Ring the Alarm Bells: Coronavirus & the Fed’s Stress Test (w/ Ed Harrison & Ash Bennington)

Video Transcription:

  Ring the Alarm Bells: Coronavirus & the Fed’s Stress Test (w/ Ed Harrison & Ash Bennington)

It's Friday June 26th just after market closed in New York this is the real vision daily briefing I'm ash Bennington from New York rail pal is unable to join us today we'll be joined shortly by Ed Harrison from Washington DC but first Jack Farley with today's stories thanks ash yesterday the u.s. broke a record for the most number of coronavirus cases in a day at 40 1113 this is the first time that daily cases have broken through the 40,000 threshold total cases in the u.s. exceeded 2.4 million according to Johns Hopkins University this surge of cases seems to be particularly affecting those who are 40 and younger in Arizona one of the states with the largest spikes 48 percent of cases are among those in the 22:44 age group in Florida the median age of residents who are testing positive for the virus has dropped from 65 in March to just 42 and in Texas 53% of people infected are 20 to 49 years old in other news the Federal Reserve is going to be keeping the banks on a tighter leash from now on the Fed announced yesterday is prohibiting the largest banks from buying back their own shares until the end of the third quarter and ordered that their dividends be capped to q2 levels this was in a sensitivity analysis that was in addition to the regular annual stress test the projections from the stress test were actually quite good lost loan rates seemed stable free provision net revenues don't look at a line and even the common equity tier 1 that vital statistics only dips down a little bit to nine point nine percent it was these findings that supported the vice chair Randall quarrels statement that the banks are well capitalized and that they remained strong in light of these shocks but in addition to the stress test the Fed also ran a sensitivity analysis that analyzed three additional scenarios of v-shape recovery a u-shaped recovery and a w-shaped recovery and the results are flabbergasting no matter what letter it is v eww all three scenarios had common equity tier ratios below the severely adverse case the situations for peak unemployment peak to trough GDP change and the floor for 10-year Treasury rates show a similar story the quotes severely adverse scenario materially underrated bad the situation would actually be so the feds analysis of the v-shape recovery actually looks worse than the doomsday scenario that was envisioned in February 2020 it's remarkable that now the most optimistic predictions are based on a model that in February predicted and up to 50% decline in the Dow Jones so now let's get back to the stress test it forecasted over 550 billion dollars worth of losses in mortgages corporate loans bonds commercial real estate auto loans muni z' ceos cielos trading counterparty risk the whole nine yards and then the Fed did a specific analysis of each Bank some banks performed well under the microscope but others really are on the knife's edge regions financials CET one was at seven point three whereas Financial Corp CET one was at just five point four remember the bare minimum is at four point five percent but it's not supposed to get anywhere close to that and remember that is the analysis that's based on the quote adverse scenario the bank specific analysis based on the V U and W shape recovery has not been released the Fed also painted a grim macro picture where in the US dollar appreciated against the euro the pound sterling as well as emerging market currencies the Fed also warned that the high levels of non-financial corporate debt could amplify the losses on bank balance sheets and create a wave of corporate sector defaults the Fed also predicted and I'm quoting here similarly the leveraged loan market comes under considerable pressure open-ended mutual funds and exchange-traded funds that hold leveraged loans and high-yield bonds face heavy redemptions due to liquidity mismatches mutual fund and ETF managers sell their most liquid holdings leading to a more extensive declines in the price of fixed income securities and other related assets the market puked on this stern warning from the Fed with bank stocks plummeting almost as if the market is asking himself what does the Fed note that I don't so now you see why the Fed decided to order banks to keep hold of their capital because they need it but some insiders insists that that's not enough in a statement yesterday governor Lael Brainard said that allowing banks to pay dividends was a key strategic mistake saying quote this policy fails to learn Akhila of the financial crisis and I cannot support it a lot to think about for sure for this and more let's go back to ash and Ed thanks jack welcome back head looking good Billy Ray looking good Randolph Waterman I'm I'm hopeless by the way talking of things that I'm hopeless about so before I get cancelled let me just say apologies to the Scottish football fans I did some research the Scottish Premiership now often called the lads broke Premiership is very much its own league with a rich history and traditions all of its own dating back to the 19th century as it turns out you and your fate are you a Rangers