Defective financial institution stress assessments are hurting the mortgage market

Throughout final week’s earnings call for JPMorgan Chase (JPM), CEO Jamie Dimon rebuked the Federal Reserve Board and different regulators for what the veteran operator described as “ridiculous” financial institution stress assessments. He then went on to say that JPM and different banks will likely be pressured to cut back one- to four-family mortgage exposures due to the Fed’s poorly conceived financial institution stress assessments.

“We don’t agree with the stress take a look at,” Dimon mentioned. “It’s inconsistent. It’s not clear. It’s too risky. It’s principally capricious [and] arbitrary. We do 100 [stress tests] every week. That is one. And I have to drive capital up and down by 80 foundation factors? So, we’ll work on it. We haven’t made definitive selections. However I’ve already talked about about how we dramatically lowered [risk weighted assets] RWA this quarter. We could try this once more subsequent quarter.”

What’s elevating Jamie Dimon’s ire? Regulators lately decided that JPMorgan might lose $44 billion in a extremely pressured financial state of affairs, largely on its $250 billion portfolio of one- to four-family mortgages. 

The stress take a look at outcome for JPM appears unbelievable and raises questions in regards to the analytical methodology utilized by the Fed’s supervision workers. The loss quantity appears to haven’t any connection to the financial institution’s precise monetary efficiency, which is great, or the broader regulatory file when it comes to mortgage losses for all US banks. 

When the Dodd-Frank regulation was handed a yr later in 2010, Congress included an expanded authorized mandate to conduct annual stress tests and for a whole bunch of banks. Since 2012, the stress assessments have devolved, from a modestly helpful non-public annual course of targeted on the highest establishments to a public media circus targeted on financial institution earnings.  Pre-COVID, the Fed’s stress assessments had been merely a monumental waste of money and time.  However now the stress assessments have turn out to be a menacing countercyclical power that would additional drive down liquidity within the mortgage market over the subsequent yr.

A part of the issue with the Fed stress assessments is that, like most of economics, the assessments are backward trying and use 2008 because the benchmark for future losses.  The Bank Policy Institute in Washington printed this evaluation: 

“For capital adequacy functions, regulators have quantified operational danger by utilizing previous litigation prices and regulatory fines, primarily judgments ensuing from mortgage losses as a part of the worldwide monetary disaster.  Leaving apart how poor a proxy these litigation losses are for operational danger in 2022 as a common matter, it’s value noting particularly {that a} financial institution funding a reserve on the Fed with a industrial or retail deposit is operating zero litigation danger.”

Loss charges on bank-owned 1-4s are principally zero and loss given default is deeply unfavorable as of Q1 2022. As readers of the Institutional Risk Analyst blog know, JPMorgan has maybe the highest-quality 1-4 guide within the banking business, together with loans and mortgage servicing rights. Dimon clearly thinks the Fed assessments are bunk, however admits that he should now construct capital and in addition cut back his financial institution’s publicity to residential mortgages. JPMorgan chief monetary officer Jeremy Barnum mentioned:

“On account of the latest stress assessments and the already scheduled GSIB enhance, we are going to construct capital and proceed to successfully and actively handle our RWA. With a view to shortly meet the upper necessities, we now have quickly suspended share buybacks.” The value of JPMorgan within the world markets fell sharply because of the suspension of share repurchases.

The state of affairs with respect to the Fed and financial institution stress take a look at outcomes is greater than a bit ironic. The potential losses that the Fed’s incredible stress assessments envision are the direct results of the manipulation of the housing sector and world credit score markets by the Federal Open Market Committee underneath “quantitative easing” or QE. 

Creator James Grant famously noticed, the Fed is each arsonist and firefighter wrapped multi functional neat bundle.  After sending the mortgage market on a roller-coaster journey over the previous two years, quickly the Fed goes to cease buying mortgage backed securities. On the identical time, the Fed’s supervisory personnel are forcing JPMorgan and different banks to promote one- to four-family mortgages to be able to cut back capital necessities. What’s mistaken with this image?

“[C]ertain mortgage progress is discretionary and portfolio-based, consider mortgages, and there’s probability we’re going to drive it down considerably,” mentioned Dimon. “We’re most likely going to drive down mortgages.”  Different massive banks will likely be pressured to observe the instance of JPMorgan.

Dimon continued to lambaste the Fed: “This [stress test has] bought unhealthy results for the economic system … and [for] the mortgage enterprise particularly is unhealthy for decrease revenue mortgages, which hurts decrease revenue individuals and minorities. … We [still] haven’t mounted the mortgage enterprise, and now we’re making it worse. … If it doesn’t make sense to personal mortgages, we’re not going to personal them.”

In 2020, when the worst fears of COVID had been driving US banks to put aside $60 billion in reserves for future loss, JPMorgan put aside $16 billion, reserves that had been in the end recaptured again into revenue a yr later as a result of precise mortgage loss charges had been so low.  But now, a yr later and regardless of the precise proof within the public file, federal financial institution regulators need us to imagine that loss charges on prime 1-4s held in portfolio by JPM and different banks will likely be considerably increased than in 2008.  

“Should you go to Europe, OK, the capital held towards mortgage is sort of a fifth of what we now have to carry right here,” says a clearly aggravated Dimon. “And we will clearly handle that and standardized risk-weighted property don’t symbolize returns or danger. … Our job is to serve shoppers by way of thick or skinny, good or unhealthy with what they want, how they want it. And now we spend all of our time speaking about these ridiculous regulatory necessities.” 

Leaders within the mortgage business and among the many regulators on the Federal Housing Finance Company, Ginnie Mae and HUD have to have a dialog with the oldsters within the supervision and regulation perform on the Fed. There are lots of causes industrial banks have fled the marketplace for government-insured loans and Ginnie Mae MBS, however the chief cause is the absurd stress testing and danger weighting that U.S. regulators assign to one- to four-family loans attributable to Dodd-Frank. 

However extra vital, the abortive outcomes of the newest financial institution stress assessments ought to give members of Congress similar to Dodd-Frank supporter Elizabeth Warren (D-Mass.) pause in persevering with to depend on these legally required however analytically suspect assessments.  Ought to Fed economists actually have the ability to arbitrarily set capital pointers for particular person public corporations? These selections should be confidential and shouldn’t be made public. 

The Fed’s stress assessments don’t take a look at the flexibility of banks to resist losses, however moderately the ability of financial institution managers at responding to the inane procedures set forth by the tutorial economists who run the central financial institution. The actual danger in banks is just not what you possibly can learn in printed financials or Fed stress assessments, however the unknown.  However what is evident from this yr’s stress take a look at is that the hand in command of financial coverage on the central financial institution doesn’t know what the opposite hand that’s liable for large-bank supervision is doing. Possibly they need to discuss.