June 23: Bank Stress Tests Bigger Than Brexit?

| About: SPDR S&P (SPY)

Summary

Oh, no — he did not just say that.

I'm jumping straight to the comments.

Wait a minute: If they raise capital requirements, that will, in essence, be a Fed tightening. Maybe this Elazar guy actually has something.

Both happen June 23rd. We wait with bated breath.

One, we got your attention. Two, we mean it.

Both are June 23rd.

Nobody is expecting CCAR to be a negative event (Except Elazar). If it is it will be a dragging negative event for the entire economy.

Brexit will be an event, no doubt (We are short partly because of it). It may domino other countries. But itself, we think will not have the lasting ramifications that CCAR has the potential to have.

Let's run through and quickly rank today's most important market factors:

Fed rates (Importance scale: 6): Doesn't matter unless they actually do something (they change their mind too much)

Inflation (Importance scale: 9): It matters and is getting much worse (Inflation +16% into FOMC). That will drive stocks more than Fed rate decisions, but Fed rates could be a catalyst, but not the central driver. The central driver is inflation.

Brexit (Importance scale: 10 on June 23rd but thereafter 5): It is a market risk event. After it happens it will have some carry over effects. The ECB has said they will step in to secure markets. To us, it's more of a one and done issue. There will be carry over impacts to markets for days, but not weeks. There is a slight chance for tail-spin risk if currencies get crazy and trigger other events.

Stress Tests: (Importance scale 10). Why? Banks drive the economy. Banks lend, store money, allow money to flow in the economy. The Fed is raising standards on banks and may continue to raise standards.

If the Fed raises bank capital requirements on June 23rd it will slow the economy. In effect, even though this is legislative, this is, in effect, monetary policy impact ...more than a 25 bp rate hike.

It has the chance to have more impact than inflation and Brexit.

Here's a sneak peek ahead of June 23rd, Fed already saying they want higher standards

The WSJ was out saying (Search Tarullo) Fed Governer Tarullo wants to increase bank capital requirements each year. The WSJ soon retracted easing that statement. We're guessing they got a call from Tarullo's office to tone it down.

Living Will Likely Toughens CCAR/Stress tests

Five banks failed Fed resolution tests. If they continue to fail these banks are at risk to being broken up. [DON'T GLAZE OVER. CCAR is an acronym (acronyms make me glaze over) but it means stress tests. C is for stress and Car is for tests...that's the acronym.]

The Fed runs BOTH the living will trials and the CCAR trials. They are both doomsday scenarios but they are both different. CCAR is how will the company manage by the numbers and living will gets into the nitty gritty of process. Do they have the actual realistic process in place to effect a self-bail-out without tax payer handouts. The Fed runs both these examinations and knows them both. (We'll explain)

On April 13th 2016, The Fed and the FDIC rejected living will plans from JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Bank Of America (NYSE:BAC), State Street (NYSE:STT), and Bank Of New York Mellon (NYSE:BK).

There is roughly $800 billion in market cap from these companies and they hold a huge amount of US assets - trillions of dollars (with a "t").

They are the center between the Fed, the consumer and the economy. If this slows, we all slow. The fortunes of these banks right now matter more than rates (especially where rates currently stand).

The Fed may catch a big flaw in CCAR which will raise capital coverage ratio requirements

If the Fed peeks at both files (CCAR and living will) simultaneously they will see that their stress test capital ratio requirements understate the real problem of banks.

Living will is failing banks because, in crisis scenarios, they can not access their funds. There are practical issues that are causing these banks, in a crisis, to still need a bail-out.

Counter-parties have their hands on funds, which is called encumbered, so banks can not move assets in a default scenario. They have those assets sitting there (adding up in CCAR numbers) but in a bail-out scenario they can't access those funds.

Let's take a step back....

Follow me here ("Follow me here"s in Elazar work is Elazar getting to a critical point that needs your attention. You will not be wasting your time by following me here...or your money back, oh it was free anyway.)

Why are we doing CCAR? Because of legislation that came into effect after 2008 not to fall into another bank bail-out scenario again. Right? What was the problem then?

Banks needed a bail-out because they couldn't access funds to bail themselves out. The problem exists today except that the notional value of those contracts (Search Ned Davis) are much higher than they were back then. The web of transactions didn't go away. Banks didn't scale down. They become continually more complex.

Let's ask a question: What capital do CCAR capital requirements include? All capital, right? Even the capital that living will is proving that banks can't get their hands on in a time of crisis? Even the capital that 5 major banks can't get their hands on, so much so that they are failing the living will tests? Yes, even that capital. CCAR coverage ratios include that capital? So go ahead and say it: That doesn't make any sense!

CCAR was designed into law to avoid a crisis and now you're telling me that the 10% or whatever coverage ratio can't even get to that capital in crisis?That's right.

So the capital requirement needs to be much higher to cover that problem. If capital numbers really can't be accessed, so what is that 10% anyway? What's the point of that number?

Right. Now we're on the same page.

So without the living will discoveries CCAR lives happily ever after.

But with the living will discoveries, we think the Fed will realize that their capital ratios under CCAR are understating the problem.

But, we think the Fed is smart. (Commenters go easy on us here)

(Seriously, if Elazar can figure that out, anybody with a title PHD.CFA.IR.CMA.A after their name can certainly figure that out.)

We think they put 2 and 2 together. They've spent enough breath publicly on the need for tighter standards.

Punch Line

We think - and here's the punch line - that banks will fail CCAR. The Fed will realize that based on not being able to grab encumbered funds, CCAR, in the time of crisis is understating the problem and too simplistic. This will lead to higher required bank coverage ratios and less bank access of their own funds for business. That will slow the economy.

The Fed has said they want smaller banks. Politicians are against the banks. The public is building opinion against the banks, and the Fed controls the entire process.

The Famous Elazar "Fed Tough On Banks" Formula

Fed tough + Fed smart + Fed strong + Fed hates the banks = Lower bank stock prices, and maybe worse, slower economy.

Source: Professor Elazar. (Professor Google, who we cited previously, didn't know that one.)

If the Fed increases these standards and/or fails banks June 23rd:

  • Bank stock prices fall, dragging down the market
  • Loan capital dries up, slowing the economy
  • Worries arise about peaking near-perfect debt performance numbers, as banks are about to pull back.

The growth rates on US revolving credit, which spiked recently in March, (came back in April) would need to re-up at higher rates as banks need to pull back on supply.

Conclusion

June 23rd is a big day for the UK and EU. We have no doubt about it. June 23rd is also a big day for the US banking system and the US economic infrastructure. For the US, CCAR may matter more than Brexit and could have carry-over impacts for much longer.

But really, really - regardless of which matters more - June 23rd is setting up to be a sloppy day for global stocks. We are short S&P 500 (NYSEARCA:SPY).

Happy trading, and please be in touch. All your comments teach us a ton. And please, make a lot of money.

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