they had to quickly adjust. And we're seeing a massive adjustment ongoing today, Mark, both on the deposit side, and the loan side. The people in the industry who want to be in business a year from now, are moving fast. They are restructuring their balance sheets. People that don't, I don't know. I think there's going to be some big banks that are going to be quite ugly by the end of the year. Bank America, for example, they just keep everything. They have twos that they should have sold, Mark. You don't keep twos. And now those twos are trading at 78 cents on the dollar.

Mark Zandi:                       Just for the listener, I mean, when you say two, these are-

Chris Whalen:                   Loans.

Mark Zandi:                       Loans with 2% interest rate.

Chris Whalen:                   Loans with 2% coupons.

Mark Zandi:                       Yeah.

Chris Whalen:                   Wealth management client, mutual friend of ours, by the way. I won't mention his name. But the guys at BA wrote the guy a mortgage, and they should have immediately sold it, but they don't. BA keeps everything. They have a very long duration book, both commercial loans and consumer.

Mark Zandi:                       Right.

Chris Whalen:                   And their salvation has been low funding costs until now, but look at them now. They're actually moving faster than the rest of the group. Jamie Diamond, by the way, is hitting it out of the park, just from a bank perspective. He had an efficiency ratio of 49 last quarter, which is 15 points below the rest of the group, which means more profit drops to the bottom line.

Mark Zandi:                       Well, I guess JP Morgan got out of the mortgage business, or a big chunk of the mortgage business, quite some time ago.

Chris Whalen:                   No, no. They're in prime. Jamie Diamond is the largest.

Mark Zandi:                       Are they in prime? Okay.

Chris Whalen:                   Oh, Jamie Diamond is the largest mortgage servicer in the United States, Mark. He's bigger than Wells Fargo now.

Mark Zandi:                       Oh, well, I guess I was thinking FHA lending. He got out of FHA lending.

Chris Whalen:                   Yes, yes.

Mark Zandi:                       Yeah.

Chris Whalen:                   But he kept that machinery, they kept investing in it, and they have become the dominant player in those high value loans and conventional, say the top half, in terms of size. Very high quality, at least 20% down ADLTV kind of stuff. And then he's been dominant in Jumbo. He finances that market too. He's a warehouse lender. He has a large MSR, mortgage servicing right. So Jamie's now the king of resi, believe it or not, but not the low part. And unfortunately, the Basel proposal is basically going to take banks out of lending to low income families entirely. They won't be able to do it. And I don't know what people in Washington are thinking.

Mark Zandi:                       Let's come back to that in a second, because the question I asked was, is the banking crisis over? And you said no. So how does that manifest?

Chris Whalen:                   Two things are going on. If you think of the average coupon today, for most bank loans, being somewhere below 4% average, banks are trying, on the one hand, to move out of lower coupon securities and loans, with as little pain as possible. On the other hand, they are trying to buy higher coupon paper to increase their return on assets and equity. Right? At the same time, they are negotiating with their depositors. Depositors are moving funds out of non-interest bearing accounts, into time deposits, at a double-digit rate. The rate of growth in time deposits, Mark, is 30% annualize right now. So the good news is, the banks are keeping those funds. They're not going into T-bills or money market funds, but it is changing the characteristics of bank funding dramatically. They have to pay for funding. Now, even people like US Bank, who've historically had 40% of their deposit base, non-interest bearing, because they're a money center, they have a big payments platform.

                                                So all the banks are having to readjust their business models. And now we're saying, we're going to be higher for longer. The floor on one to four family mortgages may be five, five and half percent right now. So if you think of the average coupon in the mortgage complex, at $13 trillion worth of paper, right? It's still below three and a half. That means two thirds of that population will not be eligible for refinance for a long time. Maybe not for decades. It depends how you feel about interest rates, right? Banks are struggling to grow yield, while they are, at the same time, seeing their funding costs moving twice, three times as fast. And again, look at the big guys. Look at Goldman. Goldman's got the highest funding costs of the top five banks, and that's not going to change.

                                                They're not really a depository. They're a broker dealer. Morgan Stanley, same way. Big changes in their funding profile, but it's okay. They don't take credit risk. Gorman, I think, has won the fight in the US, among the asset gatherers. And then you have UBS in Europe. Those are the two winners, I think, in the world of asset management, right? The universal bank. And in the US, we're going to see consolidation, definitely. But overall, I think the banks will be okay, Mark. It's just, they're going to take some big hickeys next couple of quarters.

