FSOC Frets About Nonbank Risk; Goldman Sachs Stepping Back?

September 22, 2023 | Premium Service | Few people on Wall Street noticed when the Federal Deposit Insurance Corporation (FDIC) Board of Directors appointed Arthur J. Murton to serve as Director of the Division of Complex Institution Supervision and Resolution (CISR). Mr. Murton will perform these duties while retaining his role as Deputy to the Chairman for Financial Stability.

“Art is a trusted leader at the FDIC with decades of experience. I look forward to working with him in this new role,” said FDIC Chairman Martin J. Gruenberg.

Most close observers of the FDIC were expecting Murton and a number of other senior managers to retire after years of excellent service. As an agency, FDIC is facing a crisis as senior managers retire and hundreds of years of operational experience in supervising and closing failed banks walks out the door. But readers of The IRA should ask themselves why Chairman Gruenberg has given this veteran manager responsibility for resolving large banks at this particular juncture.

The Financial Stability Oversight Board convenes today to discuss the risks posed by nonbank financial institutions. It is notable that the FSOC is mostly looking at hedge funds, money market funds and leveraged lenders in their deliberations, yet mortgage lenders and servicers are also on the FSOC agenda again. See our latest comment in National Mortgage News ("Washington's fretting over nonbank risk is misguided")

The FSOC is particularly focused on speculative activity in the Treasury market, but what do Treasury Secretary Janet Yellen and Chairman Gruenberg expect when the US is racing down the road to insolvency? Aggressively trading Treasury securities with as much leverage as JPMorgan (JPM), Goldman Sachs (GS), Citigroup (C) and Morgan Stanley (MS) will provide is an act of self preservation given the tenor of things in Washington.

Chairman Gruenberg skilfully avoids criticizing the FOMC for nearly crashing the US financial system in December 2018. He jumps right to 2020 even though the FOMC cut the duration of mortgage backed securities in half with open market operations in 2019. The mark-to-market losses on securities held by US banks is a direct result of the Fed's actions in 2019. Again, Chairman Gruenberg:

“The systemic risks nonbanks pose to the financial system were again evident when the COVID-19 pandemic first hit the United States in early 2020. Liquidity vulnerabilities similar to those that fueled the Global Financial Crisis resulted in severe market dislocations in March 2020. As this series of events unfolded, it resulted in significant outflows from money market mutual funds and liquidity pressures on other nonbanks, such as highly leveraged hedge funds, which further pressured U.S. Treasury and short–term funding markets. This caused extreme volatility throughout the financial markets that was further magnified by the high levels of leverage and fragility at some nonbanks. In response, the Federal Reserve once again utilized emergency lending facilities in order to support nonbanks and stabilize the financial system.”

The chart below shows the index of duration for Ginnie Mae MBS from Bloomberg. Notice the sharp decline in duration a year before COVID exploded onto the scene as the Fed went “big” with reserves. Gruenberg and other regulators refuse to publicly criticize the FOMC’s actions in 2019, but that is not the case in private. This chart illustrates the vast duration problem that the FOMC has created for banks and other investors.

Source: Bloomberg

Even as Gruenberg and other members of the FSOC fret about nonbank risk, the funding calendar for the US Treasury and the prospect for another interest rate hike by the FOMC sets us up for tough sledding in Q4. The negative mark on all bank owned securities could top $1 trillion depending upon where the 10-year note closes a week from now. Yet you will not hear a single word from the FSOC about the systemic risk caused by runaway federal deficits or the actions of the FOMC.

Source: FDIC

Of course, the interest rate volatility that worries Chairman Gruenberg is staring the FSOC in the face within the FDIC data for Q2 2023. The massive interest rate positions maintained by the largest banks (about 90% of total derivatives) are essentially a reflection of their customers, both onshore and offshore. Notice in the chart below that the gross derivatives position of Morgan Stanley (MS) is now almost 3,000% of the firm’s assets, but the average for Peer Group 1 is 49%.

Source: FDIC

If the FSOC and the Basel Committee want to reduce systemic risk, they should end the politically problematic attack on housing assets and focus their attention on market risk. Rather than capping mortgage servicing assets, which are the most stable capital asset on the horizon today, Basel should instead cap the interest rate derivatives of the largest US banks.

Goldman Sachs

Looking at the latest bank holding company reports for Q2 2023, we were more than a little surprised to see that Goldman Sachs is still leading large banks on net credit losses even though the bank has sold the assets attributed to the discontinued Marcus consumer business. This suggests that the institutional side of the house is the source of the losses, which are actually bigger in relative terms than the losses of the other top banks. Of note, the gross spread on GS loans and leases is now over 10% or +200bp to Citi.

Source: FDIC

As members of the financial media hold their breath about whether CEO David Solomon will stay or go, nobody seems able to ask any questions about where this business is headed over the next several years. Given the recent experience of Citigroup and Charles Schwab (SCHW), we wonder if GS is not also in danger of being “notched” down in valuation. All three of these stocks are in major indices, of note. Yet there are signs that GS is taking down the level of risk, which implies lower future returns.

Source: Google Finance

GS has been growing its use of non-core funding, a sign that management is trying to rebalance the bank’s liabilities, but some volatile deposit categories are down. Notice the huge increase in funding costs for GS and MS, but SCHW is still below 1.25% on funding costs. Yet the fact remains that SCHW is still in the crosshairs of the short-sellers who are banking on another liquidity crisis at the end of this year.

Source: FFIEC

Once upon a time, GS had a derivatives book that was over 5,000% of total assets. That was at the end of 2017, but now MS is leading the large banks in this respect. Is GS stepping back from the risk taking of five years ago? GS has the weakest position in terms of funding of the top-ten banks and no real narrative for the business post-Marcus. We expect to see David Solomon take a cautious path as the firm tries to reinvent itself with key institutional investors.

While folks in Washington fret about the risk taking of large banks, the current drought in terms of new debt and equity deals is starting to force consolidation on Wall Street. If you look at the chart above showing the derivatives footings of the major US banks, it is hard to escape the conclusion that they are taking risk down at most of the major banks compared with levels of five years ago. If volatility in the Treasury market returns, however, we may see these figures rise significantly.

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