Fed Gives Banks New Dire Scenarios for 2014 Stress Tests

Lenders including JPMorgan Chase & Co. and Citigroup Inc. will have to show they can survive the demise of a trading partner or a plunge in value of high-risk business loans in the 2014 version of U.S. stress tests.

The scenarios for the annual tests, outlined by the Federal Reserve in a statement yesterday, reflect some of the most pressing threats seen by regulators as they gauge the ability of the U.S. financial system to withstand economic shocks. Bankers will have to show what would happen to the value of leveraged loans they hold, the impact of another housing bust and how they’d fare if a firm that owes them substantial sums collapses.

The test was designed in part to build resiliency against what some see as emerging asset bubbles, said a Fed official who spoke on a conference call with reporters. The counterparty failure test aims to prevent a repeat of the 2008 crisis, when distress at Lehman Brothers Holdings Inc. and American International Group Inc. threatened to destroy their biggest trading partners.

Counterparty credit risk “has been a very big concern since the crisis,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc., a Washington regulatory research firm whose clients include the world’s largest banks. “This is an intervening supervisory step while the broader rules are pending.”

The Fed is using the tests -- based on hypothetical adverse conditions and not forecasts -- to encourage the 30 biggest banks to build capital cushions against economic turmoil. Twelve banks will be subject to the capital review for the first time.

Global Shock

The six banks with large trading operations -- JPMorgan, Citigroup, Bank of America Corp., Goldman Sachs Group Inc., Morgan Stanley and Wells Fargo & Co. -- will be required to test how their portfolios would perform against a global shock to financial markets. Details of that scenario will be released “soon,” the central bank said. New York-based JPMorgan is the biggest U.S. bank by assets, followed by Charlotte, North Carolina-based Bank of America and New York-based Citigroup.

Those six banks, as well as Bank of New York Mellon Corp. and State Street Corp., also will have to test against a scenario in which one of their counterparties experiences an “instantaneous and unexpected” default. Previous tests focused merely on incremental defaults as the economy eroded, a Fed official said on the conference call.

Weak Support

The test shows Fed officials remain concerned that banks might still rely too heavily on a single counterparty to hedge potential losses, a practice that contributed to the 2008 financial crisis.

In the “adverse” scenario, banks will be tested against global flight from long-term debt that pushes the U.S. into a recession, with unemployment rising to 9.25 percent. The yield on the U.S. 10-year Treasury note jumps to 5.75 percent by the end of 2014, and corporate bond and mortgage rates also rise.

In the Fed’s “severely adverse” scenario, the jobless rate peaks at 11.25 percent, stocks fall almost 50 percent and U.S. housing prices slide 25 percent, while the euro area sinks into recession. Developing economies in Asia also experience a “sharp slowdown,” the Fed said.

The Fed said the larger drop in U.S. house prices in this year’s severely adverse scenario is “particularly relevant for states or metropolitan statistical areas that have experienced brisk gains in house prices over the past year.”

Wider Spreads

The wider corporate borrowing spreads featured in both tests are “intended to represent a corresponding widening in spreads across all corporate borrowing rating tiers and instruments, particularly those instruments -- such as high-yield corporate bonds and leveraged loans -- that are at present experiencing particularly narrow spreads,” the Fed said.

Top banking regulators in the U.S. are recommending lenders strengthen underwriting standards for leveraged corporate loans as borrowing of the high-risk debt approaches levels not seen since before the financial crisis, nine people with knowledge of the matter said last month.

Some bankers and economists have said stresses may emerge when the central bank decides to end its current economic stimulus program that has kept rates near historic lows. The program involves buying $85 billion a month in bonds to suppress borrowing costs. Speculation about the timing earlier this year sent interest rates soaring in a matter of weeks.

“They seem to be avoiding the biggest risks in the stress scenarios,” said Chris Whalen, managing director at Carrington Investment Services LLC in Greenwich, Connecticut. “The Fed itself has created this interest-rate risk by bringing rates down to zero, so maybe that’s why it’s not able to stress too much.”

Bubble Trouble

Morgan Stanley Chief Executive Officer James Gorman, 55, said yesterday he doesn’t see evidence of market bubbles developing and that investors should celebrate when the Fed begins to taper its support program because it will signal the economy is healthy.

Gorman, whose New York-based company runs the world’s largest brokerage, was responding to remarks by BlackRock Inc. CEO Laurence D. Fink, 61, who said Oct. 29 that the Fed’s effort to boost the economy by holding down interest rates has fueled “bubble-like markets.” His firm is the world’s biggest money manager.

Banks have argued in past years that they can mitigate risks in their business deals by purchasing protection, such as credit-default swaps, from counterparties.

AIG’s Collapse

In the years leading up to the 2008 crisis, financial firms bought protection from AIG, the New York-based insurer, allowing them to subtract the CDS on their books from their reported subprime mortgage-debt holdings because losses would theoretically be covered by AIG.

When prices of mortgage securities started falling in 2008, the contracts required AIG to post more collateral to its CDS counterparties. The demands drained AIG’s cash, and the U.S. government took over the company when it was hours away from bankruptcy.

If AIG had collapsed, the protection that its clients had counted upon for their mortgage portfolios would have disappeared, leading to billions of dollars in losses and perhaps a cascade of bank failures.

The Fed, seeking to reduce the chance that one failing company would topple others, proposed in December 2011 to cap how much counterparty credit risk a bank could have with any systemically important trading partner. The limit would be 10 percent of regulatory capital.

Lobbying Limbo

The proposal has been stuck in limbo without being finalized after heavy lobbying by banks. JPMorgan, Citigroup and Morgan Stanley were among lenders arguing that the limit was poorly constructed, overstated risk and would restrain the economy. It could cut U.S. economic growth and destroy 300,000 jobs, New York-based Goldman Sachs warned last year.

“The regulators have been looking for a way to get counterparty risk into the scenarios,” said Mark Levonian, a former senior deputy comptroller at the Office of the Comptroller of the Currency. Levonian, now a managing director at the consulting firm Promontory Financial Group LLC in Washington, said the stress tests also show regulators’ concern that “recent price gains in some regional housing markets might not hold up under stress.”

Companies will have until the first week of January to submit their capital plans, and the results will be released in March.

Capital Increases

The 18 bank holding companies tested previously have increased their aggregate Tier 1 common capital to $836 billion in the second quarter of 2013 from $392 billion in the first quarter of 2009, according to Fed data. Their Tier 1 common ratio, which compares capital to risk-weighted assets, has more than doubled to a weighted average of 11.1 percent from 5.3 percent, the Fed said.

The eight banks with more complicated scenarios have been through the Fed’s stress test and capital-planning process before, as have Ally Financial Inc., American Express Co., BB&T Corp., Capital One Financial Corp., Fifth Third Bancorp, KeyCorp, PNC Financial Services Group Inc., Regions Financial Corp., SunTrust Banks Inc. and U.S. Bancorp.

Twelve banks will be participating in the process for the first time. Those banks are BMO Financial Corp., BBVA Compass Bancshares, Inc., Comerica Inc., Discover Financial Services, HSBC North America Holdings Inc., Huntington Bancshares Inc., M&T Bank Corp., Northern Trust Corp., RBS Citizens Financial Group, Inc., Santander Holdings USA, Inc., UnionBanCal Corp., and Zions Bancorp.

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