Thursday 25 June 2020 - the Fed paints itself into a corner.

Thursday, 25 June 2020, was an ominous day and may have marked the start of what might be a step towards another drop of chimney money and government bond issuance, and/or a restructuring of credit, and the banking system itself.

A few things happened on Thursday which show why Donald Trump’s sacking of Janet Yellen was not a great idea, and why Jerome Powell’s Fed is now painted into an uncomfortable corner.

Firstly, the “we can’t afford another GFC” Volcker Rule was redefined and effectively neutralised. Risk management 101 - bye bye.

Secondly, banks were allowed to redeploy capital that had been applied to margin provisioning for derivative trading amongst bank affiliates. This was on top of a reduction in the Fed required reserve ratio which I wrote about last week, and the ongoing guarantee from the Fed to do, and buy (i.e, bail-out) whatever it takes.

Thirdly, the Fed published the results of its annual bank stress test which while OK under the base case scenario, included potential COVID-19 recessionary scenarios with adverse outcomes. For the 33 banks tested, loan losses were estimated at $550 billion under the severely adverse scenario.

That number includes $85 billion of trading and/or counterparty losses from the 11 firms with large trading and private equity exposures, plus losses from the largest counterparty default component at the 13 firms with substantial trading, processing, or custodial operations. But the $85 billion only measures losses under the older and stricter Volcker Rule - not the new one.

In the event an elongated first wave, or second wave of COVID-19 were to produce the Fed’s severely adverse scenario, it seems that banks could cost the Fed/Treasury as much as, if not more than the TARP bail-out of 2008/2009. And that’s on top of the current bail-out under the Main Street and other lending programs - which already equals the GFC bail-out.

That’s why Fed governors probably won’t think twice about re-tasking the Death Star for another multi-trillion blast of welfare. It’s got to be all in if the virus persists, and that will have major implications for bond prices, interest rates, flows and liquidity.

More below.

Paul Volcker designed a ‘risky covered fund investment lock-down’ for banks, to avoid another GFC.

On 3 June 2018, I wrote about Donald Trump’s scheme to rip up the Volcker Rule, in a blog,“Volting Volcker”

In brief, the Volcker Rule is embodied in 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act and was specifically designed to prohibit insured depository banks and institutions from proprietary dealing in risky assets and acquiring, investing in or sponsoring “covered funds” i.e., private equity and hedge funds.

It was sponsored by then Chair of the Fed, Paul Volcker, in response to the crazy risk taking embedded in the banking system that preceded the GFC.

Many years later and after a lot of bond buying and accommodative rates, Janet Yellen thought it was time to remove the punch bowl, and she was right, but after a few rate hikes and only 9 months of balance sheet run-off, Yellen was replaced by Jerome Powell. Powell came in with seemingly hawkish tendencies, but on 30 January 2019 executed an unexpected back-flip, pausing rate hikes and the run-off (much to the approval of Donald Trump).

From there, interest rates were taken to zero, reversing the Yellen effect, and ramping up equity and bond markets. Powell’s balance sheet is now $7 trillion pregnant and contemplating either twins, or triplets.

Far from de-leveraging the world and central bank balance sheets, the opposite has been the case, and since the GFC and February 2020, at least another $80 trillion of new credit has been created/issued globally.

Nonetheless, back in the day when the financial system was teetering as a result of greedy sub-prime pedaling institutions, the Volcker Rule was seen by the Obama Administration as a necessary risk management/stabilisation tool to reign in the banks and avoid another GFC.

Not any more.

On Thursday night, and under the guise of clarity and efficient compliance, the FDIC voted to neutralise the Volcker Rule by redefining certain aspects.

Three directors voted for, and one against. Martin Gruenberg was the sole dissenter and you can watch Gruenberg’s reasoning here.

New definitions around what constitutes proprietary trading and a covered fund mean that the largest and most systemically important banks in the U.S. can once again engage in risky trading and relationships, as they did in 2008 prior to the collapse of Lehman and the other 22 banks which had to be bailed out.

And get ready for even more bank fuel to be pumped into hedge funds, PE/VC funds and other big end of town covered funds, as banks start to inflate already towering credit stacks.

Had the Fed’s severely adverse scenarios factored in an impotent Volcker Rule, I wonder what the $85 billion in trading losses might have looked like.

The current round of stress tests included U, V & W scenarios - but a smack on the wrist allows capital depletion.

On Thursday, the Fed stress tested the sample banks and concluded they remained strong.

However, a sensitivity analysis was carried out based on U, V and W shaped recessions, assuming unemployment rates in a range of 15.6% to 19.5%.

As a result of the analysis, the Fed believes all banks are strongly capitalised under the V scenario, but some banks would approach minimum capital levels under the U and W scenarios, and losses in the aggregate were forecast at ~$550 billion.

Even in light of the sensitivity analysis, the Fed offered little more than token hand-smacking.

It is temporarily halting buybacks for the third quarter and temporarily capping (but still allowing) dividends based on second quarter levels, and subject to earning sufficient income to cover the divy.

That’s unlikely to achieve much, and in what is not a common thing to see Governor Brainard broke ranks and published her opposition. Here’s an excerpt from the Fed’s website:

“The strong capital buffers associated with Dodd-Frank reforms have enabled banks to play a constructive role in responding to the COVID-19 pandemic. It is a mistake to weaken banks' strong capital buffers when they are clearly proving their value in the first serious test since the global financial crisis. This is a time for large banks to preserve capital, so they can be a source of strength in a robust recovery. I do not support giving the green light for large banks to deplete capital, which raises the risk they will need to tighten credit or rebuild capital during the recovery. This policy fails to learn a key lesson of the financial crisis, and I cannot support it.” Lael Brainard, Fed Governor.

Moral Hazard for US banks stoked by the Fed and FDIC.

In the event an elongated first wave, or second wave of COVID-19 were to produce the Fed’s defined U or W scenario, it seems that banks could easily cause another GFC bail-out requirement - at least.

I say at least because the Fed’s unemployment numbers might be conservative under a continuing virus scenario and because as noted above the $540 billion loss estimate only factors in the $85 billion in trading losses that might have occurred under the older and stricter Volcker Rule, not what might be expected under the new impotent version.

In addition, the Fed has committed to buy fallen angel or zombie bonds, i.e., low to below investment grade paper from challenged corporations, and in those cases there will be no corresponding asset.

Finally, it’s the convergence of all of the ‘Thursday 25th” and lead up policies which are creating a perfect storm of bank risk and moral hazard that warrants mention today.

With banks told to get off the bench and lend like there’s no tomorrow, plus trillions in excess reserves on the Fed’s bench, and with the Volcker Rule shredded at a time when COVID-19 could produce a severely adverse outcome, and with QE and Guarantee Infinity already in play - it’s fair to say that the White House, Fed and FDIC have set the scene for the largest banking system moral hazard that we’ve seen since the GFC.

We don’t yet know how these actions will eventually play out, and we all hope the COVID-19 wave crashes on a distant shore far away from the non-physically distanced crowds.

But, in the meantime we should get ready for more chimney money and more bond issuance (in competition with flows from asset purchases), and way more risky trading and investment in covered funds from big banks recently let off their leash - at a time when already towering credit stacks are leveraged to extreme levels.

And, perhaps that’s where some of the $3.2 trillion in excess bank reserves sitting on the Fed bench might be headed. Hope not.

Stay tuned.

Mike.

NextLevelCorporate is a leading independent strategic corporate advisory firm with a multi-decade track record of delivering transformative corporate finance solutions, in and out of Australia.