In this analysis, we drill down on the FRB’s findings about large-bank mortgage risk in the stress-test results released on Thursday. These results are the most fundamental driver of bank strategy because they establish the quantitative thresholds by which banks either pass or fail. Banks can adjust their planned capital distributions in the week leading up to tomorrow’s FRB decision about capital distributions and some banks may still fail this acid test then for only qualitative reasons. However, the capital adequacy required to handle the severely-adverse scenario drives lending decisions year over year as each large bank realigns its exposures in advance of what it expects next year based on the stress test before it. What this one tells us is that banks in 2017 and beyond will arbitrage residential-mortgage risk to game the Fed – that is, where the Fed thinks a mortgage portfolio is less risky than the bank believes, risk will rise as permitted within model parameters to post return without forcing a capital hike.
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