Last week the Federal Reserve Board made public the annual stress test results, a financial media circus that celebrates the bank stress test popularized by former New York Fed President Timothy Geithner.
The Fed essentially confirms what we already know, namely that banks have largely suspended share repurchases and at some institutions are looking at limits on dividend payouts.
Banks had been conducting stress scenario analysis since the 1990s, of course, as part of the Basle process. The Geithner stress test of a decade ago was about perception, that is, confidence. It worked and the Fed tests went far to restoring confidence in banks. The subsequent iterations, however, have achieved little measured by clarity on risks taken by banks and the resulting Fed bank supervisory policy.
All together share repurchases and common dividends were worth over $300 billion in 2019, but it is likely that many years will pass before investors see such cash returns on capital. To remind one and all what 2007-2015 looked line in terms of earnings, see the chart below.
Indeed, we’d not be surprised to see most of banking industry income in 2020 consumed by credit provisions (as opposed to actual losses).
Fed Chairman Jerome Powell said back in April that he saw no need to put limits on bank dividends, but that position is evolving rapidly.
Meanwhile, the cacophony of nonsensical double speak from the FOMC drones on and on.
Several Fed governors have taken to referring to banks as a “source of strength” to the US economy, a uniquely Neoclassical-Keynesian synthesis. Governor Lael Brainard commented in her dissent to the stress test results: "This is a time for large banks to preserve capital, so they can be a source of strength in a robust recovery."
In fact, it is the shareholders of banks that are supposed to be the source of strength to the insured depository institution. In the 19th Century, bank shareholders often had double liability and, upon call, could be required to provide new money equal to their original investment in the bank.
Cutting dividends is the modern-day equivalent of double liability bank shares circa 1880, for the simple reason that the Fed dares do no more. But as we've noted before, loss absorption is about earnings more than capital. Recall that much of the loss provisions put aside in 2009 and 2010 were recovered back to income in subsequent years.
Ian Katz of CapitalAlpha Parners in Washington writes that the Powell pirouette on bank dividends is not just about share repurchases. “In fact, the more common view among sell-side analysts is that at least one or two banks will cut their dividends, with Wells Fargo (WFS) and Capital One (COF) the most frequently cited.” Remember, though, that the folks at the Fed are making this up as we go merrily along.
In today’s market, we see The Federal Open Market Committee (FOMC) brazenly manipulating market rates as though they could determine the economic outcome.
By turning market prices such as federal funds into government targets for policy goals like employment, the central bank's sole effective mandate, the Fed destroyed the ability of markets to correctly price risk.
The sad truth is that the Fed is completely reactive at this point, unable to fashion an exit from years of massive open market operations. The greater good, from the FOMC’s perspective, is maintaining the access of the US Treasury to the debt markets.
Ludwig von Mises wrote, “Once society abandons free pricing of production goods rational production becomes impossible. Every step that leads away from private ownership of the means of production…is a step away from rational economic activity.”
Of course, the Fed should provide guidance on share repurchases and dividends, but banks have already figured this out for themselves. Indeed, banks are going to be issuing new equity for a while and in large quantities. But with the Fed, OCC and FDIC busily issuing regulatory guidance to counteract the impact of the FOMC adding almost $3 trillion to the banking system’s liquidity in mere weeks, the investment situation in the banking market does seem a bit surreal.
Think of the spectacle. Banks and corporate issuers are now forced to raise capital at distressed valuations, this after spending much of the past decade repurchasing shares at higher and ever more ridiculous price levels. Investment advisors and analysts must fashion some reasonable explanation of why this is good. Shareholder value will be diluted more and then some more.
And who do we thank for this blessing? The FOMC.
By manipulating the price of credit, the FOMC set the stage for the dilution of bank shareholders. In fact, last Monday we kicked out our remaining bank common in U.S. Bank (USB) and moved higher up the capital structure into some preferred. As we told Melissa Lee & Co on CNBC's Fast Money, we don’t want to get our feet wet. But, of note, USB is still trading above book value as of Friday's close.
Just as COVID19 is surging in the South, the credit loss picture facing US banks is also showing signs of monstrous growth. We are already at 2009-2012 levels of delinquency in commercial real estate and the proverbial flood waters are continuing to rise. Intex had delinquencies in commercial mortgage backed securities (CMBS) at 7.5% at the end of May. Try double digits in June easy?
In May, the top-ten delinquent CMBS issues totaled $7 billion in loans on retail and hotel properties including Mall of America ($1.3 billion), Courtyard by Marriott Portfolio ($415 million) and Innkeepers Portfolio ($755 million).
As we note in the new edition of The IRA Bank Book for Q2 2020:
“The chief risk to the system, as it was in the 1990s, comes from commercial real estate and corporate exposures rather than residential mortgages. A sharp decline in rental collections in commercial office space and retail locations is hurting asset valuations. Existential changes in business usage and consumer behavior are likely to impair evaluations for many commercial buildings.”
So ask not whether bank dividends are safe, especially with 2009-2012 in mind. The answer to that question is less and less likely. Better instead to think about the mid-1930s, which resulted from a decade of financial boom. A lot of very real losses in coming years will be caused by the period of easy money engineered by the FOMC and the Fed’s staff, magical people who truly think that they control the US economy.
The New York Review of Books recalls in a wonderful review of “The Marginal Revolutionaries: How Austrian Economists Fought the War of Ideas” by Janek Wasserman:
Hayek likewise rejected the idea that society could be planned. He saw the economy as a spontaneous order. In his 1937 essay “Economics and Knowledge,” Hayek argued that central planning was bound to fail because planners lacked necessary objective knowledge. Only the market, which Hayek later called a “subtle communication system,” could solve the problem of resource allocation, since it reflected “the spontaneous interaction of a number of people, each possessing only bits of knowledge.”
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington.
This piece does not necessarily reflect the opinion of Hedgeye.