ANNOUNCER: Welcome to TD Cowen Insights, a space that brings leading thinkers together to share insights and ideas shaping the world around us. Join us as we converse with the top minds who are influencing our global sectors.
JARET SEIBERG: Welcome to Two Cents, the financial podcast at TD Cowen. I am Jaret Seiberg, managing director and financial services policy analyst at TD Cowen Washington Research Group. Our podcast today will feature a conversation on the market with Scott Smith, TD Cowen specialty salesperson for Financials.
We also will speak with Gennadiy Goldberg, the director of US rate strategy at TD Securities, on what it would mean if Congress bars the Federal Reserve from paying interest on reserves. We'll then wrap up with a preview of what to expect in the coming month. But first, let's catch up on some of the policy news out of Washington for financials.
The future of the Federal Reserve chair is probably the biggest story. Bill Pulte, the FHFA director, continues to push for his removal. We had the historic tour of the Federal Reserve's building renovations by the president. This is one of the rare times that the President of the United States has visited the Fed. Despite all of the headlines, we do expect that Powell will serve out his full term. To us, the risk to long-term interest rates-- removing Powell is simply more than what the president is going to be willing to bear.
The other big news this month was the Federal Reserve's Bank Capital Conference on July 22. We were impressed that the broad consensus to move forward with reforms on the capital front. I think the G-SIB surcharge, which is the extra amount of capital that the biggest banks have to hold, is likely to get reformed this year. That would be positive for the biggest banks.
There also was a consensus that Basel III Endgame needs to get done. No, that's not a new Marvel movie. It's the new capital regime. I expect the version that they propose next year is going to end up being capital-neutral for the bank. But just getting this done does take a risk off the table for the banking industry.
On the stress test, the banks clearly want to retain the stress capital buffer. And they want to keep using the stress test as a tool to set capital. And it's why I do expect we'll get disclosure of the models that are used for the stress test sometime late this year or early next year.
On the housing front, I think this is clearly becoming a priority in Washington, much as we foreshadowed earlier this year. It's not just the inclusion of low-income housing tax credit and opportunity zone expansions and the reconciliation bill. We also have the Senate pushing a collection of bills. Many of those would help manufactured housing. I think you're also seeing a real push at FHFA for to try to bring down closing costs, though we would caution a lot of the talk about credit scores and credit score reform is unlikely to have as big of an impact as some of the media stories might suggest.
On the crypto front, stablecoin legislation became law, though it may be about three years until we have a real impact. Probably the most immediate threat is going to be to money market mutual funds, although banks do have an edge, as tokenized deposits are excluded from the new law.
The other big news in the crypto front is the push to tokenize equity securities and shares in private companies. The SEC could give this a big boost by providing exemptions from the Order Protection Rule. I know that sounds like gobbledygook. But it's a very important rule.
It ensures trades happen at the best available price. Were the SEC to do this, it's really going to call into question the future of the Order Protection Rule. And that could have a much bigger impact on equity trading in US markets.
Let's turn to our first guest. Scott Smith is TD Cowen's specialty salesperson for Financials. No one has a better handle on how the broader Financials team is thinking about financials than Scott. And with bank earnings season largely behind us, seems like the perfect time to check in. All right, Scott. What did we learn from all the banks?
SCOTT SMITH: Well, aside from you overselling me, we learned a couple of very interesting things from bank earnings. First of all, obviously, the capital markets businesses were a significant positive surprise, more or less, across the board. And then in the regular way, banks-- the big surprise was really that commercial and industrial loan growth was much better than anyone had expected, including, seemingly, from the commentary, the managements of the banks themselves.
Subsequently, what's been interesting is the outperformance of large banks versus regionals. And you would think that that made some sense, given the fact that capital markets activity was such a big driver. But we also did see the beginnings of what does appear to be some growing M&A.
And so in that context, the underperformance of the regionals, which actually hit a low, the spread between large and regional banks that we haven't seen since 2008-- that seems to have mostly been driven by the conference that you attended with the Fed, where Sam Altman got up and suggested that the cost around defending against AI fraud was going to be so material that it's going to be a difficult story for regional banks to actually be able to effect that kind of change in their budgets. And so expense ratios may actually go higher.
The positive sides of that, obviously, would be that we expect to see more M&A. We've seen Synovus and Pinnacle get together. We've seen an activist get involved in Comerica. And then not really in the same vein, but certainly topical, we've had a couple of different press reports about Northern Trust being a potential target for acquisition.
JARET SEIBERG: We talked a lot about the banks right now. But we look at insurers, brokers, and payments as well. What are some of the big takeaways in those spaces?