or Celtic fan yes and the vastness of my ignorance of soccer is one of the most expansive fields in the universe yeah just because you called it soccer I think some people will probably smack you for that alone football as opposed to American football I don't know so but you so Liverpool won yesterday the championship is that right that's right yeah definitely and it was because basically on points they can't be overtaken by the second-place team which is Manchester City which lost when they lost to Chelsea which is the team that I follow they were therefore ruled out of being able to overtake on points you know after 20 years of following the bond market I think I'm getting a sense of how it works I have no idea what that means it means that Liverpool so many more points than than Manchester City that they can't Manchester City even if Liverpool lost every game and Manchester City won every game to the last seven there are 23 points behind they would only be able to get 21 points so they would still lose the championship by two points well congratulations to our viewers in Liverpool it sounds like a big moment for them yeah definitely I'm the first time and I might correct myself because I think I said something about 40 years at the first championship to they've won in the top league and in English football in 30 years 30 years long run yes sort of get back to a slightly more serious note you know and I often read in fact usually every day I read credit write downs but this today's edition I think was especially insightful it has kind of a feel of a summing up about it or an overview of all the things that you've been thinking about writing about talking about on this show so I was hoping we could start out with that newsletter and first to talk a little bit about what you're seeing right now on the kovat front yeah and you know the cove in front for me as I was telling you off camera before I don't know I don't want to share you know like air my dirty laundry and so forth but it has a meaningful impact on me because I was I was telling you to tomorrow is a funeral of a good friend of mine and I won't be able to go to the funeral and and the and why it's because you know the Kovach crisis is flaring up it's becoming you know incredibly big where it wasn't before and when we see texas and florida dialing back the reopening we know for a fact that what's happening is is that the economy is gonna take a hit and so some of the more adverse scenarios that you can imagine that the Fed is running through and their stress tests are in fact going to play out and so that's a very negative both for the financial system and for banks as specifically yeah and just to update our viewers so Florida which you mentioned now is reporting nearly nine thousand cases today about ten thousand cases yesterday Texas has effectively began to halt some of their reopening process they've you know Texans if you have never been down there they take their freedom very seriously as a very strong libertarian streak this represents a real departure restaurants are reducing capacity again from 75 percent to 50 percent and bars in the state of Texas are going to be closed you know these changes come after governor Greg Abbott Republican governor down in Texas drew a line in the sand around a 10 percent positive rate for the Cova desk that line has been exceeded now and they are also reporting a single daily new case record of 6500 cases yeah and my understanding is that Florida is following on and they're also dialing back some of the reopening as well I haven't seen the details on that myself but those are two large economies we also see escalating numbers in places like California and to a certain degree Michigan these are all large states so you know I think that we're gonna see a chill in terms of people's consumption patterns we're gonna see a chill in terms of business being open and you know why would you open up your business when for instance Tyson Foods which is one of these meatpacking places they're being sued by three of the the families of three people who work there who died you know why would you risk the fact that you could open yourself up for a lawsuit when you're endangering your your employees even if you don't even if it's all about the money and you don't really care at least you care about a lawsuit so I mean at a minimum we're gonna see a lack of buying and we're gonna see stores start to close themselves down the latest that I heard very interestingly was Microsoft has eliminated all retail stores they are no longer gonna have retail why because kovat is going on too long and their retail stores weren't making them a whole lot of splash anyway what wasn't giving them that the boost that they wanted and so they're closing them down that's how things are gonna proceed going forward yeah I don't think anyone's teenagers were being asked to go to the Microsoft Store on the weekend you know just to highlight some of the points that you made I think you're absolutely right on the size of these economies you know Texas Florida California California now has a total of 200,000 cases these are economies that are the size of some small European states they're absolutely massive fortunately though we have some good news to report from down in Texas