December 5, 2023 | Premium Service | In this issue of The Institutional Risk Analyst, we release the latest edition of The IRA Bank Book for Q4 2023 for subscribers to our premium service. Copies will be available for purchase in our online store later this week.
While the banking industry’s insolvency reached its worst position ever at the end of Q3 2023, the subsequent rally in interest rates has made the ugliness of unrealized losses a little less horrific. The industry’s negative mark-to-market position is shown below with a $1.8 trillion capital deficit below.
Source: FDIC/WGA LLC
Stocks soared over the past month on the promise of lower interest rates. No surprise, we heard from a reader named Eric, who is a prominent bank owner and also an advisor to banks. He asks whether the surfeit of liquidity being maintained in the Treasury General Account at the Fed is behind the rally in stocks. By no coincidence, Simon White wrote a comment in Bloomberg on 11/28/23 claiming that the movement of cash out of the Fed’s reverse repurchase (RRP) facility and Treasury's account at the Fed helped stocks. White:
“The change in the change of reserves typically leads the one-month performance of the S&P (as shown in the chart below). Reserve growth began to accelerate about a month ago, the same time as when the market began to rally.”
The connection between bank reserves held at the Fed and stock prices has long been a favorite topic of conversation on Wall Street, yet we think that the apparent correlation may be coincidental. We asked Bill Nelson at the Bank Policy Institute about the connection between stock prices and bank reserves. His reply: “I can’t think of any reason why reserve balances and stocks would be correlated. Can you?” No, we can’t.
The chart above from FRED shows yields on T-bills (red) vs Reverse Repurchase (RRP) agreements with the Fed (blue). Obviously the yield on T-bills is significantly above RRPs. Big question is whether the FOMC will maintain the yield differential on RRPs vs T-bills as a floor on rates rather than a ceiling, as was the case for many months.
White is correct that the Treasury’s decision to focus new issuance on T-bills helped to reduce the number of money market funds purchasing RRPs from the Fed. He is also correct that when the Treasury spends cash from the sterilized TGA, it results in a net-cash injection into the banking system as payments are received throughout the economy. Again White:
“Funding much of the deficit using bills as opposed to longer-term debt has allowed money market funds (MMFs) to absorb the new supply of government debt. The Fed's higher-for-longer message has kept the rate on bills higher than the rate on the reverse repo facility (RRP), meaning that MMFs have been incentivized to draw down on the RRP to buy bills.”
Under the Volcker Rule banks cannot buy securities directly using reserve cash except for LT treasury investments. These treasury holdings are entirely passive, one of the more bizare downsides of the Volcker Rule that reduces market liquidity. In The IRA Bank Book, we note that bank securities holdings fell more than 10% in Q3 2023 alone.
Since more than 90% of the assets of most banks belong to a customer and industry assets are shrinking, only the holder of a bank liability can actually convert bank reserves into an equity investment. With banks, all things start with the liability, not with the assets. Thus only bank customers/depositors, who have a claim on the reserve asset cash, can buy stocks in a meaningful way. We queried White about the causal link between reserve growth and equity markets and he kindly replied over the weekend:
“Reserves have a balance-sheet cost associated with them, so there is an incentive for banks to do something with them. Even more so recently as the GSIB buckets are decided towards the end of the year (they were announced last week I believe), so banks want to make sure their surcharge is limited.They can consider secured or unsecured lending surplus dollars, eg repo or FX swaps, or funding eg equity future basis trades, etc. FX swaps have been coming in, suggesting some of the new supply of dollars has been lent offshore, but this is becoming less lucrative. So they can also fulfill client demand for buying equity futures, by selling them to them, using the dollars to fund a long in the cash market. Facilitating a natural demand for long equity positions (eg start of month) can gain its own momentum. Overall, the rise in reserves should be equivalent to the rise in reserves from QE, with one of its aims to reduce risk premia through the portfolio effect. But I think the above helps explain how the effect can be pretty much immediate when there's a sudden rise of reserves to the system. This would tie into your t-bills/S&P point, but again I'm not sure that fully explains the immediacy of what happens.”
