DFAST’s Faustian Bargain: Capital/Loss Iceberg
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|June 28, 2016|
The previous Viola Risk report focused on the trending similarities between the BREXIT UK referendum’s “Leave” vote outcome and subsequent market gyrations and the DFAST U.S. bank stress test results (see: BREXIT & DFAST: Breakfast of Champions for Stakeholder Stack). The report’s takeaway was that just as the BREXIT outcome was poorly projected by the debt/equity markets & risk managers, leading to the recent market instability; the latest DFAST stress test results have also been misunderstood and could lead to another markets off-balance situation causing bank markets volatility in the intermediate term.
Viola believes that the regulatory takeover of the banking/financial markets by the so-called “better educated/academic/impartial supervisory class” is still being worshipped by most all of the Stakeholder Stack (composed of debt & equity investors, risk managers and regulatory supervisors/examiners). So, the bond markets, stock markets, counterparty risk management worlds continue to take their marching orders from the “regulatory edict carpet bombing” supervisory “Establishment” class. The Fed’s latest edict is in the form of the annual “Dodd-Frank Act Stress Test” version 2016 that was released last Thursday. As we experienced with the onset of the “2000s Financial/Credit Crisis”, risk catapulted out-of-control during that 2007-2009 time-frame which severely punished bondholder/stockholder valuations, and led to ultra-enhanced risk management procedures on the counterparty risk side as well.
While the Federal Reserve “Wizards of Oz” may be waving the checkered flag declaring all stress-tested U.S. banks as winners, we are not so convinced. Instead, risk build is rising especially in the Commercial real estate/Credit card/Counterparty risk exposure management sectors. We are also getting more concerned with the Commercial & Industrial sector which is getting more risky and would add it as our fourth “C” concern, thus becoming a “CCC threat + C”. We believe that this “CCC + C” risk threat needs to be understood and monitored better. Especially before the “CCC + C” components rear their ugly hydra heads over the course of the next 12-18 months.
Iceberg Analysis: CET1 Capital Clears Hurdle For Most, Though A Good Many Below
According to Wikipedia, a major characteristic of an iceberg is that only one-tenth is visible above the sea surface. As anyone who watched the classic movie Titanic knows, the danger for the ship is beneath the seas rather than above it, and miss-calculating the threat can lead to catastrophic circumstances. Simply, that is where we disagree with the elitist supervisory stress test approach in that they declared DFAST victory as most all of the bigger more systemic banks are above the CET1 minimum well-capitalized threshold of 6.5% and even 8.5% by 2019 under the Basel III advanced approach.
Those passing-grade major systemic banks above the 2019 threshold include: The Bank of New York Mellon (11.2%), Citigroup (9.2%), Goldman Sachs (10.2%), Morgan Stanley (10%), and State Street (9.6%). Those that are close include JPMorgan Chase (8.3%), Bank of America (8.1%), and somewhat lower Wells Fargo (7.2%). Regional banks fall much further below the mark, many in the 6%-7% range including: BB&T (6.9%), Fifth Third (6.8%), Huntington (5%), KeyCorp (6.4%), M&T Bank (6.9%), and Zions (6.6%). Somewhat higher is PNC Financial (7.6%), Regions Financial (7.3%), SunTrust (7.5%), and U.S. Bancorp (7.5%). Comerica just misses the minimum at 8.3%. Auto lender Ally is much below at 6.1%, while foreign banks such as BBVA, BMO Financial are in the 6-7% range. So really, even on the capital front, many regional banks and some big banks and a finance company fall short of the 2019 8.5% threshold.
Iceberg Analysis: Projected Exposure Losses Lurking Below The Surface
Our Iceberg Analysis will focus on the severely adverse scenario since this incorporates the fat-tail risks that the Fed believes can occur in the projected 2 year timeframe. While less likely, given the recent BREXIT volatility that could be characterized as a 6-Sigma fat-tail event, this set of circumstances cannot be ruled out. With the Fed’s ability to incorporate data not available to the public, we believe this is a good stress test set of assumptions and outcomes. Our big beef is with the Fed’s interpretation of the outcomes and trends. The trends in the loss development and the concentration of those losses in a limited number of banks is our main concern, which the Fed seems to brush over.
From the Severely Adverse Projected Losses table, it is clear that the biggest loss category is to trading/counterparty losses at $113 billion. These losses are highly concentrated to the big trading banks and brokers (BAC, C, GS, JPM, MS, WFC: $110B) with a minor concentration to the two big processing banks (BK, STT: $3B). A method to measure a banks susceptibility to counterparty/trading losses is their concentration to net revenues. On that front the more diversified conglomerate banks with retail and wholesale banking activities have lower net revenue exposures to these capital markets threats. So, from lowest exposure to net revenues to highest, Wells Fargo is the lowest at 19%, while the higher exposed are Citi (38%), Bank of America (44%), and JPMorgan (50%). Still more disturbing are the pure brokers who have exposures much higher than 100% of net revenues including Goldman Sachs at 149% and Morgan Stanley at 167%.