a consortium before hospital CEOs came out today in a virtual press conference and I'm quoting directly from the Houston Chronicle quote hospitals and ICU capacity is abundant despite standing in sent out earlier this week the capacity was increasingly stretched and reaching dangerous levels that was a story that we picked up on our religion so this is some good news down in the Houston area at least in the short term is it good news or is there something else underneath that because when you say one day X and then the next day you say Y you have to wonder which is true X or Y they both can't be true at the same time yeah that's right I think it's just a case from my perspective at least we're just wanting to find some story that looks less positive but that looks more positive and less dire you know we feel for people down in Texas we went through this here in the New York metro area it is a very difficult and very painful thing and we've said this ourselves numerous times it's something that once you've experienced it when it's in your neighborhood it just feels more visceral and more real yeah I have a friend who also it's good friends with the guy who is having a funeral tomorrow and he's in Houston and he was telling me of the attacks that don't believe what you you you hear meaning that's not as bad as they make it out to be so at least I have that you know we're not there so we don't know yeah let's just see what happens yeah from my perspective the the positive is is that younger people are the ones who are being infected and we know that younger people have better survival rates obviously even if you get infected you can be hospitalized as someone who's in the 22:44 age cohort we see that those are the numbers of the people in the state of Arizona as an example who are getting most of the infections and who are also occupying the second largest cohort of hospitalizations but at a minimum we could say that to the degree that they maintain some social distance from their grandparents that might be positive in terms of it's not the oldest people who are really getting hit hard by this as yet so if you want a you know a silver lining maybe that's it maybe it can stop before it gets to that that Junction yeah this we're all searching for that silver lining for just from a human perspective you know we don't really like talking about viruses it's not something that we want to talk about certainly but as it impacts markets it's something that we have to look at and that brings me back to the idea we were saying earlier which is to turn back to the newsletter credit right downs that you wrote as specifically about the Fed and the stress has any impact of the virus on the economy yeah so the interesting bit with regard to what I was writing today is that the Fed was talking about severe adverse economic scenarios back in February this is before they intervene in the market on March the 23rd and so the interesting bit is is that they're severely adverse economic scenario or their market scenario I mean was absolutely catastrophic in terms of market outcomes immensely let me quote you quoting the Fed in the newsletter because I think this is a spot on and really cuts the point the quote from the Fed begins the 2020 market shock component for the severely adverse scenario is designed to be generally consistent with a macroeconomic background in which and then this is the meat of the quote right here the US economy has entered a sharp recession characterized by widespread defaults on a range of debt instruments by business borrowers under the scenario weaker obligor struggle to maintain their financial condition due to material declines in earnings associated with the poor economic environment while ratings agencies downgrade large portions of debt outstanding the historically high levels of non-financial corporate debt-to-gdp amplified the losses resulting from the wave of corporate sector defaults this dynamic creates feedback effects between the economy and the corporate sector sobering words yes and you know the thing that I found the most sobering reading another part of what they were saying was when they were talking about mutual funds ETFs and high-yield this is what they say that I found really kind of distressing and remember this is from Fed where this isn't from June this is before they intervened they were saying spreads widened sharply for non-investment grade and low investment grade bonds has rating sensitive investors anticipate further downwards and sell assets the leverage loan market comes under considerable pressure open-ended mutual funds and exchange-traded funds that hold leverage loans in high-yield bonds face heavy redemptions and due to liquidity mismatches mutual fund and ETF managers sell their most liquid the holdings and then they go on and talk about cielos in a very negative way as well so every single market that you know you and I have been talking about Jack's been talking about that we've been concerned about they were saying in February these markets are gonna implode unless we step in so my thinking is and they've updated their thinking they've talked about the W recession they've talked about a u-shaped and a and a v-shaped the updates that they have are so negative in terms of the tone it