Rubber Band Man?
Updated
March 30, 2023
5
m
TLDR
I’m mildly disappointed with the Fed hike. Yes, often we need to straddle multiple priorities, but often to get the required action requires picking one or the other. Like a fork in the road and deciding to plow over the sign, it does not get you to either spot.
The issue is that there’s a third implicit mandate of the Fed. We want low unemployment and low inflation AND banks not blowing up left and right.
Unfortunately, they only have one knob to tweak, which is setting funding rates both for short term, and long term fixed-income through asset purchases.
When a big part of controlling inflation is through setting expectations, going the middle road means that folks will not have full confidence that the Fed will keep inflation in check. Meanwhile, it’s also not providing enough support for smaller banks that are struggling with asset portfolios that have been annihilated by the fastest pace of hikes in a century by… hiking once more?
Sounds like a lose-lose to me. But I’m actually wrong. They have an even bigger tool at their disposal, which is macroprudential regulation. We could have imagined a world where they kept their hiking policy in place, but sounded the alarm to all bank treasury departments about upcoming hikes. And grilled them about their strategy. That’s not what they did.
The fact of the matter is that they have been asleep at the wheel. Many blame the roll back of bank regulations in 2018 that let SVB slip through the cracks and not be subject to stress tests. But the Fed has significant discretion on this matter, and could have labeled SVB a systemic risk despite its smaller balance sheet. Ok, suppose SVB did get labeled systemic and had to go through stress tests… If you look at the 2023 scenarios, it didn’t even have a scenario where rates were going up. In the severe adverse scenario, rates go to zero. That’s right, SVB would have passed with flying colors.
The last argument from Michael Barr, the Fed’s Vice Chair for Supervision is that regulators did notice these deficiencies and sounded the alarm, but were ignored by the bank managers. They were helpless bystanders looking at a slow motion train wreck.
That’s pretty unbelievable. Post 2008, bank regulations have gotten much tougher. The standard operating procedure is that if regulators ask you to jump, you ask how high and do you also want me to do a pirouette while I’m at it?
In fact, even more than simply a convention that is followed, the Fed has the ability to directly remove bankers. I repeat it again, they literally can change management if they don’t like what they are doing.
So what are we left with? A resilient, well regulated and strong banking sector before SVB, post SVB collapse, pre CS firesale, and post CS firesale. Yet here we are dealing with bank runs. At the very least it should dawn on regulators that bank runs in the 21st century require neither insolvency nor illiquidity. A large bank such as CS can be a victim of a bank run solely from social media.
Given that the time to supervise banks about rate hikes was a year ago, it’s a bit too late to ask for banks to eat those losses now and go steadfast in hiking rates. Especially when by some estimates, these total nearly $1.7T, vs $2.1T of equity which would essentially wipe out most of the equity.
The other road the Fed could have taken would have been the ultra hawkish messaging with no hikes. It’s simply identifying that financial stability in the next 3 to 6 months would take precedence over inflation. Keep rates stable, build all the tools necessary to give troubled banks necessary liquidity to weather the storm, especially since no one is disputing the quality of the asset portfolios. Everyone was simply holding treasuries. It’s not a solvency issue that we are dealing with, just a much faster liquidity crunch than previously imagined.
Force banks to shrink their Held To Maturity portfolios, which would cause a one time hit, but in exchange, you give them unlimited Bank Term Funding Program (BTFP) for the remainder, and perhaps additional funding for non High Quality Liquid Assets (HQLA) assets. That way, it paves the way for future hikes if inflation is as stubborn as the Fed believes.
That is pie in the sky thinking though. It’s not politically popular to advocate banks to take upfront losses for something that could potentially be bailed out… I mean er…“socialized” with taxpayer money later.
The middle road approach the Fed is taking is equivalent to shrinking, but instead of recognizing the losses instantaneously, they’ll bleed through earnings over many years. People prefer that for some reason.
The one possible way that everyone is saved without pain is if somehow inflation drops like a rock with the Fed easing equally aggressively, inflating bond values along the way. Does that playbook sound familiar?
Meanwhile…
While Fed Chairman Powell worked resolutely to reassure markets following the FOMC hike on Wednesday, Treasury Secretary Yellen’s testimony appears to say that no additional support would be given. This sent markets down precipitously, and resulted in her having to backpedal her statements by reiterating that additional support would be provided if needed.
