June 2018 Financials News Roundup

The biggest banking reform since the financial crisis has been signed into law, the United States could be entering its first trade war since the Great Depression, and the Federal Reserve is set to raise interest rates yet again.

In this episode of Industry Focus: Financials, host Michael Douglass and Fool.com contributor Matthew Frankel break down what each news item means to investors.

A full transcript follows the video.

This video was recorded on June 11, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, June 11th, and we're doing a round-up episode on three major news events: the largest financial industry reform since the Great Recession, the first trade war since the Great Depression, and the third Fed meeting since the Yellen succession. I'm feeling a little pinchy today. Thank you all for tolerating my sense of humor. [laughs] Matt, welcome back to the show!

Matt Frankel: Always good to be here!

Douglass: Fantastic! Let's go ahead and start in with our first news story. Deregulation is something that we've talked about in the past as being a bit of a cycle. There are number of cycles in financials, whether it's the regulatory cycle, the credit cycle, interest rate cycle, and a variety of other things. Today, we're going to be talking specifically about the deregulatory cycle. 

Congress has passed a major financial reform, a deregulation of the financial services industry. It's pretty similar to the one that we discussed on the March 19th episode of Industry Focus: Financials. If you're looking for a deeper discussion of it, head back to that one. That's where we get into the nitty-gritty. Let's talk about the broad strokes of it, because it has big impacts on bank profitability going forward.

Frankel: Basically, this was in response to what a lot of people consider to be over-reforms after the financial crisis. The Dodd-Frank reforms were the big banking reforms designed to prevent the financial crisis from ever happening again. And what this bill does, it's not a complete roll-back, it doesn't eliminate the Dodd-Frank rules. But it does roll a lot of them back. The biggest provision in the bill changes the definition of what a systemically important financial institution or SIFI is, which up until now has been defined as a bank with more than $50 billion worth of assets. This, in two steps, will raise that threshold five-fold to $250 billion. It increases it to $100 billion immediately, and then to $250 billion in 18 months.

This reduces the number of banks that are considered SIFIs to about a third of what it is currently. This makes sense. Even Barney Frank, whose name is on the Dodd-Frank bill, supported raising the threshold somewhat. The logic goes, if, say, Bank of America were to collapse, we would all be in trouble. That would be a big shock to our financial system. But if a bank like, say, SunTrust or BB&T were to go under, it would be a big shock wave, but would it collapse our financial system? Probably not. That's what they're going for here, to make the SIFI threshold more indicative of what actually is a too-big-to-fail bank.

Douglass: It's interesting, because Frank certainly did support increasing the threshold. I think his number was more like $100-125 billion. This is still bigger than what that number was. But, as you pointed out, this really gets to this core idea of, what does systemically important mean? And this has been the decision. Also, banks with less than $10 billion in assets are exempt from the Volcker rule, which prohibits various risky investments. Smaller banks can now do a little bit more to try and juice their profitability.

Frankel: Yeah, definitely. The Volcker rule, in addition to the real estate provision for smaller banks, where banks with less than $10 billion of assets can now also make mortgages that don't necessarily conform to the traditional Fannie Mae, Freddie Mac standards, giving them a little competitive edge in that market.

The other reform that I think is really what got a lot of bipartisan support on this is a consumer protection reform that makes credit freezes free. Before this, to put a freeze on your credit cost about $10, depending on what state you were in, per credit bureau, and you need to put one individually on all three credit bureaus. So, this is a big win for consumers, and it's kind of why I think some Democrats went over the fence and decided to vote for this bill.

Douglass: Let's talk briefly about the investing implications here. As we touched on in greater depth in our March 19th episode -- again, head back to that one if you really want the full discussion, because that bill was fairly similar to what ended up coming out of Congress and being signed by the president -- this doesn't really do anything to benefit the Bank of Americas of the world. And it doesn't really do that much to benefit your $10-50 billion banks, so, a lot of your regional banks. But what it does do is, it benefits banks that were right on that $50 billion threshold. Now, they can grow without triggering a lot of extra reporting and a lot of extra regulation. So, you can probably expect to see some more mergers and acquisitions in that space, at that size.

Then, of course, as you noted, Matt, there are some benefits for really, really small banks. Of course, the flip side of that is, those benefits often come with some additional risks. Conforming loans are conforming for a reason, for example. When you start doing mortgages that are really outside of what Fannie and Freddie go for, sometimes there's a good reason for that, and sometimes there are not great, let's say, risk-adjusted reasons for that.

Frankel: Right. To be clear, to your first point, the SIFI requirements for banks are pretty expensive. New York Community Bank is one that I talk about frequently that is on the cusp and had been preparing for these extra costs, and it's cost the bank billions of dollars and really driven down profits. This is a big deal to banks that otherwise would have to comply with the SIFI requirements.

