July 1, 2024 | In this edition of The Institutional Risk Analyst, we ponder the world in the wake of the Fed’s latest bank stress tests and the gutting of the Chevron doctrine by a 6-3 majority of the US Supreme Court. The former is reason for grim amusement, while the latter is probably the best news the business community has received since Republicans trounced progressive forces led by William Jennings Bryant in 1896.
Jim Lucier of CapAlpha in Washington sets the stage for the Chevron party:
“When we saw that Chief Justice John Roberts had written the majority opinion in the Supreme Court’s 6-3 decision in the Loper Bright and Relentless cases we thought that surely the Chief would have added a subtle touch, a dash of nuance, or some qualifiers to his opinion to mitigate its impact. Nope. It is a deep, broad, thorough, and total repeal of the Chevron doctrine – and one that scatters salt in the ruins of what is left, much as the Romans destroyed the city of Carthage.”
Now we can understand how progressives might be a bit saddened by the performance of President Joe Biden last week in the presidential debates. But the real disaster for the American left was the evisceration of Chevron, which in very simplistic terms mandated court deference to regulatory agencies. An earlier decision whereby the USSC ordered the SEC to try securities fraud cases in civil court is also a reclamation of prerogative and political turf by the federal courts. Again Lucier:
“Roberts’ decision basically said that only the courts interpret the law, and that the only correct reading of a statute is the one that a court determines. There is no range of possibilities in which federal regulators get to choose the one that they prefer. The implications are far reaching and profound. The ruling would affect almost anything the federal government does – from health care, labor law, financial services regulation, tech and telecom to tax and tariffs.”
The USSC decision on Chevron winds back the political clock in the United States to before the New Deal and the creation of a myriad of federal agencies in the 1930s. For decades since the establishment of agencies from the SEC to the Environmental Protection Agency to the Consumer Financial Protection Bureau, the progressive regulatory community served as a de facto fourth branch of the federal government. But no more.
Not only can private businesses fight the edicts of all federal agencies in the courts, but these agencies now have no special standing to defend attempts to expand regulation beyond the specific statutory direction from Congress. Given the level of confusion and incompetence we see in many financial agencies, for example, it is long past time for the banks and the mortgage industry to use litigation to push back the more unreasonable mandates starting with Basel III and the Ginnie Mae risk based capital rule.
Important as the USSC decision on Chevron may be, the next shoe likely to drop will be even more profound in terms of limiting future federal regulatory action. We discussed this in an earlier comment ("At the Federal Reserve Board, It's 1927 All Over Again").
When President Donald Trump signs a revision to Executive Order 12866, all federal agencies will be compelled to “report up” to the White House on all matters where Congress has not provided specific directions. Originally promulgated by President Bill Clinton to improve the federal budget process, the revisions to EO 12866 was meant to be signed in the first Trump term.
Zombie Bank Stress Tests
Although it is encouraging to see the courts finally reclaiming their prerogatives from the progressive regulatory mafia, don’t expect rational action coming from Washington anytime soon. We should remember that the US used a policy of explicit currency inflation to augment the economy in the decades leading up to the Great Crash of 1929. The more recent experiment by the Fed in monetary expansion has left the federal government with $36 trillion in debt and a banking industry that is visibly insolvent. Don't hold your breath waiting for anybody in the financial media to ask about zombie banks.
One of the signs that our society is a bit delusional is the fact that we can talk endlessly about living wills for large banks as though it were even possible to avoid a public bailout in the event of default. Taking the GSEs out of government conservatorship is another example of magical thinking. Meanwhile, the US banking industry is insolvent to the tune of -$1.3 trillion at the end of Q1 2024 (“Q2 2024 Earnings Setup: JPM, BAC, WFC, C, USB, PNC, TFC”).
Keep in mind that the eye-watering negative capital number is just from mark-to-market losses on securities. The average yield on the several trillion in bank owned securities is just 3%, which implies a M2M discount of 15-20% from par. The average cost of funds in the banking industry is 2.5% vs total assets. Overhead expenses run about 2.3% of total assets annually. Do the math. Bank's need yields above 5% to cover their costs.
