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4 Things You Need to Know About the Fed

By Motley Fool Staff - Oct 4, 2017 at 5:30AM

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The Federal Reserve is about to see some changes. Here are some of the most important things to know about the potential candidates, and what might change going forward.

Janet Yellen's term as the Federal Reserve chairperson is coming to an end, and President Trump is in the works at picking a replacement -- a choice that will have massive ramifications on the market for years to come.

In this week's episode of Industry Focus: Financials, our podcast hosts go into who the top two candidates are for the position, and how each of them will affect the future of the Fed and the American economy. Then, the hosts dive into some of the biggest changes that might get pushed through the Fed, depending on which candidate gets elected -- from a potential repeal or reworking of Dodd-Frank, to big changes to the Volcker Rule, and more.

A full transcript follows the video.

This video was recorded on Oct. 2, 2017.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, Oct. 2, and we're talking about the Fed. I'm your host, Michael Douglass, filling in for Gaby Lapera this week, and I'm joined in the studio by John Maxfield. John, great to have you back on the show!

John Maxfield: Michael Douglass, it's such a pleasure to be on the show with you. It's been a long time, my friend! A long time.

Douglass: It has. Longtime Industry Focus listeners will remember I used to run the Financials show. It must have been, what, two and a half years ago? Three years ago? Something like that?

Maxfield: It feels like an enormous amount of time ago. I want to say something about you, Michael Douglass, to our listeners. OK?

Douglass: Oh, wow. Here it goes.

Maxfield: When did you join The Motley Fool?

Douglass: It would have been January 2014.

Maxfield: January 2014. I joined a few years before that. So I've been able to see Michael Douglass' full ascent at The Motley Fool. And let me tell you something, listeners. Michael Douglass is one of those extraordinarily talented individuals. And I'm not just saying this because we work together and all this stuff. But it's been so much fun watching you, Michael, not only because you've gotten, in such a short amount of time, good at the whole Industry Focus thing and all that kind of stuff, and the editorial aspects of managing, but you've also become such a good writer. And to see all of those things progress at such a quick pace, it's been a fun thing to watch.

Douglass: Well, thank you, John. Listeners will note that I am blushing. That was not planned. Thank you, John, that's very kind of you! It's OK, I'll send you a picture later. [laughs] 

Maxfield: Another picture? God, you're sending me them all the time. [laughs] 

Douglass: So a couple of important things to note with the Fed. The first is that the hunt for a new Fed chair has begun. And there are, in a lot of ways, two big opposing camps here that President Trump may choose to favor one or the other. We wanted to talk through those. And then we'll talk through regulatory stuff. But first, let's talk about the two major different ideas as to how the Fed should function.

Maxfield: When you think about the Federal Reserve, I think a lot of people obviously know what the Federal Reserve is. But when you switch out Federal Reserve governors, you really have to know quite a bit about how it operates and how the financial system to really appreciate how big of a decision this could be at certain juncture points in time. And we're at one of those junctures right now. 

Janet Yellen's term is coming to an end, and President Trump is trying to figure out who the next person is that should replace her. And he has a choice between two starkly different ideological camps. On one side, we have a guy like Jerome Powell, who's already a member of the Federal Reserve Board of Governors. Very respected man. But all the indications that we have thus far imply that he will continue the current force that Janet Yellen has set. What that means is, continue to gradually increase interest rates as the data from the economy comes in and supports that. The second is to continue to have a heavy regulatory presence in the banking industry. Of course, this is all the result of Dodd-Frank and reaction to the financial crisis. So that's on one side.

Douglass: And on the other ...