tells you that they believe that they may have to intervene yet again even more into the markets and they already have given the adverse scenarios that that they're painting you know and based on what you just read it sounds like the only asset class that isn't affected is the cash that my grandfather used to keep stash from the freezer right you know the the interesting bit is is you know they did intervene into the investment grade market right the only market that they've intervened into so far our mortgage-backed securities the investment grade market and they've also intervened in the Treasury market and so I mean one one negative way to look at this this isn't the way that I'm looking at the one way to look at it is that they're saying when we intervene in those markets because those are markets that are liquid and that are relatively solvent but these other markets that we already identified in February the CLO market the etf market of for me open-ended mutual funds for high-yield and leveraged loans the leveraged Malone markets itself the high-yield market and they even say low investment grade bonds that's triple B's that they're not going to intervene as much they're the the biggest problem with that with that thinking that last bit the low investment grade bonds that's the the that's the first that's the highest tier with within the capital structure that they mentioned was under assault in the severely adverse economic scenario and so and they've already decided that they would intervene there even if those bonds became junk if they were downgraded into high-yield so you know that there's a slippery slope that the Fed is on so my postulation is depending upon how severe the economic scenario is and how disrupted markets become the Fed will intervene they will go down the slippery slope even further and we'll just have to see how low asset prices have to get and how difficult the situation has to be before the Fed intervenes yeah I should say that when I was referencing the asset classes that are going to be impacted I wasn't referring to what was happening now I was talking about the Fed projections about what could happen in the most dire or exigent circumstances and to precisely that point I just want to quote credit write downs again and this is you writing quote notice that the Fed is talking about economic scenarios divorced from financial conditions what they are modeling is a severely adverse economic conditions outcome in alternative economic scenarios there's a sense in which doing this isn't realistic because the financial economy and the real economy have feedback loops but even so it's a useful exercise for us to see because it gives us a sense of how the Fed is thinking yeah not only how they're thinking now but how they were thinking in the past something that presaged actions that they took so we know that they said X in February and they did Y in March and now here we are at June and we know what they're saying and therefore we can use their past actions to get a sense of what they're likely to do and so you know for me it's the fact that they've intervened in the non-investment grade in the low investment grade market already including fallen angels that tells me that there slippery slope and that there is a great possibility that if the financial conditions deteriorate enough that they're willing to go the extra mile you know who knows if they could even do equity ETFs for that matter as a result of you know moving down the slippery slope so I think the Fed is on its it's slippery slope and and that's why people think that the feds got their back but is it gonna work is it gonna be enough to levitate the market forever I have my serious doubts about that and we're about to find out and the reason is is because of the Koba 19 outbreak escalating at this point yeah and for those who aren't familiar fallen angels are corporate credits that were issued as investment grade and have been downgraded to junk after the fact you know it's interesting you're talking about the way that you view this what we're looking at is how the Fed viewed the future in the past and trying to extrapolate how the Fed will view the future in the future right it's a pretty it's a pretty abstract notion that we're drew down here but it is it is useful and helpful to just understand the thinking and the framework because these are human beings and human beings generally remain consistent in the way they view the world obviously data can change their opinions and their impressions but it does give you at least a context of framework as Roger would say for thinking about your thinking yes and you know I wanted the the intro that Jack did today is very interesting with regard to dividends on that score because it gives you an insight into where the Fed is going into the future where the Fed said and you know we've had Chris wailing on to talk about this before I don't know if you saw the e V that he did where he basically said he thinks it's a bad idea if the Fed were to outlaw dividends or to do anything on that because it would harm the banks and that he doesn't think that the banks need it but the Fed just told us the banks needed the Fed said that the the potential for a bad outcome in the in terms of loan losses is so large relative