Markets still ended up on the week, however the damage to her credibility is what matters the most here. At best it sounds like she is actually not aware of the developments happening at Credit Suisse and elsewhere when she continues to reiterate that banks are safe and sound only to have a globally systemically important bank being acquired via emergency measures requiring over $200B of support from the Swiss government.
At worst, it sounds as if the Treasury will not have the ability to contain the crisis or do what it takes to keep this crisis isolated to a few banks. Certainly no one wants a Great Financial Crisis 2.0 on their watch, but simply wishing it to be the case does not make it so.
Yet, at the same time, it seems that regulators are busy orchestrating a…
I don’t believe in conspiracy theories, so I haven’t talked about this topic until it’s been pretty obvious there’s been a clear emphasis on targeting crypto companies. The US regulatory regime has by and large turned negative on Crypto. It essentially failed to catch the biggest blowups of 2022, but has successfully managed to shut down core parts of its infrastructure.
A rough timeline of events:
Each of these actions is somewhat baffling, and when they come together within the span of a few weeks, we can see a clear pattern. They are burning the bridges to crypto. To be clear, I think we are still very far away from overt financial repression. But Silvergate and Signature anecdotally supported well over 50% of all fiat to exchange transactions. This is a big deal.
At the margin, it forces individuals to use less regulated alternatives, and companies to look elsewhere when they consider establishing a crypto/financial services company. In the heyday of crypto, you had to wire funds to an international bank account and cross your fingers. Never thought that after 10 years, we’d have even less options than that. Non-US banks and exchanges are now very reluctant to do business with US customers due to the well justified concern of the extremely long reach of US law.
The Great Financial Crisis (GFC) was unprecedented in its impact on financial markets. It put the Fed to the fore and also gave the opportunity for central banks globally to experiment with new monetary policies to support their flagging economies. In hindsight, it seemed obvious that those fiscal and monetary measures were not inflationary (at least in terms of goods and services), because it was coupled with regulatory action requiring higher capital, causing banks and financial institutions to massively de-lever and tighten lending standards.
A simple analogy is that credit creation is like a rubber band. It can stretch and fund investments of various quality, which incrementally tightens the rubber band causing tighter financial conditions for the next marginal investment.
Post-GFC, the rubber band has been massively extended in length (monetary stimulus), only to be put into a steel cage (financial regs). Hence the “slack” in the financial system. The only outlet came in the form of asset price inflation. The only thing better than earning 8% per year on stocks is to borrow at 0%, lever up 100% and earn 16%!
It’s not a free lunch however. The rubber band must be able to offer credible resistance against infinite stretching, otherwise it cannot hold anything together and financial assets of all sorts within its circle of influence crumble and...the currency falls out!
The US national debt stands at over $31.5T, which has tripled in the span of slightly over a decade. Notice how the speed of growth has been accelerating. This is unusual when GDP has only grown 50% in the same time span.
It’s not necessarily disastrous however, since every dollar of liability is really someone else’s savings (I wonder who owns a lot of Treasuries?) Oh wait, Banks do! With marked to market losses around ~$2T. And now we come full circle.
Banks were incentivized to buy Treasuries, instruments that underpin the market for nearly all other lending, thereby lending to the US Government at below equilibrium rates. The government then takes that money, and helicopters it into the hands of individuals during COVID, who spent the money hand over fist on toilet paper and meme stocks.
Add a dash of once-in-a-century pandemic disrupting the rhythm of the industrial complex, and we have a textbook demand + supply shock occurring at the same time.
Now that we are here, there’s only 2 ways out. To save the banks, bond prices need to be propped up. This means that we’ll lose the battle on inflation and debase the currency to allow debtors to inflate their way out albeit slowly. This is a textbook play and has happened time and time again across less developed countries. Everyone's a millionaire!
The other way is to keep inflation in check. The massive rise of asset prices in the last decade needs to be undone. This will require much higher interest rates, forcing investors to reprice opportunities with much more conservative and higher cash flow requirements, crushing valuation multiples of stocks, bonds, commercial real estate, etc. In this process, the unrealized losses realize themselves, either as poor earnings or direct capital hits. This essentially stops all lending in its tracks as banks de-lever due to loss of capital. All but the top 50 US banks survive? Massive job losses? Have you seen the streets of Paris lately?
Guess which one is more appealing to regulators. See you next week!
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