Does this answer the question? Not really. While the return of funds from the sterilized confines of the Fed’s balance sheet to T-bills definitely represents a significant increase in liquidity, the amount of Buy Side cash that has been parked on the sidelines over the past two years is also quite large. Indeed, every time that officials of the FOMC say that it is too soon to conclude that tightening is over, the bond market rallies. and so do stocks.
“Jerome Powell probably did not mean to trigger a significant easing of financial conditions on Friday, but that’s exactly what he did,” wrote Jim Bianco on X over the weekend. “The chairman of the Federal Reserve gave a talk today at Spelman College in Atlanta in which he declared that it was ‘premature’ to conclude that monetary policy was ‘sufficiently restrictive’ or to speculate on when the central bank might start cutting rates. He even added that the Fed is prepared to tighten further if needed. The market’s reaction was a flat-out rejection of that idea.”
Whether we attribute the rally in stocks to rising reserves due to expenditures from the Treasury General Account or the vast piles of cash on hand among Buy Side managers, the fact is that the inflation injected into the financial system by the Fed has impacted the effectiveness of US monetary policy.
We have a solution for the Fed's messaging problem. Instruct the FRBNY to at least hit the $35B cap on MBS runoff every month from the System Open Market Account. That is, actively sell MBS. As rates fall and MBS prices rise, the Fed should be selling MBS into market strength. Seling more MBS will accelerate the normalization of the yield curve. The FOMC is already losing trillions. Time to double down.
Inflation has skewed the investment risk preferences of funds and other nonbanks to such a degree that private credit seems attractive. Going long credit at the top of a LT cycle in asset prices strikes us as a profoundly bad idea. We’ve heard from a number of fund sponsors seeking to enter the world of private credit in the past month and there will no doubt be more.
The common refrain from the large mutual fund managers seeking to stand up a credit trade is that “there is so much cash looking for a strategy.” Very true. When the credit trade goes sideways a year or two from now, however, please do remember that funds and nonbanks have no comparative advantage in managing credit risk compared with a commercial bank.
Meanwhile, we note that the Bitcoin ponzi has reached $40k, the highest levels seen since last year. The resurgence of Bitcoin is a fascinating phenomenon, but as we wrote last week, regulators in the G-20 nations are increasingly treating crypto as a legal and compliance problem that triggers anti-money laundering and know-your-customer conserns. No thanks.
More notable, in our view, is the rise in gold prices, which is due to a shift in Asian risk preferences from Treasury debt to gold. One long-time reader named Henry, who manages an offshore gold fund, wonders if gold is not slowly going to supplant the dollar and Treasury securities as the prefered risk free asset. With gold, Henry notes, there is no counterparty risk and price discovery in gold has now shifted to Asian markets dominated by China.
We'll be looking at how the Treasury's strategy to fund its mounting deficits with T-bills is helping Jay Powell out of his RRP problem but is also forcing offshore counterparties to seek out substitutes like physical gold. You can use gold as collateral in an ISDA swap. Yellen's clumsy management of the Treasury's funding needs is undermining the dollar and setting the US for a funding crisis down the road.
Finally, we note the bankruptcy of Rene Benko's Signa Holdings, an Austrian based real estate developer that provides a lovely example of the Basel III concept known as Exposure at Default. Exposure at Default (EAD) measures unused but committed credit lines banks make available to consumers and business. These bank lines are committed and may be drawn at any time.
The debt of the Signa group held by some 200 lender banks ballooned in the months before the default, illustrating that committed but unused credit lines can be a significant source of risk for banks. For every $1 of loans held by US banks, there is another $0.80 of unused commitments that can be drawn by the obligor at any time prior to bankruptcy. Sad to say, banks rarely cut unused lines in time to avoid a loss after a default event.
The level of EAD in the industry is over 80% of total loans and illustrates the current high risk appetite of banks. Since the COVID crisis, US banks have added $2 trillion in unused credit lines. Despite worries about an imminent consumer recession, banks remain aggressively positioned with almost $10 trillion in undrawn credit vs $12.4 trillion in total loans.
Even with the current carnage in multifamily and commercial real estate that we document in this issue of The IRA Bank Book for Q4 2023, the great asset price reset for stocks and residential homes is still a couple of years out. Maybe Treasury Secretary Yellen will return to the private sector by then, leaving the mounting mess in the Treasury debt market for some one else to manage.
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