Mark Zandi:                       Yeah. Okay. So not a crisis. I mean, obviously it's not-

Chris Whalen:                   No, but painful. Really bad for shareholders.

Mark Zandi:                       Yeah. Right. Right. It's going to take a while for banks to be able to restore profitability in any meaningful way.

Chris Whalen:                   Well look, in an economic sense, quantitative easing took almost a point out of the return on average, return on earning assets for US banks. They're trying to get that back now. But really, financial repression, if you look at it over a long-term basis, has really been taking from banks, going back to the nineties. Nineties were bad, by the way. Nineties banks really got killed by interest rates, as you know. But they had a really good run for about 40 years, where they were making, what you and I would say, were super normal returns. Now that's changing, I think.

Mark Zandi:                       Let's come back to the... You mentioned the Basel three capital standards, this next round of changes to the Basel standards for bank capital and liquidity. And one of the changes that... There's a lot of moving parts there, and it's very complex. A lot of things. G-SIBs, the big systemically important banks have to raise a lot more capital if this thing goes through. But you mentioned on the mortgage side, that if the standards go through, it will have a very chilling effect on the ability of banks to invest in mortgage assets. You want to explain that a little bit?

Chris Whalen:                   Yeah, sure. What we're seeing is very interesting, Mark, the whole idea that banks are now going to be penalized for holding loans that have less equity in them. In other words, high LTV, loans that, say, have 10 or even 5% down. That's typically the government market, the FHA market, right? The potential equity returns for all one to four family mortgages for banks, is basically going to be cut in half, if the current Basel proposal goes through. So whereas in the past, Wells or JP Morgan could earn 15, 20% equity returns holding a portfolio, prime mortgage loans, not junk, but really good solid 80/20 kind of loans, now they'll be lucky to do high single digits. What that means, is that the banks are going to move away from holding one to four family mortgages. And they already were, as you know. They've already gotten out of the bottom third of the market, in terms of government lending, just because of reputational risk.

                                                So what we're seeing, Mark, is that they're going to take the economics of mortgage lending down to such a degree ,that I think you'll only see the banks involved on the wholesale side. So they'll lend to independent mortgage bankers. They'll do warehouse, they'll fund mortgage servicing assets, corporate lending, right? Because that's already 100% risk weight. What the regulators are doing, is they're taking a one to four family mortgage, which normally would've been a 50% risk weight, and it's going to go up to 70 or 100. So it'll look just like a commercial loan, from a risk perspective and a capital perspective, but you earn half as much. So you might as well do the commercial loan, no reputational risk, right? And just stay away from anything that's direct to consumer.

Mark Zandi:                       Let me ask, we don't think we want to go deeper into the weeds, because this is really obtuse, but it clearly is making it more difficult for banks to invest in mortgages.

Chris Whalen:                   Yes.

Mark Zandi:                       What's going on? I mean, fundamentally, in your mind, why are the regulators doing this? Because my understanding, and maybe I have this wrong, is that this increase in standards, the change in the risk rates is even greater than what's being proposed overseas. Basel is capital standards for all global banks, and this is... Here in the US, we're layering on top of that, those standards, and making them any more restrictive. So what do you think? I'm just confused by it. What's the motivation, do you think?

Chris Whalen:                   Well, Bank Policy Institute in Washington, Bill Nelson and his colleagues have been writing really great stuff about this, by the way. I would recommend that your listeners take a look at that.

Mark Zandi:                       Yeah, they're great. Yeah, very good.

Chris Whalen:                   And what you'll see when you go look, is this Basel proposal is five years old. It's stale bred, okay? It should have been reworked. And the Fed is in such a defensive posture, because of the bank failures earlier this year, which they totally missed that. I think they are just desperately trying to put something together, that from a political perspective, they can use to defend themselves. So you hear talk about higher capital, you hear talk about living wills, which are a total waste of time. Living wills are the most ridiculous thing I've ever seen. And I worked at the Fed, I've worked for two receivers, okay? I know about restructuring companies, no restructuring professional, nobody at the FDIC or the Fed would ever look at a living will.