Maxfield: There's another side. The other side is represented by a guy named Kevin Warsh. And Kevin Warsh is also a former Fed governor. He was a Fed governor from 2006 to 2011, whereas Jerome Powell is still a Fed governor. Kevin Warsh is more of the ilk that he thinks you should come in and, as opposed to gradually continue the current course, that you should dramatically reform the Federal Reserve from a variety of different angles. One of the things that he has argued in the past in a Wall Street Journal Fed piece is that the Federal Reserve is too confident and too reliant on its data analytics and data analysis, because you're analyzing things that are so difficult to predict in the future. You're relying on these precise models about really imprecise things. And that's an overarching belief of his. And that would impact the rate at which you would increase interest rates, because if you're looking at the data really closely to determine if and when to raise interest rates, that's going to dictate that whole thing. But if you don't think the data should be given as much respect, then you're going to be making that decision outside of that channel.

And on the regulatory front, Warsh -- and this won't surprise anyone, given the underlying currents in current administration ,in terms of how they feel toward regulations -- he thinks the Federal Reserve is much too robust of a regulatory agency, and thinks it needs to step back from that role in the banking industry.

Douglass: So what we'd be seeing here is either a stay-the-course versus a dramatic change. Certainly, with this administration, it's hard to predict which way they'll go. That said, the general sense of things has been that they've wanted to pretty radically change things, and particularly shrink the role of government where possible, so you could certainly see a stronger argument for them going with Warsh, ultimately. And there are interviews going on right now. President Trump has not announced a pick. Of course, with our luck, he will announce a pick before we go live, before this posts on iTunes, but such is life.

Maxfield: And here's another point about Warsh that I think is fair to say is a very relevant point, in terms of whether he'll be selected or not. Warsh is married to the granddaughter of Estee Lauder, the makeup empire. And his father-in-law is friends with Donald Trump. This is what the reports are -- his father-in-law has been personally lobbying the White House to pick Kevin Warsh. You also have that element at play. So I'm with you, Michael. If I were forced to bet on this, who was going to be the person selected, I would probably bet on Warsh.

Douglass: Yeah. Fortunately, we don't have to make bets, which is all for the best, because my ability to predict the future is pretty poor. But this is going to have a big impact on the stock market, not just in the short term but in the long term, and also in the Fed's role in the economy. So this is definitely a big story you're going to want to watch.

Now, with that in mind, let's turn to talking about the big issues at play in the Fed right now. John, you and I talked before the show and homed in on four major ones, the first one being the Volcker Rule. Let's talk through the Volcker Rule -- first off, what it is, and then why it's potentially on the chopping block.

Maxfield: Right. Let me give some overarching infrastructure. Again, there's two things the Fed is responsible for -- monetary policy and regulations. In the regulations area, there are four specific things that people think where regulators and the Federal Reserve in particular have gone too far. The first, as you said, is the Volcker Rule. The Volcker Rule says that banks -- and these are particularly banks with Wall Street operations -- should not be allowed to proprietary trade, to basically act as hedge funds, to buy and sell securities and derivatives for the bank's own account. This is something that Citigroup did, JPMorgan Chase did, basically all the banks did before the financial crisis. And they're trying to get that risk out of banks, because, remember, banks, to make trades like that, to buy assets and make loans, the money that banks use to do that are, in no small part, federally insured deposits. So the thought is, why should federally insured deposits be backing proprietary trading? So what they're trying to do is get the banks to stop doing that.

Well, the problem is, the big banks on Wall Street are called universal banks, so they have both commercial-banking operations and investment-banking operations. And they play a really important part or role in the capital markets.

So you have an insurance company, or a university endowment, or a state pension fund, or whatever it is. And it needs to go out with the money that it collects and buy and sell assets in order to fund their liabilities that they have to pay out in the future. Well, in order to buy and sell, you need help buying and selling those assets. You can't just go to Target or Wal-Mart -- I suppose you could try, but you're not going to have a lot of success. You can't just go there and buy these things. So what you do is go to these big universal banks to buy these things. And in order for these banks to buy these things, they need to buy it from somebody else, take it on to their own balance sheet, and then they'll sell that asset to the person or institution that needs it. That's called market making.

