We wanted to frame timing of possible forced bank liquidations following up on our recent piece, 'The Living Will Meltdown Hypothesis.'
As an initial aside, as we wrote previously, whatever the timing of actual liquidations, we still believe that the worry alone can scare markets. Joint press releases by the Fed and FDIC in November or the resubmissions by banks in October can figure into political debates and potentially wake up the issue in markets.
Our starting point for analysis is the April 12, 2016 letter from the Fed and FDIC to JP Morgan Chase (NYSE:JPM) that gave JP Morgan a failing grade on their living will contingency plans. This is not the first for such failing reports, which makes us think the 2 year time frame to forced liquidation has already been set in motion.
In that letter they refer to rule 381.5b as exercising their rights to determine deficiencies in living will contingency plans.
Our focus is rule 381.6 which then gives the right to these agencies to order liquidations and divestitures. These moves would (we think negatively) impact financial markets.
The Forced Liquidation Clock Started Ticking
In layman's terms, from the point that the Fed and FDIC give a joint failing grade to a bank's living will plans the forced liquidation clock starts ticking.
If 'The covered company has failed, within the 2-year period beginning on the date on which [The Fed and FDIC]... jointly determine that a revised resolution plan submitted...does not adequately remedy the deficiencies [The Fed and FDIC] may jointly, by order, direct the covered company to divest such assets or operations'
Possible Countdown To August 2016
If we use the Fed's April 12th 2016 letter to determine when to start the timer it's when the August 2014 letter was issued by the Fed. In that letter The Fed and FDIC said there were multiple shortcomings. We think that starts the clock. They specified the shortcomings as 'unrealistic or inadequate' along with failure to 'make, or even to identify, the kinds of changes in firm structure and practices that would be necessary to enhance the prospects for orderly resolution.'
That should be enough for the two year clock to start running. That two year time frame would just happen to end August 16th of this year, which is 3 months away.
We don't think the Fed has the authority to initiate forced liquidations based on this rule before that time due to a lack a joint conclusion by the Fed and FDIC previous to that August 2014 letter (see last paragraph).
Even though the Fed has recently given a new resubmission timetable for October 1st, we don't believe that cancels the countdown that started ticking after that August 2014 letter.
Possible October 2017 Deadline
The April 12, 2016 letter also refers to a February 2014 letter (last paragraph) which clarifies bank requirements. If leeway is given to meet these clarifications then the 2 year clock could be reset from October 2015 and be up October 2017.
Counting 2 Years From October 2016 Seems Incorrect
We've heard that investors are saying the banks have two years to align with requests. Based on the legal language above, we think it to be a risk to push it out that far.
Risk In Any Event
Whatever timetable you prefer, the market is an intelligent discounting mechanism. Questions will be asked on conference calls of bank executives. More reports of this kind will come out. Politicians have enough ammunition to get public attention on this issue.
We are reiterating a sell rating on the XLF (NYSEARCA:XLF).
The Fed and FDIC used strong language that many banks are not even close to meeting their requirements. Read the language the Fed uses and decide for yourself. The banks have serious capital divestiture decisions ahead.
The clock is ticking.
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