Mark Zandi:                       Living will being the bank-

Chris Whalen:                   Roadmap for restructuring and closing the bank. We don't close big banks, Mark, we put them in conservatorship, we fix them up and we sell them. And that's the key, is that in the first quarter of this year, you couldn't get a bid on a bank because nobody knew what the assets were. The move in interest rates was so large and so fast, that it caught everybody by surprise. And so FDIC goes out and tries to get a bid for Silicon Valley Bank. Guess what? It was crickets. There was no one in the room. It was like when Sheila Bear tried to sell indie back, there was no one in the room, right? And she had to throw loss sharing on the table to get the party started. Likewise, here, FDIC essentially gives you the assets at a deep discount, to create new capital to support the system.

                                                And then if you don't have a bid from somebody else, right? Then the FDIC has to liquefy the whole thing, and that doesn't work. Our system is based on inflation. Let's be fair. That's how we make this work. Asset prices must go up. So I think the Fed and the regulators are just so behind the curve, Mark. They should be focused on market risk. They should be raising the risk weight on mortgage backed securities to 50% at least, just to say, hello everyone, these are dangerous. You are [inaudible] if you own a mortgage backed security. Nobody talks about this. And I think, unfortunately, they just didn't have the time or the political opportunity to rework the Basel proposal to make it relevant. Capital doesn't matter. If you look at those three bank failures, Mark, do you think anybody ever thought about their capital? No. They're thinking about the worth of their assets. And that's really the Fed, at the end of the day.

Mark Zandi:                       Well, Chris, I get this real sense, you're very critical of regulators. The Fed. Yeah.

Chris Whalen:                   Well, because I was one. I worked at the Fed of New York for some of the best. I worked for Billy Rutledge and Jerry Corrigan, okay? I was hired by Paul Volker. So I look at this, and I say to myself, why can't these regulators characterize business models? Why don't they know what business a bank is in, like Silicon Valley Bank? It was a hedge fund. Sorry, that was not a bank. That was an FDIC insured hedge fund. But they can't do business model characterizations, Mark. So if you don't know what business your banks are in, how do you regulate them? How do you possibly look for outliers that'll lead to contagion events? And they don't. So yeah, I'm critical of them, because they're not doing their jobs, honestly. They have the data in-house to do this kind of work. And frankly, I'm thinking about creating a couple of ETFs based on my work, and our work on banks, because I know how to characterize these institutions.

                                                It's funny, the street does it. The street just buys everything and they hope it's going to come out okay. Look at the big ETFs. They buy the good banks, and the bad, and they mush it together, and they hope it's going to come out because the whole market's going to go up, right? In fact, my whole bank complex this year, has rallied considerably. Has anything changed? No. I think their fundamentals are probably weaker today than they were in January.

Mark Zandi:                       So just to characterize things so far. We've been focused on the banking system, and the system is going to remain under pressure for obvious reasons. Funding costs are up, lending rates are down. They're going to have a hard time.

Chris Whalen:                   Net interest margin compression, but some banks are going to turn the quarter in the third quarter. I think you're going to see some new growth from some of these banks.

Mark Zandi:                       But it doesn't feel like we're talking about anything breaking, because-

Chris Whalen:                   But you may have more failures. You've got to be ready for that. There's embedded losses in the system of hundreds of billions of dollars. The US banking system, 18 trillion in assets, has about 2 trillion intangible equity. The top level number is a little over three, but you subtract at least a trillion dollars from that, to get to tangible equity. So if you're already impaired a trillion dollars, that's not a good place to be. In fact, I think that's why the Fed's going to slow down on rate hikes. They're getting the message.

Mark Zandi:                       So I want to move now, to the shadow system, the non-bank part of the financial system. I know you do a lot of work there.

Chris Whalen:                   They're my peeps. My people.

Mark Zandi:                       Your people, your people. But before I do that, let me turn it back to Chris and Marisa, and see, anything you want to push on, that Chris said, before we move on, Chris deRitis?

Cris deRitis:                        No. My interpretation was, the Feds really just want more capital in the system, right? That's what I heard.

Chris Whalen:                   But that's their old thought.

Cris deRitis:                        They'll find any way to do it.

Chris Whalen:                   That's all they can talk about in Washington. If you sit down with members of Congress, and you talk about anything more complex than capital, you're going to lose them.

Cris deRitis:                        Right.

Chris Whalen:                   So that's part of the issue. I don't think our regulatory community is tuned up enough on market risk. They just don't understand it. And I help them in the background. I never help these people publicly.

Mark Zandi:                       Okay. Marissa, anything you wanted to add, weigh in on?

