"Banks are again taking big risks, the same risks that helped trigger the financial crisis, and they’re understating these risks."

"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 “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...

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.

...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.

...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....

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.”


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