Source: FFIEC
Like the currency inflation and financial speculation of the early 1900s, the Fed bank stress tests are another sign of magical thinking in Washington. Even though the industry is insolvent on a M2M basis, and even though losses from CRE could cost trillions of dollars in losses to developers, REITs and banks, the Fed has given most banks a "pass" on stress tests. This means higher dividends and stock repurchase programs, but not nearly at the levels seen five years ago.
Source: FFIEC
How can the Fed can give the industry a pass based upon a “stressed” scenario created by an economist, when the credit markets suggest trouble ahead for banks and nonbanks alike? Good question. Goldman Sachs (GS) analyst Richard Ramsden, for example, noted that the Stress Test results “were broadly worse than expected for the banks.”
Ramsden explained that the year-over-year change in results was largely driven by banks generating much lower pre-provision net revenue (PPNR) during the test period. For the largest banks, Bloomberg reports, PPNR fell by 9% year-over-year. The table below shows Q1 2024 stock repurchases by the largest banks as a percentage of Common Equity Tier 1 (CET1) capital.
Source: FFIEC
One reason that banks might generate less pre-provision net revenue in the future is that the yield on bank owned securities is abysmal. It will take years for the average yield on bank owned securities to crawl up to 4%. The only way many banks can survive is to swap some of the eventual upside on these low-duration securities for cash today. But no true sale please.
Keep in mind that bank regulators and the major audit firms have for years been quietly softening rules for delinquency to mask the truly gnarly state of credit for low-income borrowers and businesses. Bank regulators and housing agencies have contributed to this dumbing down of credit measures.
Mortgage Credit
Source: MBA, FDIC
Think about the default rating of the bottom third of households post-COVID. Some progressives think you can just ignore low income, the cause of low credit scores and rising loan defaults, and just talk and talk about helping low income families. The solution to low scores and high default rates is higher income. Our educated guess is that bank default rates are understated by a third due to loan modifications for consumers and business.
Of note, Bill Moreland at BankRegData has recently introduced an Adjusted Coverage Ratio which modifies the standard Coverage Ratio by adding in 'Performing' troubled debt restructuring (TDR). Love it. Before Marty Gruenberg left the building at FDIC, we suggested to our favorite agency that they ask the FFIEC to include some type of credit risk transfer metric by loan category type. We’ll see. The chart below shows the commercial real estate (CRE) concentration ratio for all large banks.
Source: FDIC/BankRegData
Even as the Fed waives in the banks in the latest stress tests, credit is growing more and more opaque. There are a lot of “performing” loans in the banking system that are really modified loans that have essentially defaulted. Call them zombie loans.
Such is the level of political fantasy in Washington under President Joe Biden that delinquent borrowers can be modified multiple times, and fail each time, yet still be shown in the loan portfolio of a bank as “performing.” Likewise defaulted commercial borrowers are being modified to varying degrees to avoid foreclosing on a property that nobody really wants.
Part of the reason we think that the Fed and other agencies need to address the issue of unrealized mark-to-market losses is liquidity. When a bank has more and more assets that are trading at a deep discount to par, that discount becomes a current debit against capital. When we then face credit issues that force us to provide forbearance to borrowers, the bank becomes even less liquid. Because the impaired, modified loans pay less or not at all, and cannot be sold anywhere near par, the solvency of the bank is damaged.
Ultimately, whether a bank faces a loss on a low-yielding security or carries a zombie loan on the books as performing, the result is the same. The bank receives less cash and it holds assets that cannot be sold for face value. We suspect that a significant portion of the $13 trillion in total loans and leases on the books of US banks is impaired. Just in the world of consumer mortgages, there are hundreds of thousands of borrowers in the system who have been modified multiple times and now are heading to an eventual resolution.
As we noted in an earlier piece (“Capital Confusion at Ginnie Mae & Mortgage Servicing Rights”), the delinquent consumers rarely go through to foreclosure and most often sell the house and pocket the surplus above the loan balance. As and when home prices soften, then the cost of default will again become positive as it is today in commercial and multifamily credits. The only real question is why the Fed is unwilling to tell banks to retain capital rather than allowing increased dividends and stock repurchases.
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