Marisa DiNatale:              No, I don't think so. I think we talked, I think last week, about the Fed's stress testing, and their lack... The big hole in the stress test, of not stress testing interest rate risk, right? Which was what ultimately brought down SVB, and some of these other banks that got into trouble.

Chris Whalen:                   Well, you know what they really should do? Follow Jamie Diamond. What does Jamie do with his bank? He always knows where the net duration of the bank is, and they have a view on rates. And depending on their view on rates, they're either leaning up or down, in terms of duration. Right? They do a good job on this, they really do, and it shows up in their earnings. If you see somebody like Penny Mac or Mr. Cooper, those guys have to manage interest rate risk too. So what's the answer? The whole industry, the banking industry should have to generate a net duration number every month, and they should be able to discuss it. Okay? If they can't discuss it, then they have to dumb down the bank until they get to the point where they understand the risk, to your point, right? I mean, otherwise, I think we're missing it. They're focused on credit risk. Everybody keeps waiting for a credit risk event. And one to fours are still at zero loss given default for banks. Zero.

Mark Zandi:                       You're not worried about credit risk? You're not worried about defaults?

Chris Whalen:                   No. It's in commercial this time. Commercial is upfront, right now.

Mark Zandi:                       Right, right, right. Okay. Well, let's move on to the non-bank part of the system, and the area that you focus on mostly, is the... Well, you focus on all of it, but the area where you're kind of down into the DNA, is the mortgage finance system, the independent mortgage banks. And one of the issues there, and I think you've kind of been out there shining a light on this, is that the funding for the independent mortgage banks, that it feels pretty tenuous to me. They rely on, in most cases, warehouse lines that's getting funding from larger financial institutions. Like a JP Morgan Chase provides the funding for the independent mortgage bank to go out and make their loans, their mortgage loans. And of course, the independent mortgage banks now dominate the government mortgage finance system, Fannie Mae, Freddie Mac, and FHA. They're the predominant lenders. The big banks have largely exited that business. Do you think that's a real significant vulnerability in the finance, mortgage finance system, and the financial system more broadly, the tenuous funding that the independent mortgage banks have?

Chris Whalen:                   No, it really depends on who you're talking about.

Mark Zandi:                       Okay.

Chris Whalen:                   If you're talking about the big players, with large servicing books, no.

Mark Zandi:                       No.

Chris Whalen:                   They're going to inherit the earth. I think you're going to seek consolidation in this market, where the top five or six, in terms to the unpaid principal balance of their servicing book, mostly well above half a billion dollars. Or excuse me, half a trillion dollars. You got to have at least 200 billion in servicing book to be stable. Okay? Once you get above that level, you start really generating a lot of cash flow, and that's what the business is about. So those old-fashioned guys that saved their pennies and invest in servicing, and keep it, are going to do very well. The rest of the industry, as you know, that's been geared to basically selling the loan and the servicing together, and not keeping anything. They're going to exit the door. They have to get out, because they're losing money on every loan they make right now.

                                                The inversion of the yield curve means that there's very little premium out there, and it also means that when you close a loan and you have it sitting in your warehouse line before you're going to sell the pool, you're losing money on the carrot every day. So there's no juice here, Mark. It's not like 2020 and 21, when we were making four or five points on close, including the funding, right? The funding was generating a point. Now it's the opposite. So we're going to force out those lenders that don't have servicing income to protect them.

Mark Zandi:                       So the industry's going to consolidate then.

Chris Whalen:                   Oh yeah, we got to drop half a capacity. We're going to do 2 trillion in mortgages this year, 2 trillion next year. 90% purchase business, by the way. Very expensive loans, 13, $14,000 per loan to acquire and close costs. That's the difference. And when the sun was shining and rates were low, this industry did record volumes. But now we are short. We don't have that business to do today. But at the same time, what's interesting is, Americans are still doing refunds. They're still looking to take money out seven, seven and half percent a year, because otherwise they're going to pay 20 on their credit card.

Mark Zandi:                       Right.

Chris Whalen:                   Right? So rates are still not that high, in relative terms. But going back to the independent mortgage banks, I have to believe that the entry of the banks into mortgages, was an anomaly after the SNL crisis in the nineties. Beginning of the 2000s, you had GE, Citi, Northwest, all the boys playing in there, right? But they were still mostly wholesale players. They were buying loans from non-banks. Since then, with the settlement in 2012 and the financial crisis, everything else, banks have basically gotten out of lending to the bottom third of American consumers in terms of FICO scores and just the loan. So mostly, they've run away from government lending. Even banks that lend to non-bank lenders have sold their servicing. Flagstar, for example, they don't want to know. Most of the big banks you mentioned before, they've pretty much sold their government servicing. They keep the conventionals. And that, I think is the model, going forward. Banks will still make conventional loans to rich people. They'll do jumbo loans, but the banks will mostly sell those loans to the non-bank sector.

