Everyone who lived through the Global Financial Crisis (GFC) remembers the Emergency Economic Stabilization Act of 2008, if not the name itself. The law had authorized TARP (among other things). It was passed during the messiest part of the panic, being signed into law on October 3, 2008. You can always tell what is not going to happen by whatever crafty name politicians attach to these things.

TARP itself was not a single provision, either, as it included several intended means for the Treasury Department to somehow bail out a banking system that just a few months earlier the Treasury Secretary had claimed was in relatively good shape. The Federal Reserve Chairman had said things really were looking up.

Instead, officials unable to figure out what was wrong set about trying to do something right anyway (this has become standard practice; buy first, ask questions later). Thus, the Capital Purchase Program (CPP) was initially allocated $250 billion under TARP to invest in all sorts of financial institutions who voluntarily wanted (needed) Uncle Sam as a quasi-partner.

The government never did hit that upper limit even though the crisis continued to rage all the way into March of the following year. Partly as a result of this lack of complete interest (eventually $205 billion would be spent under CPP), Treasury’s efforts morphed into something called the Capital Assistance Program (CAP).

Once it became clear (after millions upon millions of American workers had been laid off) having all sorts of banks take on the federal government “voluntarily” as a partner wouldn’t quell the maelstrom, the federal government instead would put a great deal of effort into reassuring markets the financial system was sound and secure. This would require, the part of CAP people might remember, SCAP.

The Supervisory Capital Assessment Program thrust open the books of the banking system’s nineteen largest institutions operating in the United States. The more curious among us had already wondered what good this would do since supervisors had access to all manner of banking records since there were first supervisors and banks in this country.

The SCAP was different, they said. Between February and April 2009, not only would regulators scrutinize bank books they would “stress test” the firms to definitively decide who did or did not need the government’s further largesse whatever had been left authorized by TARP. The markets would know just who might need more “capital” in order to 100% withstand a really adverse scenario.

Like the one which had already unfolded.

The results were released in May 2009 to widespread mocking. Ten of the nineteen were found to be deficient, in Treasury’s wise estimation collectively requiring an additional $75 billion of capital. The CAP stood ready to provide it should it become necessary.

It wasn’t. Those ten institutions found their investors from among the private markets which were already back on their way up. By the time there was anything to do the rebound was already well underway. Showing up after it was over, the CAP bailout never spent a single nickel.

This didn’t stop officials from telling the public it had been extremely effective anyway. Critics ridiculed this stance because it was pretty clear in the results what had really happened. The government basically took the banks’ data as its starting point for these stress tests and then applied some minor adjustments in order to create the appearance of useful knowledge.

Fed Governor Daniel Tarullo would later admit in 2014:

Because the original SCAP was developed on the fly and under considerable time pressure, supervisors necessarily had to rely on firms’ own estimates of losses and revenues as a starting point for analysis, although they evaluated the firms’ estimates and made significant adjustments.

Having made such a big deal out of stress testing the tool was made permanent by Dodd-Frank. SCAP became CCAR (Comprehensive Capital Analysis and Review) and as such a regular annual regulatory exercise which practically no one pays any attention to.

It has been assumed that the big problem with capital ratios is that they are static; these are bank stats that look backward. Bear Stearns as Lehman Brothers had been “adequate” as far as their capital ratios were concerned. As Tarullo said, SCAP had “demonstrated in practice, not just in theory, the value of simultaneous, forward-looking projections of potential losses and revenues based on each bank’s portfolio and circumstances.”

The big assumption here is that authorities can adequately model what the future will look like. That’s an enormous challenge because, as regulators found out only starting in 2007, they are often way behind the present times. Thus, to develop any chance of useful stress testing requires staying up on current events – only as a start.

This was one of Daniel Tarullo’s main points in 2014.

In short, we do not regard the supervisory stress test and CCAR as finished products. In fact, we should never regard them as finished products, since to do so would be to overlook changes in the real economy, financial innovations, and shifts in asset correlations across firms.