SCOTT SMITH: So insurance has been interesting. We saw with Brown & Brown, in particular, this week some negative commentary on pricing-- take the broker trade out a bit. And some of that is because people are now seeing the benefit of the bank trade becoming much more clear. And so brokers are a little bit less interesting in that vein.
And then if you add in the fact that pricing seems to be slower-- or slowing on a continuing basis, we've seen that trade come to the fore. Underwriters of risk-- the quarters have been OK so far. And we're really still waiting for a number of the life insurance companies.
Over in payments, it's been a pretty interesting story. Credit quality continues to be pretty good, if not better than expected. Where we've seen remarkable strength have been in some of the more nontraditional names. You had SoFi, Lending Club both up incredibly sharply after their earnings. But across the board in the consumer finance space, the story remains largely as it has been all year. Credit quality continues to be just fine.
JARET SEIBERG: Take a step back, and you talk to folks about what this market is like right now. What's your big overarching messages?
SCOTT SMITH: The biggest overarching message is it does seem like investors are back in financials. There's been an uptick in interest that's fairly significant. And I think a big chunk of that is, obviously, the regulatory environment, but also the fact that at this point, the economy is still doing vastly better than anybody would have thought a couple of months ago.
So the interest level is there. People are very excited. We're waiting for whatever the next step is on tariffs and the next step around the Fed. But it seems like the names are relatively cheap. There are probably going to be, broadly speaking, beneficiaries of AI implementation in terms of what it will do to costs on a going-forward basis. That's a fairly significant, if not predominant, theme that Steve Alexopoulos, our large-cap banks analysts, has been highlighting. So the interest is there. People are excited.
JARET SEIBERG: All right. Well, I think we're going to leave it there. Scott, thank you very much for the update. One issue that's starting to percolate in Washington is the idea of barring the Federal Reserve from paying interest on reserves. This is seen as a way to reduce borrowing, as the Federal Reserve could send those funds to Treasury instead. To help us really understand what this could mean for banks and monetary policy, I'm delighted to introduce Gennadiy Goldberg, the head of US Rate Strategy at TD Securities and part of our dynamic duo over there that tracks our friends at the Federal Reserve.
All right. Gennadiy, welcome to the show. No reason to beat around the bush. What happens if the Fed cannot pay interest on reserves?
GENNADIY GOLDBERG: And thanks for having me, Jaret. So nothing good, unfortunately. I know it sounds like a brilliant idea. But there's a reason that the Fed's allowed to pay interest on reserves. And just from a quick plumbing standpoint before everyone's eyes glaze over once I talk about Fed plumbing, there's a reason the Fed pays out interest on reserves. It allows, basically, to set a floor for how low interest rates can go because, as we all know, the Fed's been running a very large balance sheet over the last couple of years-- basically, since 2008. And it really hasn't gone back to what we call as quote unquote, "normal."
Pre-2008, we were running a scarce reserve framework. Basically, the Fed was trying to make sure there weren't too many reserves in the system. They would conduct repo and reverse repo operations, your macro 101 from back in the day, if you're old enough, before quantitative easing came about and everything got thrown out the window and the textbooks had to be rewritten.
Since then, the Fed's been, basically, using a floor system. So with the use of interest on reserve balances, the banks are basically incentivized not to lend below a certain rate. So if you set that, let's say, just in the low 4's at the moment, banks will not actually conduct business until we're past that level, which is basically a minimum level of lending.
If you get rid of it, and let's say suddenly-- so let's run through that theory where we wake up tomorrow and the Fed just can't do that. Well, what happens? Very quickly, the banks are not going to be holding as many reserves as they do now. Now, reserves are being held for payment reasons, for liquidity reasons, for regulatory reasons. But there's a lot more that is being held by banks than they probably need. So they're going to go down to the absolute itty-bitty, tiny minimum.
And that means there's going to be a lot more reserves in the system than the Fed currently needs. That money is going to be looking for a home. So any dollar that was invested in reserves, which is basically cash, is going to be looking for a home. So what's going to happen is it's going to fly into all sorts of other money market rate products-- Treasury Bills, for one. And it's going to really sharply lower interest rates on just about every money market product.
JARET SEIBERG: Gennadiy, I got to stop you there. Why isn't that a good thing? We hear the president talking all the time about the need for lower rates. Why shouldn't we want this outcome?
GENNADIY GOLDBERG: Well, that's the upside risk of this. The downside risk is the Fed has basically lost control of interest rate policy. And the way for them to fix that, the way for them to actually target the right level of interest rates, is to get their portfolio down very, very quickly. So they have to start selling assets fast. And when you've got a $2 trillion a year or 6.5% of GDP deficit or so, selling hundreds of billions of dollars of additional treasuries and mortgage-backed securities to get that balance sheet sharply lower is not going to go well.