                                                And I think non-bank share and servicing is going to increase if this Basel proposal goes through. So look at the FSOC discussion this year, about non-banks, which you're basically referring to, right? And then look at the Basel proposal, and tell me how these two proposals interact. The answer is, they don't. But I must tell you, I think having non-banks servicing loans and making loans, is the optimal model, because they're much better at it. Banks can't get out of their own way when it comes to servicing. So having the banks as the wholesale funding, makes sense. Mostly, what we have to fix, Mark, is just housing finance. The home loan banks, Fannie and Freddie. The politics, unfortunately, during the Biden administration, around Fannie and Freddie, have been bad. Both of the GSEs are penalizing lenders now, if they don't bring them mission loans to poor people. So it's unfortunate right now, is the way I would put it. We could fix most of the problems with the non-banks, if we had the opportunity. But the politics of Washington is so dysfunctional, you can't even have a conversation with people about this.

                                                So that's kind of where we are. In my view, home loan banks should be the balance sheet. They should buy loans from everybody. Why can't they buy loans from non-banks? Non-banks were the first members of the home loan bank system. And then Fannie and Freddie will issue securities, but I think you should allow anyone to use that platform, private label, whatever, right? And then we clean up this mess. We need financing for the Ginnie market, clearly. It may have to come from the Fed. Let me leave you with this thought and I'll shut up. We had to take over a reverse servicer in November, early December, reverse mortgage funding. Treasury owns that book now. They can't sell it.

                                                So I think treasury has to get more actively involved supporting HUD and Ginnie Mae. Ginnie doesn't have the people right now, with the skills for restructuring that I just wrote about, the blog. But if we had some enlightened people get involved in this, we could prevent another seizure. If we have another government lender go down, and the treasury has to pick up the asset, that's not going to be good. And I think we got to get proactive. I use Conseco as an example of how you fix things like this. And I think the good news is, I think we can fix all of the issues around not that hard.

Mark Zandi:                       So just to reiterate, the concern around the non-banks is they get cut off from their funding sources all at once, and if they get cut off, then difficult for them to make loans. And they're such a big part of the market, then no mortgage loans, housing activity goes down, and of course [inaudible] but you don't think that's a big deal?

Chris Whalen:                   No, these are the terrified nightmares of economists that don't have any market sense. This is Janet Yellen and the rest of them. But see, what they don't understand, is that non-bank companies, like Mr. Cooper or PennyMac, have a very close and personal relationship with their banks. The banks hold their escrow balances for the mortgages. Okay? So basically, the bank is lending the mortgage bank, the escrow balances, with FDIC insurance. Okay? That's how it works. So do you really think that JP Morgan is going to get up one morning and say, well, I'm going to go out and cut off all my customers, but yeah, the deposits are going to go somewhere else? No. No. That's not how this works. This is some of the highest margin business they have. So they don't want to be involved in lending to consumers. That's a very low margin, very dangerous business, but lending money to independent mortgage bankers to finance their operations at 100% risk weight, yep, because the yield on those loans is two or three times higher than the yield on the one to four family mortgage. There's no reputational risk.

Mark Zandi:                       We're really deep into the weeds here, I know, and I don't know how many people are actually following along.

Chris Whalen:                   [inaudible]

Mark Zandi:                       I just want to ask one other question about this. You mentioned the federal home loan banks, and federal home loan banks, for folks out there, are kind of the quiet set of institutions that provide liquidity to banks, banking members and others. Insurance companies, CDFIs and the banks can borrow from the federal home loan banks, very, very cheaply. They've got backing from the federal government, and therefore their cost of funds are very low.

Chris Whalen:                   No, no. They're the highest cost. If I'm an independent mortgage bank, my bank is my cheapest funding.

Mark Zandi:                       Well, it depends. I mean, in a risk off environment, when you need them, they're definitely cheaper,

Chris Whalen:                   But they're always there. They're always there.

Mark Zandi:                       Yeah, they're always there.

Chris Whalen:                   But high collateralization, they have very high haircuts. They can't take losses.

Mark Zandi:                       Right.