The problem is, in that market-making process, when a bank buys an asset from somebody, holds it on the balance sheet temporarily, and then sells it to someone else, it's taking on risk. And the question is, that can look very much like proprietary trading. It's very difficult to determine between proprietary trading and market making. The problem there is, in order to explain to regulators that they're not proprietary trading, but they're in fact market-making, requires an enormous amount of paperwork, an enormous amount of bureaucracy, an enormous amount of expense.

So the thought process is, in the Warsh camp, is to tailor back the Volcker Rule, to make it less burdensome on banks, but it'll still stop, for the large part, proprietary trading, but allow them to serve as market makers in a less income-burdened fashion.

Douglass: Right. As you pointed out, that's definitely a big concern, particularly in the Warsh camp. John, you're saying a lot of people feel this way, it's very much the banking industry feeling this way, and the analysts who are covering it. I think that's something we always have to keep in mind. Usually, people do want things to be better for their particular area of things. On the flip side would be what serves the public interest. But you make a good point about the difficulty of telling the difference between market making and proprietary trading. I think it'll be interesting to see how that develops.

Let's hop on over to stress tests. Now, this is something that has been in the news a lot more than the Volcker Rule. It's probably something that people are a little more familiar with. But this is very much an issue, and not so much because banks aren't arguing for getting rid of the stress tests, but they basically want to understand how the test is being administered and what the inputs are so they can better adhere to what the Fed wants.

Maxfield: That's right. Basically, every year, the Federal Reserve puts out a list of, like, 30 things that happen in a hypothetical economy. They're horrible things, like, unemployment goes up 10%, house prices, asset prices fall 25%, commercial real estate prices fall 30%. And the question is, what banks thus come in and try to figure out what's going to happen to their balance sheet in that situation. Are they going to go broke, are they going to have enough capital to make it through, etc. Well, most bankers are very much in agreement with the importance of the stress tests as a valuable exercise. Their problem is that they say, "Look, the Federal Reserve doesn't release the specifics of its models that it uses to see how these hypothetical economic situations are going to actually impact the bank balance sheets." And the banks are saying, like, "If you're going to expect us to go through this test, then at least tell us how you're going to grade us, so it'll allow us to perform better on it. Because when you release the results of these stress tests, that impacts our credibility, that impacts our reputation, that impacts how investors and other business people think about banks." So they're just looking for more transparency.

Douglass: And in a lot of ways, I think that makes a lot of sense. Let's turn to capital returns. Currently, for the big banks, and that's the $50 billion-plus assets, the Fed can basically say, "That's really nice that you want to pay a dividend. Tough. You don't get a chance to do that." Same with share buybacks. They basically get to decide whether and what banks can do, in terms of trying to do some of those capital returns. Obviously, there's a lot of concern about that, both from the banks themselves and also investors, in terms of wanting to be able to chart their own course there.

Maxfield: Can you think of any other industry where -- and I'm asking this genuinely -- the regulators tell the companies how much they can pay in dividends and how much stock they can buy back?

Douglass: No, none come to mind.

Maxfield: Yeah, so it's this interesting idea. If you believe that the market provides the most optimal outcome as opposed to a controlled situation, then you would be dramatically opposed, right, to this idea that the capital at banks, how banks handle their capital, is being totally dictated by the Federal Reserve. And so that's a major argument that I think is a very valid argument. I don't think there's a right or wrong answer to it. But that veto power of the Federal Reserve has become a very unpopular, as you can imagine, power among banks and bank executives.

Douglass: And probably investors, too. With that in mind, Industry Focus listeners, what do you think? Do you think the Fed should have veto power over how banks distribute dividends and stock buybacks? Send us your opinion. And, while you're at it, if you have a viewpoint on another industry that you think should be regulated that way, we'd love to hear it, too. Again, We read every email that we get from listeners. Frankly, we pretty much personally answer all of them, at least all the ones that we can. So I would love to hear from you. I know John would, too. Drop us a note -- 

With that in mind, No. 4 -- growth thresholds. Now, this is an interesting one, because a lot of people talk about taxes and say, "If you're about to go up a tax bracket, you want to keep your income below that, because then suddenly you're going to be taxed more." And what I think people forget is, the way the tax brackets work is -- and I'm making up this number -- if you have $80,000 of income at the 15% bracket, and you go to $81,000 and pop up into the 25% bracket, what actually happens is, you're taxed 15% on that lower amount and 25% only on the higher amount. There's never, from a strict tax standpoint, a disincentive to make more money. I think people forget that a lot of the time. That said, on the bank side, there's absolutely a disincentive to get beyond a certain size. Those growth thresholds are $10 billion, $50 billion, and $250 billion. 

