fedfin

The phrase “paradigm-busting” has become a cliché, but the construct in Thomas Kuhn’s landmark 1962 book on scientific revolutions is an illuminating way to understand the pandemic.  We know it has broken the global paradigm of health, food, and economic security.  But the U.S. has another paradigm:  a financial system constructed of private companies that win or lose due not just to managerial success and market opportunity, but also and often principally to adroit arbitrage of the porous boundaries between private finance and government backstops.  In 2020, we have not only a macroeconomic crisis unparalleled since 1929, but also a financial-market realignment unseen even in the midst of all the Fed’s 2008 interventions.  In its wake, we could well have a new financial system consisting principally of a gigantic central bank, enormous quasi-private utilities, and narrow banks operating on short leashes serving these mighty masters.  This may not come by act of law so much as by force of nature – by the time the economy begins a strong recovery, the Fed may have grown so big no one can deconstruct it, banks may have grown so unpopular that no one wants them the way they are but bankers, “shadow” banks will have been dragged into disinfecting sunlight, and bigtech companies grown still more powerful will dominate any financial sector they select.

Let me take each one of these portents in turn.  First to the Fed, which will soon have at least $10 trillion on its balance sheet in concert …

Responding to a request from G20 heads of state in 2019 and renewed focus earlier this year, the FSB has outlined its approach to global stablecoins (GSCs) of which Facebook’s Libra is the most prominent, if troubled, example.  The governing body of global banking, securities, and insurance regulators has identified many issues of initial concern with Libra  and other GSCs – e.g., liquidity risk governance, how stablecoin values will be derived, reserve requirements – but left many others – e.g., standards for wholesale GSCs, impact on global finance and emerging market economies (EMEs), and monetary-policy impact – largely unaddressed.

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As with its concession yesterday to servicers, FHFA’s bow today to originators with loans in the pipeline is a very limited-time offer which must be read carefully before opening.  We do not think it spells the end of conventional securitization, as some has posited, but it reinforces our view that FHFA, Treasury, and the Fed want the mortgage system of the future to rely on counterparties with balance sheets to fall back on.  Yesterday, the GSEs provided a bit of liquidity and today they are on the hook for some capital; tomorrow, the mortgage system will have weeded out many players who needed far more of both.

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In 2018, Joe Nocera interviewed me on nonbank mortgage servicers, the risks they ran, and the rout that might result.  In response, he and I received furious calls, including one from a top nonbank executive proclaiming that I had badly misstated his company’s resilience.  I went to see how much capital his company posted, but couldn’t find it because the company is privately held.  Questioned on this critical point, the executive stoutly insisted that his mortgage firm had loan-loss reserves and was thus well-capitalized.  Questioned about the difference between loan-loss reserves (then set under the generous incurred-loss methodology) and equity capital, the officer gave no ground beyond complaining that bank regulation is too literal-minded.  Mortgage servicing isn’t the only sector that ran afoul of bank regulators by refusing to accept even a bit of post-crisis regulation, but so far it’s about the only one not yet bailed out – oops, given liquidity support – by the Fed.  Succor may soon come also for nonbank servicers, but servicers need to know why it’s taken so long now if they hope to get funds flowing while they’re still able to receive them.

When the Financial Stability Oversight Council late last year presaged the nonbank-servicer systemic risk now upon us, vilification was again in vogue.  Now, as FHFA Director Calabria rebuffs requests for a servicer liquidity facility, he is the target of the type of personal attack President Trump has sadly made de rigueur.  Mr. Calabria is wrong about servicer liquidity …

In the course of crafting the CARES Act, Democrats in the House and Senate sought so far unsuccessfully to launch the U.S. quickly into providing a U.S. central-bank digital currency (CBDC) in which banks act as agents for the Fed, gathering deposits and then passing them on to the central bank.  Although the initial impetus for including this in the COVID packages was as a way to speed federal payments to households and small businesses, the Senate version in fact brings the Federal Reserve System fully into the deposit-taking fabric of U.S. financial intermediation, with legislators planning to pursue the measure both in connection with the U.S. COVID response and on its own.  The bill does not address whether the Fed would also make loans, how banks would do so without these deposits, the future of U.S. finance without bank financial intermediation, or implications for monetary policy and macroeconomic growth.

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We noted yesterday that the interagency IFR deferring appraisals and evaluations actually puts lenders in a most difficult position.  Here, we disentangle them to conclude that portfolio lenders face a sudden, severe regulatory risk sure to drop portfolio lending below already sharply-reduced crisis levels.  HELOCs, seconds, and other equity-extractors also face even greater obstacles that, in the near term, could reduce debt-service capacity at some households for non-mortgage debt in ways that, if sustained during a prolonged crisis, create contagion risk for mortgage repayment when forbearance ends.  Mortgage credit enhancement could be more welcome than usual at big-bank lenders.

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Federal Financial Analytics, Inc.

April 14, 2020

Early Warning: Structure of Fed Windows Will Crash Current Finreg Construct

After the rescue comes the retribution. Near-term targets abound based on early winners and losers from the Fed’s munificent rescue operations. This update names names.

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In the midst of a crisis, one minor casualty is robust political-risk forecasting. But, based on in-depth analysis to date and the blips on our early warning radar, it is already clear that the following financial-sector entities are in the red zone:

• Big Banks: This isn’t so much because they’ve done anything wrong – indeed, the largest banks have been astonishingly resilient due, as the Fed likes to say, to all of the pre-2020 rules. Even so, big banks will still get slammed because 1) they always do; 2) the differences between them and the rest of “Wall Street” are indistinguishable from both a market and political perspective; and 3) they’ve grown even more gigantic in the course of COVID, leading to still more calls to break them up and limit the monolithic control some believe they have been exerting in the course of disbursing all the Fed’s trillions and implementing the PPP.

The Fed: As a recent Karen Petrou memo noted, the Fed’s taken on tremendous fiscal and political risk just by setting up new credit-allocation and liquidity facilities. As it becomes more and more clear that high-risk sectors are profiting thereby even as small towns …

The FDIC has proposed to formalize the requirements it says have generally governed parent companies of industrial loan companies (ILCs) and other non-traditional insured depository institutions (IDIs) owned by companies exempt from FRB supervision at the parent level.  Doing so would codify practice, provide the FDIC with grounds for parent-company enforcement actions, and better ensure the willingness of parent companies to serve as sources of strength for ILCs and other special-purpose nonbank banks.

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Another day, another $2.3 trillion from the Federal Reserve.  I’ve been asked ever since the Fed first opened its enormous windows on March 23 if this all brings the Fed too far into fiscal policy and, if so, then what.  The answers to these questions are first yes – the Fed is now a fiscal agent – and then that a lot could go wrong.  When it does, Congress and President Trump will of course blame the Fed, not themselves.

In the CARES Act, Congress reserved for Treasury the direct lending to manufacturers from which the Fed is barred under even the most creative readings of the Federal Reserve Act.  This amounted to $46 billion.  The remaining $454 billion authorized for Treasury is to backstop Fed operations that its Chairman and the Treasury Secretary proudly announced would lead to at least $4 trillion in new credit.  “Main Street” and municipal finance are singled out as must-dos, but the Fed was also cut loose to print trillions to salvage any other financial sector it and Treasury favor.

If the Fed hadn’t volunteered to intervene with Treasury’s blessing (not to mention billions), then Congress and the White House would have had to take the fall for the CARES’ four trillion.  There are two ways the U.S. – like the rest of us – gets to spend money:  on and off the balance sheet.  Congress can tax and spend – actions that show up in the deficit – or, as it’s now …