So what's going to happen is, yes, you're going to see money market rates-- so three-month bills, for example-- probably plummet. But you're going to see longer term interest rates. So anything out the curve two years plus-- probably really take off. So talk about 10-year interest rates probably rising 50, 100, 200 basis points-- really, what we view as a loss of control of interest rate policy. And that will cascade into consumer products.
So we always like to talk about mortgage rates. Well, what's that going to do for mortgage rates except to push them sharply, sharply higher? We used to think 7% was terrible. Now we're going to think 7% is great because we'll be going to something like 9% or 10% if done in an uncontrolled fashion.
JARET SEIBERG: All right. So that sounds really bad. So then I take back my earlier comment. If this is going to be so bad, then why is this getting serious consideration?
GENNADIY GOLDBERG: I think it's the issue of the Fed not paying interest back to the US Treasury. So for years and years and years, at least post-2008, what eventually-- what essentially happens is every security that the Fed holds of the US treasuries, anything that they don't need for their own operational purposes-- so basically, to pay interest, to pay themselves, to pay their staff, to pay rent-- gets remitted back to the US Treasury. It's basically money printing, effectively.
The issue now is because the Fed bought a lot of very low-coupon securities and because they're not prepaying fast enough, the interest rates are low, they're actually paying out at north of 4% on interest on excess reserves or Interest on Reserve Balances, IRB. But they're receiving much lower interest rates. They're basically upside down. They're basically like what happened to the banking system around SVB.
Now, the Fed's not going to go bankrupt. There's no issue with that. What it does is just accumulate on the bank's balance sheet, on the Fed's balance sheet, until such a point where interest rates come down or the portfolio actually adjusts and they will start paying interest once again. But it's that view that it's a loss of revenue. That's really, I think, the driving factor behind this push to disallow the Fed to pay interest on reserves.
JARET SEIBERG: Clearly, this is a-- would be a big deal for traders, a big deal for the banks. The market is normally very good at looking forward and pricing things in. Are we seeing this being priced in at all? And how should we think about the probability of this actually happening?
GENNADIY GOLDBERG: I'll defer to you on the probabilities because I do think that's a function of what's going on with-- in DC. I would call it a low-probability, extremely high-impact type of event. So this is a tail risk. This is, effectively, a gray swan, if you want to talk about it in those terms.
I don't think the market can price that in. Markets are not very efficient in pricing in these big, big, big tail risks that are 1% probability or 0.5% probability, depending on who's up on Capitol Hill. I don't think this is something that they're pricing in right at this moment. If it starts to get more traction, then absolutely, the market will start to price this in. And you may see some shifts preemptively out of the banking system, maybe going into Treasury Bills, maybe markets being worried about asset sales from the Federal Reserve to try to get their balance sheet lower. And it really does depend on the time frame.
When the law was implemented allowing the Fed to pay out interest, initially, the initial writing of the rules was starting in 2011. Now, that got pulled forward from 2006 initial bill to 2011 implementation to actually 2008 because we, basically, needed the program. And that got pulled forward.
If this is a five to 10-year phase-in, it'll lower the probability that something terrible happens because the Fed can have a little bit of time to adjust. But it'll still be a market-moving event, for sure. It's just really a function of how fast this happens and whether it really starts to get any traction.
JARET SEIBERG: All right. Well, I think we're going to leave that issue there. I would say in terms of key catalysts in Washington to watch, we have September 30, which is the end of the government's fiscal year. We have talk of another reconciliation bill either late this year or next year.
This type of provision is often used as a revenue offset to those types of spending packages. And so to me, those would be the big risk areas to pay attention to. Gennadiy, thanks for your time today. We'll get you back on here in the fall to give us an update on where it stands.
GENNADIY GOLDBERG: Thanks, Jaret.
JARET SEIBERG: So I want to wrap up our podcast with a quick preview of what to expect in the coming month or so. Congress is in recess until early September. That's when they will return and start to focus on the spending bill. The government's fiscal year ends on September 30-- hard to see much else getting done until there is some deal on keeping the government open.
We also have the Federal Reserve's Jackson Hole conference August 21 to 23. That's really the first chance to signal if interest rate cuts are forthcoming. Expect that to be an even bigger media circus than we see every year.
More broadly, tariffs and trade and President Trump's agenda on that front-- with Congress away, that's probably going to be the biggest economic story out of Washington. And I think that we should continue to expect headline risk on that front.
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That wraps up our TD Cowen Two Cents podcast. Thanks, everybody, for joining us. Thanks to Scott and Gennadiy, our guest speakers this week. And we'll be back at you next month.
ANNOUNCER: Thanks for joining us. Stay tuned for the next episode of TD Cowen Insights.