Chris Whalen:                   So the home loan banks tell them to be very cautious. And honestly, they need to be renovated. If I were made head of FHA, first thing I would do is go up to Capitol Hill, and demand that they-

Mark Zandi:                       That's a whole other podcast.

Chris Whalen:                   Yeah.

Mark Zandi:                       But let me ask you, because the independent mortgage banks are not part of the Federal Home Loan Bank system, they can't get funding. And one of the reasons is, they're not regulated, right? There's no Prudential regulator, right?

Chris Whalen:                   No.

Mark Zandi:                       No?

Chris Whalen:                   FHA can take care of this. Sandra Thompson has come very close to picking up the ball and saying, okay, I am now the regulator for all independent mortgage banks. She hasn't done this, because she doesn't want to bury Ginnie Mae. Ginnie Mae has a role here. But really, if you think about it, Mark, FHA can provide the regulatory overlay that should satisfy the home loan banks. Because remember, we're talking about eligible collateral here, that can be sold in a mortgage backed security. So every 30 days, these things roll. And you know what? If the independent mortgage bank fails, we deliver the collateral and we go on our merry way. These are self-liquidating transactions. There is no risk here. This is what all of these talking heads in Washington do not understand. I finance loans, this is what I do in my spare time during the day, when I'm not writing, right? So I know how this works.

                                                There is no risk, and that's the point. So home loan banks, they have some risk. This is why, when FDIC takes over a bank, the first thing they do is pay off the home loan banks. They don't have to, but they do. Just send them on their way, goodbye. And then they keep the collateral. That's how it works. I think we make too much of this, Mark. If we had a little bit more attention from Congress, we could fix this in an afternoon, you and I.

Mark Zandi:                       So you're saying the independent mortgage banks are... Well, at least the ones with servicing portfolios, are on pretty solid ground.

Chris Whalen:                   The rest of them are going to go bye-bye, because they're sales organizations. That's why they're here.

Mark Zandi:                       Right.

Chris Whalen:                   And you know what? If you have a small shop right now, Mark, and you don't have a big servicing book, why do you want to lose money? You made a ton of money in 20 and 21. You should send your people to the beach, pay for it, shut it down, and come back in two years.

Mark Zandi:                       Yeah, right. Yeah. But yet, you think the system could be stronger if better Home loan banks were able to provide that source of liquidity to them? Okay.

Chris Whalen:                   US Mortgage Finance, including Ginnie, HUD, the Home Loan Banks, is 100 years out of date. It goes back to the age of Smokey the Bear and FDR and the New Deal.

Mark Zandi:                       It's worked pretty well though, Chris. I mean, for 100 years, right? When you think about it.

Chris Whalen:                   Yes, but in a very quirky and idiosyncratic fashion. Home loan banks need to do what the Fed did, which was the centralized market execution and credit in New York. Now, I'm not going to tell them which bank to pick, but they need to get into the 21st century. The risk management and market execution capabilities of the different home loan banks are so widely disparate, that I think it just begs the question, but nobody pays attention to these things. So there are ways that non-banks... Let me break it up for you. Conventional loans, the GSEs already take care of the non-banks. They reimburse them after four months, for all their expenses. In Ginnie, you have a funding problem. And I think one way or another, if we had a crisis tomorrow, the Fed would have to step in and lend. That's the answer.

                                                Ginnie has tried to fashion some interesting things. VA just came out with a proposal to help bankers fund delinquency, which is the big challenge. And it doesn't work, because of the statute. We need Congress. So whether you want home loan bank membership for non-banks, which I think is an obvious thing to do, we still need Congress to come and fix the statute. And there's a long list of stuff we have to do in that regard, by the way.

Mark Zandi:                       Well, any chance you become FHA director?

Chris Whalen:                   Well, if they offer it to me, yes, but I would use my Republican connections to get stuff done. I would merge Fannie and Freddie together. Really, at the end of the day-

Mark Zandi:                       Oh, you've thought about this. You've really thought about this.

Chris Whalen:                   Oh, yeah. Oh, yeah.

Mark Zandi:                       Yeah, yeah.

Chris Whalen:                   Well, because we don't need these pieces the way they were. Remember in the old days, before Fannie Mae even issued securities? You and I were children. Today, do we need them to issue securities? Maybe. But the point is, is that the pieces need to be redirected. We have all the pieces we need. The home loan bank should be at a place where people sell loans if they have to, and they will compete with Fannie and Freddie in that regard. But I think the charm of the platform that Fannie and Freddie have built, is maybe to let everyone use it and have a national standard for all securitizations. That would be useful. And maybe they don't need a government guarantee, right? Maybe Jamie Diamond can take the deal out without a guarantee.

