Yves here. Former Fed Chairman William McChesney Martin famously said that the job of the central bank was “to take away the punch bowl just as the party gets going.” That line of thinking went out of fashion under Alan Greenspan. Now we have the perverse spectacle of the most bank-cronyistic regulator, the Office of the Comptroller of the Currency, berating the Fed for spiking the punch via overly accommodative monetary policy. But this isn’t the first time the OCC has played the unlikely role of the more responsible parent. In the runup to the crisis, it was the OCC that did some enforcement of the regulations on subprime lending, the Home Ownership and Equity Protection Act. The Fed was nowhere to be found.
By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Testosterone Pit.
Banks are again taking big risks, the same risks that helped trigger the financial crisis, and they’re understating these risks. It wasn’t an edgy blogger but a bank regulator of the Federal Government – the Office of the Comptroller of the Currency – that issued this warning. And it explicitly blamed the Fed’s monetary policy.
The report fingered the stock market’s “fear index,” the VIX, which measures near-term volatility of S&P 500 index options; and it fingered the bond market’s “fear index,” the Merrill Option Volatility Estimate (MOVE), which measures volatility of Treasury options. They have been flirting with, or hit all-time lows. VIX levels below 20, “and especially below 15” – it’s now below 12 – “suggest complacency in the stock market, which often has led to sustained increases in risk appetite and subsequent market instability.”
Complacency is at about the same level as it was in 2007. Back then, it was followed by “subsequent market instability” – a euphemism for the financial crisis. Reason? “The longer volatility remains low, the more likely investors are to chase yields to maximize returns, often selling options that expose them to losses if prices drop suddenly, or taking on increased credit risk.” As banks pile on these trading risks when volatility is low, something else happens:
Low market volatility causes banks to “understate trading risk”
First the culprit: the Fed’s “unprecedented monetary policy easing has resulted in sharply lower interest rates, higher stock prices, and lower market volatility.” That volatility is a “key factor” in how banks compute risk measures. When volatility is very low, something happens to the Value at Risk models that banks use to measure and disclose the risk of their trading activities:
Aggregate VaR has dropped significantly since the end of the financial crisis at the five largest U.S. banking companies with trading operations. While some of the VaR decline is a result of lower client activity and reduced bank trading risk appetite, the low-volatility environment is the primary cause of lower VaR. In a more normal volatility environment, one without sustained monetary policy accommodation by the Federal Reserve, bank VaR would be meaningfully higher. Thus, current VaR calculations may understate trading risk in the banking system.
I’m wondering if the folks at the OCC are still on speaking terms with their counterparts at the Fed.
But trading operations weren’t able to fill the holes opened up by the Fed’s low interest rate climate which compressed the interest rate margins by which banks traditionally generate their income. And so banks try to make it up with volume – by lowering underwriting standards and diving into riskier loans, like….
Subprime auto loans
Auto lending jumped 12.9% in the fourth quarter 2013 from a year earlier – the report uses data through December 31, leaving banks with $250 billion or 31% of outstanding auto loans. A mad scramble has ensued across the industry to lend to auto buyers. Deadbeats, no problem. Subprime auto lending is booming. Loan to value ratios are on average over 100% across the industry. Used vehicle LTV ratios are hitting 120% at banks (and 150% at finance companies!). Everything gets rolled into the new loans: title and taxes, aftermarket warranties, credit life insurance, and other fluff-and-buff, plus the amount buyers are upside-down in their trade-in. To bring the payments down on these monster loans, banks lengthen the terms. Average charge-offs have been rising. “Signs of increasing risk are evident,” the report notes dryly. Then it swings from retail to corporate subprime….
Ballooning leveraged loans accompanied by loosey-goosey underwriting:
Syndicated leveraged loan issuance reached a record high in 2013 as the search for yield in the low interest rate environment drove an increase in risk appetite across institutional investors such as collateralized loan obligations (CLO) and retail loan funds.
Ah, CLOs! They’re uncannily similar to subprime-mortgage-backed Collateralized Debt Obligations, the toxic waste that contributed to the financial crisis. But they’re backed by junk-rated corporate loans – for example, the “leveraged loans” that private equity firms use to strip-mine their portfolio companies. These overleveraged companies borrow even more money from banks. But instead of investing it in productive assets to create income with which to pay off the loan, they pay it out as a special dividend to the PE firms. It pushes the company deeper into the hole, lines the pockets of the PE firm, and saddles the bank with a dubious asset. The bank then packages these leveraged loans into a lovely CLO and unloads it to institutional investors and retail funds. A business that is booming at record levels, the OCC lamented.
M&A loans are part of the leveraged loan miracle. Last year, they “achieved the highest issuance volume since 2007” – just before the financial crisis brought down the house of cards. The average total-debt-to-EBITDA multiple for leveraged loans increased to 4.7X, the highest, you guess it, since 2007.
Hence the toxic mix: higher leverage, lower yields, riskier borrowers, and tighter credit spreads, nicely packaged in ever flimsier covenant protections for lenders, all to feed “investor demand for high-yield products” that “continued to surge.” A record $258 billion of these new covenant-lite loans are issued last year. Not just a record, but “nearly equal to the total cumulative amount issued from 1997 to 2012.”
That, the report explained, was “ample evidence of increasing credit risk in the leveraged loan market.” And the “quality of underwriting” was “a supervisory concern.”