to what we're prepared to tolerate that we want you to a stop using any sort of buybacks and be you can only give dividends to of a certain amount and and here's the kicker that I found absolutely astonishing that one of the Fed governors issued a statement saying that actually that path is irresponsible that it wasn't enough that you have to stop all dividends altogether Lael Brainard the Fed governor said you know no dividends ASAP timeout on dividends that tells you that the Fed is incredibly worried this so if the Fed is that worried right now and they're talking about these severely adverse impacts what does that mean in terms of what we should be thinking is going to happen economically and to to financial markets it should definitely give us a sense that policymakers are speaking in a very sanguine language publicly but their actions are showing that they're much more worried privately yeah and we should point out it's it's relatively unusual for a Fed board governor to effectively write a dissenting decision from a policy action and then post it on the Fed website which Jack Farley assiduously crawling through data this morning found yeah I was I was very astonished at how plain the language was in terms of saying that this isn't the right move we should be doing more so clearly if she you know she's saying look I'm opening the doors to a internal discussion that we're having here at the Fed an argument if you will we're having between policymakers because I didn't get my way that tells you how contentious that that discussion piece must have been yeah as everyone who's been on a team knows when you go outside the team and say you know we've had a little bit of disagreement internally it usually means you were screaming at each other and the doors were closed we of course don't know whether that's the case but it does suggest I think the possibility that there is some real dissension within the ranks of the Fed governor definitely that that's my takeaway there so what does it mean given the volatility that we have how can we sort of wrap this up in a way that is relevant to what's going on in the markets the moment what we're seeing in the markets right now is reflective of this this trend we had the what I would call the the post opening rally the reopening rally and that got us up to a highs again on the Nasdaq got us near highs again on the S&P it on the Dow and now as a result of the reopening we're seeing a massive increase in viral contamination and and so now we have to reconsider how how adverse are the near-term impacts gonna be from that recontamination we're gonna find out very shortly when you know we see the delay in terms of the death counts when we see the what the the numbers look like in terms of consumption and also in terms of output yeah you know I'm talking about the real economy feedback loops and markets let's cut really quickly to what happened today in equity markets because it is material the Dow Jones Industrial Average down two point 84% to the twenty five thousand fifteen level the S&P 500 down two point four two percent to the three thousand nine level and finally the Nasdaq down two point five nine percent to ninety seven fifty seven closing below the ten thousand level again today yeah those are some some pretty weak figures I have to say and it's emblematic of where we're headed in terms of the volatility that we're seeing and you know what I was saying to you earlier is that we're in a seesaw here now because we had the reopening rally up and now we're at this point where we've gotten to a certain level and we're trying to see is this level adequate given now that we have more data on the reopening and that's when we're getting hit by the the kovat wave and and therefore we're seeing violet ility until we get a is this wave going to have a significant economic impact yeah and perhaps the clothes will cook quote Edie Harrison quote if you take the view as I do that the real economy and the financial economy are interlocked then you have to see the severely adverse scenario the Fed is outlining as more likely than it has been willing to admit when the w-shaped recovery is happening right before our eyes there it is exactly I mean the W that is the second dip it's happening exactly right now it's right in front of us I mean when we see stores closing when we see Texas rolling back they're reopening when we see Florida rolling back the reopening that's the W that we're talking about and we know for a fact now that the Fed has been saying one thing and then underneath they've been talking about more adverse scenarios when they're talking about hey wait a minute we're going to cut dividends to zero potentially because they have a debate about how bad it's gonna be that's when you have to think yes we have to be considering more adverse scenarios for markets not just for the economy and that's where we are right now o take a while until we get the answer but that's where we are now well exactly that ties it up nicely and as always great analysis good to talk to you ash I was thinking you know as we ended it I was gonna say you know Billy Ray but we'll we'll try it one more time again next week well rehearse for next week thanks for joining us thanks for joining us everyone we appreciate it.