Mark Zandi:                       All right. Okay. Good luck with that, Chris.

Chris Whalen:                   Well, they're not going anywhere.

Mark Zandi:                       Yeah, yeah.

Chris Whalen:                   Fannie and Freddie are postal now. After 12 years of conservatorship, they're not going anywhere.

Mark Zandi:                       Yeah, I agree with you. Hey, we're running out of time, but the non-bank part of the financial system is this big place. A lot of things, moving parts, a lot of things going.

Chris Whalen:                   We can always do a non-bank session if you want. I mean, I covered them all.

Mark Zandi:                       Yeah. I did want to ask, looking out, peering out into the shadow system, so-called chat system, is there anything out there that really kind of... You mentioned economists worried about things. Is there anything out there that you're worried about? Any aspect of the shadow system that makes you unsure and very nervous?

Chris Whalen:                   I'm writing about this for my next column for National Mortgage News. The difference between residential housing and everything else, Mark, is that the federal government guarantees those loans for credit default. So that means that there's a marketplace for them. There's always a forward market because of treasuries, where we price interest rate risk, and we can also price mortgage backed securities. So this market is very well protected from recession and from interest rate changes. Outside of that though, in the world of commercial lending, autos, credit cards, all of the other pieces of asset backed finance, I worry, because those areas are shut down right now. I think you're going to see real trouble in commercial real estate, and in the bonds that finance commercial real estate. And you can't generalize about this, because these are big assets. Some of them are fine, some of them are not fine. Some of them are being marked down by 50 or 75% from valuations of two years ago, especially legacy office buildings in big cities. So I'm worried about everything but residential mortgage right now, Mark. That's where I'm really focused.

                                                Resi mortgage, like I said to you before, I tracked the bank data really carefully. Loss given default on one to four families owned by banks. Two and a half trillion dollars worth of loans is negative. It's below zero. Multifamily bank loans, on the other hand, have totally reverted to above the average. They're almost 100% loss given default. That's not good. So it tells you that the real heat, in terms of loss today, is commercial assets. Think of C&I loans at US banks. That's another two and a half trillion dollars worth of assets, right? A third of that is commercial real estate. Marina Walsh at MBA told me that a while back, and it's a pretty-

Mark Zandi:                       The C&I, the commercial and industrial loans, two thirds are...

Chris Whalen:                   About a third of its real estate exposure.

Mark Zandi:                       Really? These are C&I loans to real estate firms?

Chris Whalen:                   Loans that would include any commercial credit.

Mark Zandi:                       Okay, makes sense.

Chris Whalen:                   You know what I mean? It's all in there. They don't break it out beyond that. I wish they did.

Mark Zandi:                       That's interesting.

Chris Whalen:                   It would be neat to see the subsets, but that's considered non-public. They don't make that available.

Mark Zandi:                       That's an interesting point. Yeah. So you're worried about, really, credit risk in the non-residential side of the financial system. Anything related to that?

Chris Whalen:                   Well, look, when I was at Kroll, I rated most of the community banks in New York City. Their major asset is one of the four family stuff, and then multifamily apartment buildings.

Mark Zandi:                       Right.

Chris Whalen:                   Which went up in value for 75, maybe 100 years.

Mark Zandi:                       Right.

Chris Whalen:                   The whole commercial complex, Mark, is predicated on seven year loans, interest only, that they roll. Okay? And they anticipate that the value of the asset is going to rise. This is the way the sector has been forever. So when you have falling asset prices, that puts a lot of pressure on people, because the lender is going to turn to you and say, Mark, happy to roll the mortgage for you, but you've got to bring it back to 50 LTV. And by the way, the value of the building just fell 20%, because your rent roll is down.

Mark Zandi:                       Right.

Chris Whalen:                   You've had to make concessions to tenants. This is why New York is really scaring me. Rent rolls are falling in New York City for most BCD kind of properties. Well, how are we going to finance them? Nobody's going to put more equity into a building like that. Why? Doesn't make any sense. So the trophy properties are still okay, the really nice stuff. And then outside the cities is fine. But go down to Houston, go down, even San Antonio for Christ's sake. Overdeveloped. It's correcting right now. So the asset allocation in commercial real estate's even crazier than residential. They move in parts.