Maxfield: If you go back in time to the financial crisis and think, what was the big rallying cry against the banks? It was this too-big-to-fail thing. You had these huge banks, Citigroup and Bank of America in particular, that ran into trouble. But if you let them fail, I mean, Bad News Bears, OK? If Citigroup and Bank of America failed, Bad News Bears for the economy. Big time bad news. Potentially transforms it from a recession into a depression. So that's the underlying thing here.

What that Dodd-Frank Act did and what regulators have done since then is put in these targets at these different size levels for banks -- $10 billion, $50 billion, $250 billion -- that each time a bank passes that, their regulatory burden gets stiffer, more expensive, harder to meet. And what researchers have found is, these thresholds completely distorted the growth patterns in the bank industry. And what they found is, at the $10 billion threshold, and this is $10 billion in assets on a bank's balance sheet, is that banks accelerate their growth rate through that. They make bigger acquisitions of other banks, they do more acquisitions of other banks to accelerate through that, to give them the economies of scale that is needed in order to then absorb those additional costs of being a larger bank.

But then, here's the thing -- the $50 billion threshold, that's the point at which banks then have to start participating in that public stress-testing process, and all of these other things happen at that threshold, too.

Well, that threshold has become almost an impenetrable barrier for growth in the bank industry. Only one bank has passed it since the financial crisis -- CIT Group, with its purchase of OneWest. OneWest traces its roots back to a bank that was a major bank in the California area that failed during the financial crisis. Well, it passed, and then it's just been doing horrible ever since. I guess I shouldn't say horrible ever since. It has struggled ever since to rationalize its business model.

Well, there's another bank that tried to pass. We've talked about this bank on this show, and we've written a lot about it at The Motley Fool. It's called New York Community Bancorp. New York Community Bancorp forever has paid out something like 90% of its earnings in dividends, and it's just, ever since it went public in the mid-1990s, it's just been an incredibly successful company. It's one of the top-performing bank stocks over that time period. It was at, like, $44 [billion]-$45 billion in assets, and it stopped, it literally stopped growing organically so it wouldn't hit that $50 billion threshold. So it would be selling assets off its balance sheet so it didn't cross that threshold and then have all these additional costs.

Well, then, when it did try to pass that threshold with a large acquisition, it had to do all these different things in order to come into consonance with what the regulators were looking for from a larger bank. And one of the things it did was cut its dividend by a third. So it totally changed the investment dynamics of this bank.

The problem is, that deal didn't go through. The regulators were taking too long to get that deal to go through, so the two banks split apart. So ever since then, you have this bank that's performed so well for so long, and predicated in part by paying out 70%-90% of its earnings each year in dividends to its shareholders, that cut its dividends by a third, invested all of this money to meet its added compliance burden, but yet wasn't allowed to pass that threshold.

So what we're seeing is this extreme distortion in growth in the bank industry right now. And again, to your point earlier, people outside the industry, I don't know how much of an opinion they would have on some technicality like this, but I would say inside the industry, and I would say even industry observers, are all in agreement that growth thresholds like that are not necessarily the healthiest way to govern that or deal with that too-big-to-fail issue.

Douglass: Sure, absolutely. Thanks for that commentary there, John, that's a good background. That's it for this week's Financials show. Questions and comments, you can always reach us at, or tweet us @MFIndustryFocus. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For John Maxfield, I'm Michael Douglass. Thanks for listening, and Fool on!

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