To your second point, the small banks, yes, mortgages are conforming for a reason. The non-conforming mortgages were, arguably, the reason for the financial crisis. But, like you said, there are some valid reasons. As long as this is done responsibly, it's a big win for the smaller banks. But it does come with a certain level of risk, and it should be closely monitored to make sure that non-conforming mortgages that are being offered aren't getting out-of-hand again.

Douglass: Right. So, they key investing takeaway here is, at least in the short to medium-term, there are some significant benefits here, especially for some of your medium to large banks in particular.

Let's turn to our second story, which is something that maybe, you don't necessarily think, "Oh, financials," but, the trade war that appears to be brewing between the United States and a number of other countries, let's say, certainly has some big potential impacts on the financial industry.

Frankel: Yeah, definitely. And whether we're actually in a trade war yet or not is another argument for another day.

Douglass: [laughs] Right. Let's just say, if we end up in one at some point.

Frankel: Yeah, let's just say. Basically, our president's mentality is that it's unfair if certain countries charge us high tariffs on goods and we're not charging the same tariffs in response. And, to be fair, it's tough to make the argument that, say, if another country is charging us 50% tariffs on imported cars and we're charging that same country 5%, it's really a tough argument to make that that's fair. But it's a lot more complex than that. That's what we're getting into now with this back-and-forth on what trades we're going to impose, what countries they're going to be imposed on, who's going to be exempt, and all these things. It seems like we are going in the direction of a trade war.

With that said, the effects of a trade war are generally going to be, life is going to get more expensive. Trade wars generally lead to inflation because the increased tariffs are passed on to consumers. You may have read that other countries are considering retaliatory tariffs on us, which would make some of our products a little bit more expensive. This, in turn, higher prices are also known as inflation, and the Federal Reserve likes to keep a close watch on inflation as one of its triggers for raising interest rates.

So, higher consumer prices can lead to higher interest rates, which could lead to not only an economic slowdown or recession, but it also translates to higher borrowing costs. So, not only are goods and services going to be more expensive, but it's going to cost you more money to borrow for them. So, this could be a very taxing trade war on American consumers' pockets.

Douglass: Yeah. Just to operationalize that a little bit, some things respond directly to interest rate hikes, some things don't. For example, credit card rates usually march in, not precise lockstep, but very close to. The Fed announces a rate hike, credit card rates go up. Pretty much, it's a one-to-one. With, say, mortgages, for example, it's a little bit more tenuous of a relationship. They tend to react a little bit more slowly. But, long-term, those also tend to go with them. Auto loans tend to be a little bit closer to a one-to-one relationship, similar to credit cards. There are definitely a lot of things that could be getting a fair amount more expensive in, let's say, a relatively short-term. 

Now, again, one of the big questions here is, do we end up in an actual trade war? There's a lot of saber-rattling going on. What actually ends up happening ultimately? Then, what parts of the economy are affected? There are a lot of different things at play here, in part because we haven't really been in a true trade war since the Great Depression. Now, to be clear, that was during the Great Depression, not before it, so it wasn't necessarily a cause. But the Smoot-Hawley tariffs are generally viewed as a set of regulations that worsened the Great Depression. The other piece to keep in mind there is that it's been almost 90 years since that happened. The world has changed a little bit since the 1930s. So, there are a lot of question marks as we think about that going forward. But, for banks specifically, higher interest rates, generally a good thing, but in this case, not necessarily.

Frankel: Yeah. First of all, like Michael said, most people alive have never lived through a trade war. That's why you're seeing the market jump all over the place every time, will this tariff be announced, will there be retaliatory tariffs. You'll see the market jump a little bit more than you might expect, just because no one really knows what to make of it, especially in the current situation, when we're talking with our allies, talking about putting tariffs on them.

This is not necessarily good news for banks, especially if we see an economic slowdown and things like lending demand drop. That's definitely not a positive thing for the bank. Or, if unemployment starts to pick up because of it, and consumers can't pay their bills, that's a negative for banks. So, there are a lot of reasons why this is not as good news for banks as when, say, interest rates rise because the economy's doing well, as has been a case for the past couple of years.

Douglass: And that's one of the interesting things -- again, taking us back to that earlier conversation about cycles. The economic cycle itself really underlies a lot of these other ones, so when the economy starts, let's say, turning south -- which, inevitably, it will one day, because things can't just expand for forever, much as we all wish they could -- when that happens, the credit cycle starts to turn, basically, banking gets tougher. And that's when banks that have done a really good job of properly managing their credit risk really shine compared to everybody else. That's because everyone's facing a headwind. And that can be a difficult thing across the board. 

It's definitely something we're going to want to watch going forward. For obvious reasons, it's very difficult to pick out winners and losers, or even what people should do right now, because it's been so long since we were in a position like this that it's just not clear.

Frankel: Yeah, definitely. It's been a little while since we've had to deal with this. Like you said, we'll see what actually happens with it. Maybe it'll turn out to be a whole lot of talk over not a big problem. And, some tariffs may actually do their job and be a positive catalyst. But we'll see where this goes.

