The Fed's Supreme Confidence in U.S. Banks

NEW YORK ( TheStreet) -- The Federal Reserve's recent muddle in communication about a change to its bond buying program may be a quiet vote of confidence in the nation's largest banks, even if it causes billions in writedowns.

In late June, Fed Chairman Ben Bernanke moved bond markets when he signaled a so-called "taper" to the Fed's $85 billion a month in mortgage and long-term Treasury bond purchases by September. Bernanke's comments, coming at the end of the second quarter, were also perceived by some prominent investors and analysts on Wall Street as a way to cool overheating credit markets.

Cool they did. A surge in bond yields at the end of the second quarter made it the worst three months in the bond market since 1994, when an unexpected decision by the Fed to raise interest rates blew up portfolios across Wall Street.

The inclination is to believe Bernanke's comments may have been grounded in such context. Financial institutions might have been reaching too far for risk and as large banks such as JPMorgan ( JPM), Bank of America ( BAC), Citigroup ( C) and Wells Fargo ( WFC) report their earnings for the quarter, there could be pay a price to pay.

In particular, banks face the prospect of billions in writedowns to their available for sale (AFS) securities portfolios. Ratings agencies such as Fitch Ratings and Standard & Poor's have taken aversion to banks growing their securities portfolios as a means to cushion earnings in a weak lending environment.

It wouldn't be surprising for the Fed, which "stress tests" the nation's biggest banks, to have a similar perspective.

For instance, in February, Fed Governor Jeremy C. Stein detailed his view of the Fed's policy options if, at a time of historic monetary expansion, it perceived that efforts to support asset prices were causing systemically important banks to chase risk in a manner that would undermine the central bank's post-crisis efforts to repair Wall Street.

"I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability," Stein said. He argued the Fed's regulatory authority might be insufficient in preventing large banks from reaching too far for yield. Monetary policy, on the other hand, might be more effective.

After the Fed's sudden change in communication, Stein's words stood out as a possible alternative thought process at the central bank, centered on systemically risky credit bubbles.

On June 28, Stein rejected such speculation.

"Although asset purchases also bring with them various costs and risks -- and I have been particularly concerned about risks relating to financial stability -- thus far I would judge that they have passed the cost-benefit test," Stein said.

On Wednesday, however, Fed Chairman Ben Bernanke indicated new uncertainty about asset purchases may have helped to unwind some highly leveraged credit market bets, in a beneficial development for the financial system.

Some of the bond market's prominent investors and analysts took Bernanke's comments as confirmation that the Fed was targeting overheated credit markets in its communications change.

"Fed tapering due to levered risk positions," Bill Gross, founder and co-chief investment officer of PIMCO, said on Twitter.

"Risk premiums got too low, and we didn't like that #bubblepopperinchief," Guy LeBas, Chief Fixed Income Strategist of Janney Montgomery Scott, added on the social network, paraphrasing Bernanke's comments.

While Stein and Bernanke's comments seem to be in conflict, a closer read indicates that there very well may have been a troubling credit bubble forming. It just might not have been relevant to systemically important banks.

If there was a credit bubble, mostly perceived to be outside of the banking system, Stein and Bernanke's comments could both be true.

Data supports such a view.

Amid a surge in bond yields, the nation's largest commercial banks have seen their shares perform steadily, even as analysts and ratings agencies begin to model in significant securities portfolio writedowns.

The same cannot be said for other prominent bond buyers, for instance, highly levered real estate investment trusts (REITs) or high yield bond funds.

Shares of mortgage REITs such as Annaly Capital ( NLY) and PennyMac ( PMT) have fallen sharply since Bernanke's June 23 comments. Bond exchange traded funds (ETFs) such as the SPDR Barclays Capital High Yield Bond fund ( JNK) have similarly suffered.

In his February warning call to credit markets, Fed Governor Stein mentioned junk bonds used to finance leveraged buyouts, bond ETFs, agency REITs and AFS holdings of large banks as some areas where systemic asset bubbles could form outside the Fed's regulatory power. As long-term interest rates have risen from near-record lows, all have taken a hit.

However, according to Stein's recent statements, the issue hasn't spilled onto bank balance sheets in a way that might meaningfully hurt the financial system. In that sense, Stein's belief that the central bank's bond buying hasn't been undermined, expresses confidence in the standing of the nation's largest banks.

Furthermore, many see the market move as beneficial to large lenders like Wells Fargo and JPMorgan.

For example, a rise in mortgage rates spurring losses on banks' AFS portfolios might push them to slow their securities buying and increase their lending, Fitch Ratings financial institutions managing director Joo-Yung Lee said in June.

While rising interest rates will invariably cloud second-quarter bank earnings, they may prove more of a long-term benefit for banks.

JPMorgan, Wells Fargo Shuffle Riskiest $38 Billion Amid Bond Boom

-- Written by Antoine Gara in New York

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