Mark Zandi:                       When you say you're worried, is that... I mean, again, going back to the way you characterize the banking system, it's going to be painful. It's not going to be any fun. Is that kind of how you're thinking about this as well? Or do you think this is more than that?

Chris Whalen:                   Solvency of banks. Yeah. The hits to some small and mid-size banks could be significant enough that it causes their failure.

Mark Zandi:                       Yeah. Right.

Chris Whalen:                   Remember, regulators want 50% equity in commercial real estate. That's tough, because you know what happens? You see the headlines, they do the numbers, and they say, we're not putting any more money in. And they give the keys to the bank. Remember jingle bells, from the great financial crisis? Well, it's going to be for commercial this time, and instead of the house keys, you're going to get the keys to them all.

Mark Zandi:                       To them all.

Chris Whalen:                   And you don't want them all. I mean, think about Signature Bank. Did FDIC want to take over those assets? No. No other banks ruling to buy them. So all of the 8A properties, all of the subsidized multifamily in New York City, they're going to be sold to non-banks. It's the only bid out there. Now, interestingly, everything was sold, by the way. F D I C had no trouble selling the securities at all. They're all gone.

Mark Zandi:                       I didn't know that. Is that right?

Chris Whalen:                   Yeah, I see this stuff every day.

Mark Zandi:                       Yeah.

Chris Whalen:                   So it was good. That's the good news. In fact, they should sell more, Mark. You know these people, tell them to sell some bots. They want to tighten things up, you want to drain some liquidity, you got to sell some bonds, because otherwise, I think this economy runs hot for another year, and I think people are going to see home prices go up, Mark.

Mark Zandi:                       Really? Well, that's a whole nother kind of conversation. Even at a 7% plus mortgage rate, you expect-

Chris Whalen:                   No, it's not enough. We've got to get rates up above eight. Lenders would make money at 8%. They're not making money now, and you would slow down housing enough to maybe declare success on inflation. I think Powell has painted himself in our corner, because he doesn't want to sell the bonds. How do you cool this economy down, with trillions of dollars of excess liquidity sloshing around?

Mark Zandi:                       I think most people don't want to cool down too much, right? You think it's really that strong?

Chris Whalen:                   There's no supply in the bottom half. Lori Goodman, dear friend of mine, at Urban Institute, always reminds everybody that we lose a couple of points a year in existing homes, because of obsolescence.

Mark Zandi:                       Yeah.

Chris Whalen:                   So we're not building enough homes. And it's concentrated in that bottom half of the FICO band. The top half, no, those home prices will compress, you know the story.

Mark Zandi:                       Yeah.

Chris Whalen:                   Aspirational pricing in the millions of dollars. But remember, the market for those big loans, has disappeared. A year ago, people would have no problem buying up a $5 million jumbo mortgage, that was interest only. The stuff First Republic was originating. And there's no market for that loan today. So people who need to refinance a big house, for example, they're going to have to go to their bank. Jamie Diamond will do that loan. He'll keep that loan, but he is not going to do anything to a lower income borrower.

Mark Zandi:                       Well, Chris, I want to thank you for spending time with us. That was very instructive. I'm just trying to figure out whether I should be nervous or not nervous. I can't quite... I'm not sure. I'm not sure.

Chris Whalen:                   I am cautiously nervous.

Mark Zandi:                       Cautiously nervous. Okay.

Chris Whalen:                   I accept the fact that the market... look, this equity market wants to go up. JP is back to one and a half times book. Is there a recession here somewhere? I don't see it.

Mark Zandi:                       Okay. Okay. Okay, fine. So fundamentally, you're okay. You're reasonably up. Yeah.

Chris Whalen:                   Watch the government loan market. I wrote a very detailed blog about the aftermath of that failure in December. If we have to seize another government asset, we're in big trouble.

Mark Zandi:                       To my point, I'm not sure whether I should be nervous or not nervous. Anyway.

Chris Whalen:                   If you can't sell things in our market, remember the rule. Inflation is the rule.

Mark Zandi:                       Yeah.

Chris Whalen:                   If the asset prices aren't going up, then we have a problem.

Mark Zandi:                       Yeah. Yeah, that's true. All right, well thank you so much for taking the time.

Chris Whalen:                   Bye, guys.

Mark Zandi:                       And really appreciate that. And to the dear listener, we'll talk to you next week. Take care now.