Why Yellen's Fed Wants Lenders on the Hook for Bank Bailouts

Goldman considers new capital requirements for big banks like Wells Fargo "manageable," although the companies are $120 billion short of compliance. The rules shouldn't hurt bank stocks, Jim Cramer says.
By Carleton English ,

This article, originally published at 8:12 a.m. on Thursday, Nov. 5, has been updated with market reaction and comments from Fed Chair Janet Yellen.

Covering a $120 billion shortfall would be an insurmountable feat for most people or businesses, but Goldman Sachs (GS) - Get Report believes the challenge is a "manageable" one for the nation's largest banks.

They'll probably have to borrow money to meet it, however. And at the same time, ratings firm Standard & Poor's says it will review assessments of the companies' credit. The proposed Federal Reserve policy that creates the shortfall makes it less likely the government would bail out the banks in another financial crisis like the one in 2008.

The policy, proposed under the framework of the Dodd-Frank financial industry reform law, would require the eight biggest banks to take on long-term debt - borrowings that don't become due for more than a year - that could be converted to stock during a financial crisis.

By converting a failing firm's debt to equity, the rule would wipe out some of the company's repayment obligation. Creditors, who may have had a chance to recoup some of their money in bankruptcy proceedings, would become shareholders with a stake in ensuring the business's survival because they would get nothing if it fails.

"If losses were to wipe out a firm's capital and push a firm into resolution, a sufficient amount of long-term unsecured debt would provide a mechanism for absorbing additional losses and recapitalizing the firm," Fed Chair Janet Yellen said during testimony before the House Committee on Financial Services on Wednesday.

"This requirement provides a means for "bailing in" a firm's long-term debt holders so that a taxpayer bailout will be unnecessary," she said. 

At present, the shortfall on meeting the debt requirement -- one piece of what the Fed calls total loss-absorbing capacity (TLAC) -- is spread over six banks.

The darker blue bars in the chart below, which was provided by the Fed, show the amount of long-term debt that the eight biggest banks would need to hold to meet the new standards. The amounts vary by bank, with the largest requirements imposed on the ones whose failure is likely to cause the most economic damage.

Source: Federal Reserve

"The reforms we have adopted since the crisis, including those mandated by the Dodd-Frank Act, represent a substantial strengthening of the regulatory framework for the largest financial institutions," Yellen told lawmakers. "In the coming year, we anticipate moving forward on other rulemaking initiatives that will complement the steps we have already taken."

By the Fed's estimate, banks could reach their targets under the new rule by funding $700 million to $1.5 billion over the next few years until the rule takes effect. Goldman Sachs says that banks may also sell riskier assets and make other adjustments.

"With the rules not starting to phase in until 2019, we see a number of factors that could potentially mitigate the shortfall," Richard Ramsden, an analyst with Goldman, said in a note on Monday.

Bank investors appear unfazed so far. The KBW bank index has climbed 2.5% since the Fed proposed the rule on Friday, outperforming both the Standard & Poor's 500 and the Dow Jones Industrial Average.

"While I think lots of capital may have to be raised, it is very much 'in' the stocks, and they are now being priced off of the possibility that the Fed will raise rates and nothing else," said TheStreet's Jim Cramer, portfolio manager for the Action Alerts PLUS charitable trust. "So I think the stocks are fine even if they do have to raise capital."

Action Alerts PLUS is long Wells Fargo and has a $63 price target on the stock. Get full analysis on it with a free trial subscription.

Meeting the new requirements may be easier for some banks than others, with more conservative companies taking the worst hit.

Wells Fargo (WFC) - Get Report , for example, is one of the safer banks under the Fed's rules for determining which companies are systemically important financial institutions because of its large deposit base and limited debt. The new rule will require the San Francisco-based company to borrow more.

The bank "has such a high concentration of deposits that they don't have enough long-term TLAC-eligible debt on the balance sheet," said Brian Kleinhanzl, an analyst with KBW.

By contrast, large banks such as JPMorgan Chase (JPM) - Get Report and Goldman Sachs have habitually held long-term debt on their balance sheets as a funding source. While adding more could be cumbersome, it does not require overhauling their business models.

Across the board, "there will be a modest earnings drag from having to issue debt versus holding deposits," Kleinhanzl said.

That won't occur for some time, however: Banks are unlikely to start borrowing money to make up for the shortfall immediately because the rule isn't finalized, much less in effect, and debt with a long-enough maturity to meet requirements for a far-distant date would carry higher interest.

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