Douglass: Speaking of predicting the future, because why not? [laughs] Our third story today is a preview of the Fed meeting, which starts tomorrow, right?

Frankel: No, Wednesday.

Douglass: Close enough. Anyway, that happens this week. Amongst other things, the Fed is widely expected to bump the interest rate, raise the fed funds target to 1.75-2%, which is a 25 basis point hike.

Frankel: This would be the seventh rate hike in the current cycle. Basically, a quick background on what this means, when you hear that the Fed is raising rates, this means the federal funds rate, which has wide implications, as we've already discussed a little bit. Specifically, the prime rate is directly linked to the federal funds rate, so anything that's linked to the prime rate is also going to rise. This includes pretty much every credit card in existence. I think something like 99% of credit cards are directly linked to the federal funds rate. Home equity lines of credit also will rise in tandem with the federal funds rate. And other consumer interest rates, like we mentioned, mortgages, auto loans and such, tend to move in the same direction, although it's not a perfect correlation. The general rule is, the shorter-term the lending instrument is, the better the correlation will be. This is why auto loans tend to move a little bit closer in line with the federal funds rate than, say, mortgages.

But, the real story here isn't about the rate hike. There's over a 90% chance of a rate hike already priced into the market, so it's pretty much a certainty that it's going to happen. The real stories are what else the Fed talks about -- specifically, where do they see interest rates going? One of the big questions is, will there be another one or two interest rate hikes after this year? At the beginning of the year, the big thing was three or four, and this will be two. The Fed's projection, which is known as their dot plot, if you see that in articles after the meeting, should give us a little more color on what to expect the rest of this year and the next few years.

Douglass: Of course, I imagine one of the big questions that will be coming out from the Fed -- I'll be very interested to see what the Fed governors make of a potential trade war, and how they see that impacting things, and how likely they think that is to happen. I think a lot of market-watchers will be really laser-focused on this particular meeting to try to get an understanding of where our central bankers essentially think things are going and what's really going to happen. 

Matt, as you and I were talking a bit before the show, the Fed generally paints a pretty rosy picture. Unemployment projections are supposed to be down to 3.6% 2019 to 2020. Does that get impacted? Inflation is supposed to be about 2.1% in 2020. How does that get impacted from here? The Fed very clearly views very gradual ramps up in inflation, down in unemployment, and GDP growth that's in the twos, which is pretty darn good. The question is, what does the current uncertainty, what does the recent bank regulatory reform, what do all these other things, how do those come into this forecast and change it?

Frankel: Right. It's worth noting that one of the big questions here is that, you mentioned the unemployment, they're projecting 3.6% for 2019 and 2020, and only about 2% inflation. That's remarkably low inflation historically for such good unemployment. Generally, when unemployment gets to that level you'll see inflation in the 4-5% range. And, it's also worth mentioning that all those projections you just mentioned were revised up significantly at the last meeting. It'll be interesting to see if the Fed still sees it going in such a rosy direction, or if all of this talk about trade wars and things like that have made them a little more cautious and taking a step back.

Douglass: Yeah. I think that's going to be a big question. Of course, one of the other big issues we'll have to see happening from here is, what's going to happen with the balance sheet runoff, and how is the Fed going to reduce its exposure there?

Frankel: Basically, in the aftermath of the financial crisis, the Fed started buying up treasuries to stimulate the markets, and wound up with a balance sheet of about $4.5 trillion. Recently, not too recently, the Fed has indicated that it was going to start selling these off, unwinding its balance sheet. Most of the Fed directors indicated that it would generally get down to about $2.5 trillion in this round of unwinding. Now, recent reports are indicating that this might end a little sooner and be not quite as deep of an unwinding as we thought, which could be indicating that the Fed isn't going to hike rates quite as much as initially projected over the next few years. So, that's another thing to keep an eye out for, the Fed's balance sheet, and any comments toward that. There's some speculation that they might wait until the August meeting to really talk more about it. But they could surprise the market. There's a big buzz that this is coming this meeting.

Douglass: Yeah. Again, it's one of those things where, when you look at the Fed, what you have to think about is the Fed's viewpoints on what future growth looks like, and then, how risky or how likely, how certain they feel about that growth actually occurring. Future growth is going to happen, the Fed's going to raise rates, just as a general rule. And, they're going to try to, again, get those treasuries off their balance sheet. If there are risks to those outcomes, then the Fed is going to become more conservative in how it approaches those things. So, that's going to be a big thing for us to watch going forward.

Frankel: Just remember, at the end of the day, the Fed's goal is to maintain orderly, non-panicked markets. Pretty much everything they do will be toward that goal. If they see something deviating from what they feel is a normal, healthy market, then expect them to modify something you're doing.

Douglass: Right. And, of course, much as they are experts, the Fed cannot predict the future, nor can the rest of us. Do not take anything that they say, or anything we say, or anything anybody else says, as gospel, because no one really knows for sure what the future is going to bring. 

Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at [email protected]. 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 Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!