Why bring this up now? As part of its “adverse scenario” for the upcoming 2020 stress tests the Fed will add “heightened stress” in the leveraged loan market, along with CLO’s. Vice Chairman Randall Quarles said in a recent statement:

This year’s stress test will help us evaluate how large banks perform during a severe recession, and give us increased information on how leveraged loans and collateralized loan obligations may respond to a recession.

While that seems to be a positive development in a very (VERY) narrow sense, you have to wonder “why now?” Looking at the history of SCAP in particular you can’t help but notice that bank regulators like the Fed are always, always behind the curve. They develop these stress test tools to reassure the public the banking system is sound long after problems become apparent.

In this instance, should we believe they are for once being proactive about CLO exposure?

Let me be perfectly clear about what I mean; I’m not saying the Fed has discovered this massive vulnerability that is already well on its way to creating GFC2. What is more likely is that CLO’s and leverage loan structures have been a big enough problem already, if not that big, which has led to a lot of people talking.

After several years, and several “anomalies”, regulators finally get up the courage to address it in their CCAR exercise. Make a very public statement about it, too. Why? What is there that might need a little extra attention in order to reassure the public this time?

Like repo, I doubt Quarles or anyone at the Fed really knows. And that’s because CLO’s might have already been an issue in repo (collateral), just not in the place Jay Powell has anyone looking (bank reserves). What regulators do know is that there may be “something” to this CLO thing and they want you to know they’re on top of it.

Whether you believe them is another story. The ultimate downfall of capital ratios after being treated for decades as the ultimate gold standard in modern bank thought was that banks had already worked their way around them. More to the point, the way they did led to all sorts of liquidity chokepoints like repo and collateral.

The main problem with subprime mortgage structures wasn’t really the credit losses they would eventually lead to (which weren’t all that much in the grand scheme of things). As even Ben Bernanke relayed in May 2009 when talking about the need for SCAP:

At the beginning of this episode, bank losses were focused in a few asset classes, such as subprime mortgages and certain complex credit products. Today, following the significant weakening in the global economy that began last fall, concerns have shifted to more-traditional credit risks, including rising delinquencies on prime as well as subprime mortgages, unpaid credit card and auto loans, worsening conditions in commercial real estate markets, and increased rates of corporate bankruptcy.

In other words, it started in something small and spread to something beyond anyone’s wildest imagination. That can only be systemic frailty. But of what kind?

SCAP and CCAR are meant to reassure how the banking system is sound – from only the standpoint of capital reserves and credit losses. It says nothing about the liquidity issues that might arise from a repo-dependent system suddenly doubting its collateral. Credit losses in subprime mortgages wasn’t the thing, the re-valuing of nearly all collateral sparked first by subprime was.

And that lack of systemic liquidity (including CDS and the havoc the breakdown there created for tranche pricing) is what led to OTTI impairments and then the write-downs. Liquidity problems came first. Other symptoms like credit losses and lack of faith followed, and only then after the damage was devastating did regulators come in and “restore” confidence.

The mere fact that the Fed has made an effort to publicize CLO’s and leveraged loans demonstrates only one thing – that in all likelihood there is something here, enough that it has grabbed even their blind attention. The stress tests say nothing about any liquidity problems that might arise (or have already arisen) should CLO’s be retested by repo markets and shadow repo markets (transformation).

But that’s not CCAR’s job, the bureaucracy will reply. Stress tests are for capital adequacy only. Liquidity? That’s been left to Basel 3. Its capital ratio-like LCR is now the epitome of modern bank thought. There’s no way something like that would ever fail us, is there?

The issue here isn’t crash but vulnerability and weakness. How a monetary squeeze might still be able to squeeze the financial system. Twelve years later, regulators still don’t know much. But what they do now is that CLO’s and leverage loans are potentially something to watch.

Sounds vaguely familiar.

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