Federal Regulator Details Crazy Risk-Taking By Banks, Blames Fed

Wolf Richter's picture

Wolf Richter   www.testosteronepit.com   www.amazon.com/author/wolfrichter

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

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Comte d'herblay's picture

ahem..... ?  "Again"???

When have banks EVER not been risk takers with the fractional reserve system??

It's like driving a car.  Most people think their kids have a greater chance of being gunned down in school, than they have of some old, grey, blind Floridian, missing a stop sign in a 50 mph zone.

We become so used to things as they are and forget all about the inherent risks in just getting out of bed in the morning.


what's that smell's picture

what happened in 2007?

as i remember, the stock market tanked for a couple of months, the FED showered free money all over wall street, and the bonus pools went off the charts....

the sheer horror of it all.


MagicMoney's picture

Hehehehe yeah, US is heading for econ bust. The so called recovery is an illusion just as much as the booming economy from 2002-2007. When interest rates rise, asset prices will collapse, banks will have a lot non-performing loans, bank bailouts all over again, this time around, maybe even hyperinflation from the possible massive dose of money printing from the Federal Reserve.

Duc888's picture

Racer:Penalties that are a tiny cost of doing business encourages repetition of the same criminal behaviour, and actually compounds it because there is no real punishment to speak of.


Not only that, the penalties are just "overhead" for the shitbags, they just pass the cost of business on to the smurfs.

disabledvet's picture

There's nothing a bank can do about a recession...especially one they caused. "They all lent to Europe not the USA." That was not just one but two mistakes.

Number One: there was no collapse.
Number Two: there was a huge recovery in the equity space (equity meaning anything you can borrow against in order to raise cash or capital.)

Markets have responded forcefully and vith vigor here. It's not the fault of the markets that the "solution" was "more debt and more inflation." Not even the Fed can be blamed for that. "This was a war against the Taliban" (even though they didn't attack us on 9/11. Nor did Iraq I might add. This is THE major problem of the conspiracy people: "if it was a conspiracy how come we didn't go after the conspirators?)

And indeed that might be what we're doing right now.
"With economics as a weapon."

JRobby's picture

Network A - Fed blames bank regulators for all the crazy risk taking.

Network B - Bank regulators blame the Fed for all the crazy risk taking.

HardlyZero's picture

One of these days...risk will become less transparent (invisible) and visibly opaque.

Pure fiat currency allows risk invisibility...and John Law's Mississippi Bubble.

In 1833 Andrew Jackson shut down Second Bank of the U.S. since it was too powerful and out-of-control.

Fed's Jekyll Island must have been wild party 100 years ago.

History repeats.

One of these days.

Racer's picture

That's what you get if you don't punish the crime with proper punishments that sting.

Penalties that are a tiny cost of doing business encourages repetition of the same criminal behaviour, and actually compounds it because there is no real punishment to speak of.

TVP's picture

Those aren't punishments.  Those are the acts of "regulators", complicit in the massive fraud, who seek to skim a little off the top .  

They don't care about us.  They only want a slice of the profits, and they will allow the charade to continue, even as it causes society to rot and decay.  

Dr Benway's picture

Proper punishments would not "sting", they would "sever" or "snap".