Blain’s Morning Porridge June 27th 2024: Bank Stress Tests or a Chocolate Tea Pot – which is more useful?
“Everyone has a plan until they get punched in the mouth…”
The market is distracted by the up, down, shake it all about noise in Tech. Watch banks! The US Fed passed all 31 major US Banks in its annual bank stress test. I can’t think of anything that could scare me more…
While stock markets fret about the number of chips that might be required to maintain the momentum of the AI everything-rally (clue; the same number as angels standing on a pin-head), and people brace themselves for tonight’s snore-a-thon between two political lightweights way beyond their sell-by dates (expect a cataclysm of rudeness, interruptions and insults), you need to look deeper for the real issue in markets… complacency.
We have been here before:
- Buried in the FT this morning is a comment how the senior tranches of European Asset Backed Bonds (securitisations) backed by UK shopping centres, German housing units, and French office space are all under pressure, and about to be hit with losses as the global CRE crisis (too many of the wrong buildings, for optimists; not enough of the right ones!) starts to bite. Gosh, who knew a shopping centre in Dumfy (Dunfermline as it’s properly called; famous for Andrew Carnegie and Gordon Brown (God bless him)) would be worth the square root of unrequited love?
- There is a brilliant story on Bloomberg about the final 72 hours of doomed not-a-Family Office/Hedge Fund Archegos. The writers reconstructed the timeline from tapes, messages and emails and what emerges is a tsunami of confusion, mistakes, chaos and a stream of garbled deflection between the Fund and Global Investment Banks as reality sank the fund. (As always, when caught in a sh*t-storm, Goldman Sachs came up smelling of roses, having received instead of paid a wire transfer for $500 mn from the fund, they refused to hand it back or make the original payment for $500mm the fund has been expecting, giving them a convenient $1 bln cushion against the losses inflicted across the rest of the street!)
- Yesterday, the Federal Reserve handed out end-of-term passes to all 31 major US banks after its annual “stress-tests.” It modelled a hypothetical 9-month recession under which unemployment soared to 10% triggering massive credit card defaults, corporate failures, the stock market crashing 55%, a collapse in CRE by a further 40% plus a number of major Hedge Funds failing. Every bank passed with flying colours, prompting bank analysts to immediately call for the coming Basle III accords; more onerous and costly bank capital regulations, to be watered down, and bank dividends to be increased. (Apparently, it doesn’t matter that three US banks collapsed last year as higher interest rates triggered liquidity crises that sank them in hours… not 9 months.)
- On Bloomberg, JP Morgan was quoted saying the Fed’s stress test result for the bank in the hypothetical downturn was more optimistic than their own. “Optimistic” is not a word you want be hearing in the context of possible banking issues.
Banks worry me. I know banks. They are not half as clever as they think they are.
I spent the first half of my markets career as a Financial Institutions Banker, winning occasional bank capital bond and pref mandates for Bear and then HSBC. (My greatest contribution to the bank capital industry was drawing up a pretty spread-sheet explaining the subordination ladder, Tier 1, 2 and 3 capital, and how these related in spread terms. It was very pretty.. and highlighted why banking’s gain was the art-world’s (very) small loss)
However, the real skill in being an expert in the arcane rites of bank capital is gaming the rules through capital arbitrage.. laying off and transforming risk via financial engineering. Central banks kinda understood it was going on and were not happy. The pre 2008 Capital rules were made obsolete when the Global Financial Crisis changed everything. To ensure bond holders also suffered in future crisis, global central banks decided to flip the principles of subordination bottom over breasts through the introduction of “contingent capital” – COCOs, “the bastard stepchildren of deranged central bankers and desperate banks”, as I wrote at the time.
Since then we’ve seen Basle 2 and shortly, (maybe next year if the Shermans don’t pull out), Basel 3.. enormously complex rules on in what form and how much capital banks should hold against the risks on their books. And one of the biggest games in hedge-fundery remains the art of synthetic risk transfer to arbitrage the capital rules. “Show me a rule and I will find you a way to profit from it..” is how bank capital works in practice.
Central Bankers and Regulators are essentially reactive. Bank stress tests have been around since the last crisis, and were an attempt to be proactive. Sadly they have become a tickbox, giving investors a nod’n’wink that all is well and good in banks. Sadly… the reality remains: a) regulators plan to address the next financial crisis by understanding and planning to fight the last one, b) financial crises keep repeating, but no two crises are alike, and c) risk is not a constant, it is constantly changing dynamic.
“There’s now’t as safe as houses,” says the famous investment advice. History teaches house prices rise steadily over time. Until suddenly something happens and the housing market tumbles 50%. Every home owner is then busted by negative equity, which means they can’t borrow to pay off their other loans, which means their bank goes bust on credit card losses, triggering an unravel of synthetic risk transfer trades, a collapse in confidence in markets followed by a bunch of funds admitting their were 12 times levered and are now broke, neatly collapsing the rest of the banking and insurance sector, leading to global mayhem and destruction… and all because someone thought buying a house was a good idea…. consequences, consequences…
You get the drift…
Bank stress tests are fun. They are interesting. So is a game of monopoly. Do not mistake either for reality.
Three factors make bank stress tests meaningless:
- Consequences – you can set scenarios, but in the real-world unanticipated consequences make it impossible to fully model outcomes. No plan survives first contact with the enemy. See the Mike Tyson quote on the top this morning if you need it explained more clearly.
- Risk is dynamic – it can’t be destroyed, only transformed or transferred. It changes and does not go away.
- Banks die quickly not slowly. Liquidity crises kill banks swiftly. They don’t get 9 months to unravel positions from plentiful capital reserves.
- Confidence in banks is an ephemeral thing – it has a half-life measured in nano-seconds when it starts to go wrong, and when it goes critical it can’t be reversed.. witness Lehman and Credit Suisse. Decades apart. Both died because the market lost confidence.
Apologies for no porridge tomorrow. We are off to see the Olds in North Wales tomorrow, and taking She-who-is-Mrs-Blain for a birthday treat..
Out of time, and back to the day job….
Bill Blain
Author of the Morning Porridge
