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October 11, 2023 | Last week, we had the opportunity to speak with Julia LaRoche (a/k/a "Sally Pancakes") about the financials and the economy. During our conversation, we focused on what we call the “Silent Crisis” created by the FOMC in the banking and commercial finance sectors. Following on the heels of the Powel Panic and the COVID lockdowns in 2020-21, the Silent Crisis is led by banks, and residential and commercial real estate. But not consumers -- yet. Wait for it.
The asymmetry of the current financial crisis in terms of “traditional,” consumer-led recessions represents a huge threat to the US economy, the banking system and the credit standing of the United States. But the threat is largely invisible to policy makers and economists. The Mortgage Bankers Association (MBA), National Association of REALTORS® (NAR), and National Association of Home Builders (NAHB) wrote to Fed Chairman Jerome Powell this week:
“According to MBA’s latest Weekly Applications Survey data, mortgage rates have now reached a 23-year high, dragging application activity down to a low last seen in 1996. The speed and magnitude of these rate increases, and resulting dislocation in our industry, is painful and unprecedented in the absence of larger economic turmoil.”
Notice the end of the last sentence. There is no “larger economic turmoil,” only confusion and incompetence at the Fed and within the Biden Administration. As we noted in our last comment (“Texas Capital Bank v Ginnie Mae”), President Biden’s appointees at HUD, the Federal Housing Administration and Ginnie Mae have done immeasurable damage to the US housing market. The Powell Panic starting in 2019 is shown below in a marvelous Bloomberg chart showing the effective duration of all GNMA MBS.
The Powell Panic
Source: Bloomberg
First the banks left the government mortgage market a decade ago. Prudential regulators told banks not to lend to low-income families. Now many nonbank lenders that support underserved communities are fleeing the Ginnie Mae market as funding costs reach impossible levels. The Biden Administration's new capital requirements for nonbank issuers make profitable operations impossible in the government loan market.
Leaving aside the public displays of idiocy within the Biden Administration, the Fed remains the real culprit in the malfeasance, first and foremost by inflating home prices by roughly 40% over the past five years via overmuch QE. Now the FOMC is trying to correct that "fine tuning" error by driving the housing market into the ground. It is basically a forgone conclusion that the entire market for government-insured reverse mortgages will be owned by the US Treasury before long.
The damage done by the Powell FOMC to housing is but a secondary effect to the real disaster, which shows the US banking system headed for another peak in unrealized losses on loans and securities created during the great ease of 2019-2021. The chart from our earlier comment on Q3 bank earnings is below.
Source: FDIC (RIS), WGA LLC
By our calculations, the US banking sector will be almost completely insolvent in Q3 2023 vs $2 trillion in tangible capital. Proposals to restart TARP so that the Treasury can lend US banks a mere $1 trillion to offset part of these unnecessary mark-to-market losses illustrates the degree to which the Federal Reserve Board has careened out of control. And these same people want to talk about increasing bank capital? Really? H/T to Jack Farley.
At the end of last year, Bill Nelson at the Bank Policy Institute and his co-authors issued an NBER/Hoover working paper about the outlook for Fed losses. Nelson:
“One of my coauthors, Andrew Levin (an econ professor at Dartmouth) has just finished an updated forecast based on the current configuration of market rates. This projection indicates that the Fed will make no remittances to Treasury until 2032. Indeed, from 2023:Q4 to 2039:Q4, the Fed’s net interest income (and hence its cumulative remittances to taxpayers) will be about $1.6 trillion lower than if its balance sheet consisted solely of Treasury bills. That’s more than the annual GDP of Spain. About $1 trillion of this cost to U.S. taxpayers is a direct result of the Fed’s QE4 purchases from May 2020 onwards (that is, its securities purchases made after the Treasury market turmoil had subsided).”
The longer that interest rates stay at current levels, the more likely it is that banks and eventually the US Treasury itself will be engulfed by the interest rate mismatch created by the Powell FOMC. With SOFR at 5.3% this morning, most market participants cannot hold Treasury debt or corporates or mortgage-backed securities without taking a loss on carry. Just how do Treasury Secretary Janet Yellen and Fed Chairman Powell propose to finance the US budget deficit if dealers are losing a point or more annualized on their inventory?
It is not just that the US banking system or housing is in trouble thanks to the Fed. The entire complex of public and private debt created over the past half century is now about to enter a period of debt deflation as described by the great American Irving Fisher a century ago. The only way to avoid catastrophe is for the FOMC to drop interest rates and publicly demand that Congress start cutting federal spending aggressively.
The Powell Fed needs to drop short-term interest rates back down to 4% and leave them there indefinitely. At that level, banks and lenders will be able to function and slowly dig themselves out of the hole created by the FOMC. Then, however, Chairman Powell must discard his reticence about lecturing Congress on fiscal policy and demand that the federal deficit be cut in half. Powell may lose his job by jawboning Congress, but it is the right thing to do.
Aside from short term considerations like bank failures or collapsing home prices, the larger threat facing all Americans is the federal debt. The growing likelihood that the Treasury will eventually default in economic terms represents an existential crisis for the US government. If the deficit is not cut, then the Fed will be forced to again actively purchase government debt.
If the Fed is forced to grow its already swollen balance sheet from current levels, any pretense of “fighting inflation” will be discarded. Banks will balloon in size as their losses mount, the special role of the dollar will be destroyed and Americans will face hyperinflation that will make the 1980s seem tame by comparison. Merely keeping the Treasury from defaulting on $35 trillion in debt in nominal terms will require double digit inflation. Ponder that.
In political terms, the Biden White House and most members of Congress are on the wrong side of the inflation issue. Nor does former President Donald Trump have any credibility on fighting federal deficits or inflation. It may be, ironically enough, that the conservative tendency in the House of Representatives that will force the change to business as usual in Washington.
“In the end, a government of the people cannot escape the 'debt contraction deflation' disaster Irving Fisher described in 1933 by which the people suffer when the government foolishly thinks its obligations can be ignored or unfunded,” notes veteran securities counsel Fred Feldkamp. “We either grow or we will collapse, as one nation—we are inseparable in that regard. Fortunately, as long as we act responsibly, the world will support us. It has no alternate choice.”
Let's hope Fred is right.
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