The takeaway is that the trading/counterparty markets continue to be much too concentrated with the pure brokers highly at risk to a severely adverse markets meltdown. These conditions should be highly troubling to the Fed and not lead to is blasé attitude towards it. Our solution would be for the big brokers to dramatically reduce these concentrations more in-line with the big banks. Part of this is via off-loading these exposures to other banks that are willing to conduct these activities such as the largest regional banks including U.S. Bancorp, PNC, BB&T and SunTrust all of which have expanded their capital markets activities over the last several years.
Another area is to expand the activities of the exchanges and other clearinghouses and other electronic trading platforms to drastically reduce this huge potential counterparty risk to Goldman Sachs and Morgan Stanley stakeholders. Still, we would like to see the exchanges and clearinghouses included in the DFAST/CCR stress tests to see the financial system’s exposures to those emerging super-counterparties. Those entities would include: the CME, ICE, DTCC, The Clearing House Payments Company LLC, CLS Bank International, Fixed Income Clearing Corp., National Securities Clearing Corp.
Loan Losses – Banks Most Exposed & Where
On the traditional loan exposure front it is clear that the mortgage mess of the mid-2000s has dramatically subsided as a potential mega loan loss concern. As the table above displays, 1st mortgages ($38B) and jr. mortgages ($32B) rank towards the bottom of the loss categories. In its place, commercial & industrial (C&I) losses ($93B), credit card losses ($92B), and commercial real estate losses (CRE) ($52B) have vaulted to the top.
In coming reports Viola will outline in more detail our emerging concerns surrounding these categories. Briefly, credit cards are one of the only major lending areas where banks can make attractive operating returns and margins. Given the historically low interest rate environment, there has been refocused efforts to extend credit card loans to bank retail customers and commercial card users. With the demographic evolution of the “millennials” as the chief spenders in the economy, this new class of borrowers is untested as to their payment behavior.
So given the debacle that emerged with subprime lending and other non-prime borrower difficulties, we believe that the banks could repeat these same mistakes in the credit card arena. Low credit losses as compared to outstandings now could jumpstart higher in a matter of 9-18 months if “millennials” take advantage of tantalizing card reward point offers and overdose on credit card debt making repayment more difficult. Banks with high credit card loss content include Citi ($21B, 14% of loans), Capital One ($18B, 19.3%), American Express ($6.8B, 9.5%), and Discover ($7.6B, 12.8%).
C&I: More Than Meets The Eye
The commercial & industrial category is a bit more heterogeneous with big banks focusing on leveraged/syndicated arranger lending with some middle market lending as well. Regional banks are more exposed to middle market lending across smaller geographic regions whether the industrial mid-western U.S., the service sector and manufacturing in the southeast & Texas, and tech lending in California and the Pacific Coast region. Just as plummeting oil prices has slowed economic growth in Texas and parts of Colorado, Louisiana, Oklahoma and North Dakota, idiosyncratic regional economic risks can impair banks across various regions. Big banks with high C&I loss content include: JPM ($13.7B, 9.4%), WFC ($12B, 3.3%), and BAC ($10.1B, 5%). Citi is at the low end of range at $8.8B (5.5%). For regional banks the higher loss content includes: USB ($6.4B, 9%), PNC ($4.7B, 6.7%) and STI ($2.2B, 4.7%).
Commercial Real Estate: Bubble Bursting Brewing
Commercial real estate has been on a roll since the end of the credit crisis and has been particularly robust in urban, walkable areas popular with the young millennial working class. Even empty-nester baby-boomers have been escaping the suburbs to frolic and feast in the cities where some are closer to their workplace and eliminate the commute. New York City & Brooklyn, San Francisco, Boston, Washington DC, Miami are among the areas to see the most robust growth. Lagging cities like Philadelphia, Chicago, Los Angeles, Seattle have seen more traction of late. Foreign buyers reinvesting new windfall riches and hiving away their gains from more restrictive governments in China, Russia, African nations and parts of Asia and Latin America have also added to the froth.
But the incredible CRE money machine may be slowing to inverting as BREXIT concerns add to other signs of a slowdown in global economic growth. Just as there were other cycles in CRE, we are overdue for a correction and there are various signs including percolating vacancies, slower to no rental growth have advanced to the front pages of the newspaper and twitter feeds. Big banks with high exposures include: WFC ($10B, 7.4%), BAC ($5.7B, 7.7%), and JPM ($4.5B, 4.6%). USB leads regional banks at $4.2B (10.5%) with M&T and PNC in the $2B range (6.8%, 6.6% respectively).
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