Fed Chair Janet Yellen may deny it well past her retirement, much like Alan Greenspan is still feverishly denying it, but the OCC simply states it: the Fed-engineered “low interest rate environment” causes banks to make bets and take risks that cause banks to collapse. They did it in the run-up to the financial crisis. And they’re doing it now.
“We fear that, once the effects of monetary stimulus disappear in the US, the weakness of the economy due to income inequalities may suddenly be revealed.” Read…. Investment Bank: The End Of US Economic Growth
Well, at least the “End the Fed” movement is alive and well–IN GERMANY!!!
“It’s depressing to think, however, that there is a larger and more active anti-Fed movement in Europe than there is in America itself.”
Surely someone will save the “indispensable” nation, and the world, from itself.
Ironically, it looks like it is going to be Putin who saves the world from this dispensable nation.
You’ve got an un-closed bold tag somewhere! (or maybe you’re just trying to emphasize this whole article?)
Former Fed Chairman William McChesney Martin famously said that the job of the central bank was “to take away the punch bowl just as the party gets going.” Yves Smith
Yes, and that corrupt saying has made me hate the Fed ever since along with Al Greenslime’s testimony to Congress: “If you understood what I just said, I must have misspoken.” The punch bowl should be smashed and I’m tempted to say over someone’s head!
But keep thinking that a private money system that requires government privileges and secrecy can somehow be stable, if only properly regulated?
I suppose chattel slavery could have been properly regulated too since what we have today is debt and wage slavery?
‘Loan to value ratios are on average over 100% across the industry. Used vehicle LTV ratios are hitting 120% at banks (and 150% at finance companies!).’
Well, hell, Wolf. 125% LTV loans worked so well for housing. Why not extend them to collateral that’s actually useful and portable?
If Alan Greenspan were still at the helm, he’d praise these loans as an example of productivity-enhancing ‘financial innovation’ … and urge consumers to ask for floating-rate versions, if they can find them.
Just a thought about Keynes. Max Keiser has been saying ‘you can’t ease a ponzi’. That’s catchy because before 2007 there was a blatant ponzi – collateralized ponzi obligations. The reason for that is (Wolf is correct) that there was/is no functioning economy holding itself up. So it was a pyramid of rehypothecated investments that no one could decipher. A great big pyramid. But what about a wheel. Can you ease a wheel? A little this way and then a little that way. If the securities are garbage and risky, at least they keep money circulating and if all the banksters are cooperating, and none of them freaks out and refuses to buy any more garbage, then the wheel will work. The Fed is going to sell back all the junk it bought someday. There’s no rush because it can hold it till it runs off if it wants to. It won’t want to until it can create an underlying economy which will happen slowly. So the Fed is operating on good faith, the wheel is like a prayer wheel. If the Federal Reserve and the private banking system were nationalized we would still have a devastated economy and sovereign banking would have to do the job of creating an economy just like the banksters are doing now – creating profits for investors – to keep capitalism alive. It is profits for investors that could ultimately cause the end of capitalism because those investors aren’t putting their money to good use. I’m not sure what my point is. I guess that you can have a fake economy for a long time.
Endless debt is an abomination; a universal bailout with new fiat could eliminate much private debt and without increasing the National Debt either.
Oh well, I did not design our money system and never have supported it and have loathed it for decades. Where’s that bowl of water and a towel?
I know little about economics but in your pyramid analogy, the base and therefore the volume of the pyramid is constantly expanding in a ponzi scheme. In your wheel analogy, is it’s circumference continually increasing due to money being printed or will the circumference remained eternally fixed over time, perhaps similar to our prayers which swish around through time, at least perhaps hopefully until they are answered?
I think you have a good sense of what is going on. It’s all smoke mirrors and sleight of hand, and most importantly it is mysterious. I think the Fed and the the financial community realize that risky behavior is not actually risky for anyone except the public as a whole and even then, since all this activity is strictly electronic, more money or financial instruments can be created if things get rough. And should that fail, debt can be just cancelled or discounted–of course all that may be completely wrong but people are making fortunes on all this churn so it’s all good.
Great article! Hats off to the smart folks at the OCC who have demonstrated enormous political courage.
The Fed acts as though there is no systemic risk that cannot be addressed through aberrant monetary policy. The negative -2.9 percent Q1 2014 GDP nos. reflect the abject failure of Bernanke’s QE-ZIRP monetary policy coupled with the absence of domestic non-military fiscal spending and regulatory enforcement, as money has been diverted into highly speculative activities under a continuance of socially disruptive “Privatize the Profits, Socialize the Losses” policies.
Hopefully the OCC’s stance in breaking ranks with the Fed and SEC reflects the emergence of a new environment where the “No regulations, no criminal prosecutions, forbearance of the rule of law” ideology is nearing the end of its useful life to its beneficiaries. But let’s also hope they don’t shoot the messengers before this once again becomes self evident.
You can blame the Fed, but the real blame lies with the administration and Congress, who together have failed to support Main Street and the 99%. Where is our FDR? Where is our Huey Long? Where is our Pecora?
So has the OCC truly pulled it’s head out of it’s ass? I’m agnostic pending further announcements and actions.
Regarding the issuance of CLO’s, are the banks including a tranche or two of CDO’s (or something similar with a new name)? No worries mate, you can sell that shitty deal because everyone’s overreaching for income stream and besides, IBGYBG.
The desire to get ‘something for nothing’ knows no bounds.