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The Institutional Risk Analyst

© 2003-2024 | Whalen Global Advisors LLC  All Rights Reserved in All Media |  ISSN 2692-1812 

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QT, Interest Rates & Bank Solvency

Updated: Mar 31, 2023

March 30, 2023 | Watching the testimony by various officials of the Fed and FDIC this week, it occurred to us that the central bank is replaying several scenarios at once. This may account for the confusion and, at times, contradictions in some of the congressional testimony this week.

First, we are replaying the 1980s, when Fed Chairman Paul Volcker pushed market rates points above bank funding costs, and annihilated a whole class of non-banks known as Savings & Loans. By pushing benchmark interest rates above bank deposit rates, many S&Ls and commercial businesses died.

Second, we are replaying the scenario of the Great Crash of 1929, when the FOMC slammed on the brakes in mid-1928, raising short-term rates from 4% to 6% to stamp out “speculative behavior.” That relatively large increase in interest rates led to the Great Crash of 1929.

As we noted in “Financial Stability: Fraud, Confidence & the Wealth of Nations,” the Fed applied its gold standard model and hiked interest rates through 1928 and the first half of 1929. By May 1929, the crisis of which GM founder William Durant warned President Herbert Hoover “was already visible and would increase like a massive storm.”

In a timely comment, Greg Baer and Bill Nelson at Bank Policy Institute asked the obvious question: Why is the FOMC competing with federally insured banks, even as regulators fret about the cost of resolving Silcon Valley Bank and Signature Bank? They write in “Why Is the Federal Reserve Abetting a Drain of Deposits from Banks?.”

“Every day, the Federal Reserve borrows money from money market mutual funds, GSEs and certain other nonbanks at its overnight reverse repurchase agreement (ON RRP) facility. The facility is subsidizing money market funds as an attractive alternative for uninsured bank depositors. Why is the Fed continuing to operate it at its current $2.2 trillion size?”

Baer and Nelson are two of the best analysts of the Fed and banks in the business. When we asked Nelson why the Board of Governors does not push down rates on reverse repurchase agreements and reserves deposited with the Fed, he responded:

“I think they are in a pickle. If they just lower the rate on [overnight reverse repurchase agreements] ON RRP, fed funds will trade at the bottom of the range or below. So they need to simultaneously lower ON RRP and raise [interest on reserve balances] IORB rate. But they don’t want to raise the IORB rate because they are losing a couple $billion a week.”

So true. At the Fed, because “confidence” is considered a factor in “policy,” it is OK to fib and obfuscate about the true cost of monetary policy. For example, when Fed Vice Chairman Michael Barr said that the monetary policy and bank supervision staff “communicate quite well,” that was a fib. We invite VC Barr to document these meetings between monetary policy and bank supervision staff.

Our pal Nom de Plumber is certainly more agitated than usual. He offers this sage observation upon hearing that the resolution of SIVB and SBNY will cost the FDIC’s bank insurance fund $23 billion. He relates:

  • Uninsured depositors fled from small and regional banks, to large banks, money-market funds, and Treasuries.

  • The FDIC guaranteed the leftover uninsured deposits, in hopes of preventing more outflow, and shuttered regional banks.

  • To pay for the wind-down losses, FDIC will levy special assessments, hitting insured depositors at large banks.

So the depositors of large banks pick will pick up the tab for two bank failures that should never have happened in the first place. Had the Fed’s monetary policy staff and bank supervision personnel actually discussed QE before the fact, would the FOMC authorized a doubling of the central bank’s balance sheet in 18 months? No.

While the Federal Reserve Board is busy trying to balance its various active interventions in the markets, we think that the time may have come for Congress to tell the FOMC to reduce its balance sheet. The losses to the Fed (and, indirectly, the Treasury) will mount, but unless we force the Fed to reduce the scale and range of its market intervention, we may never emerged from “quantitative easing.”

For example, while the Fed has rightly taken steps to provide cash to banks, it has not yet addressed the hundreds of billions or more in cash flow losses facing banks that own securities issued during 2020-2021. Even if the Fed does not raise the target for federal funds (FF) above current levels, these losses will threaten the existence of dozens more banks, large and small, later this year.

So, what is to be done? The FOMC needs to gently push money market funds out of the RRP facility and into the private markets. At the same time, the FOMC should sell MBS from the system open market account (SOMA) with the goal of keeping the 10-year bond above 3.5% yield. Don't worry if Fed funds trades on the floor, we want to keep LT rates positive and stable.

Give the Street back the duration that is sitting, passive and sterilized, inside the SOMA. Market rates will start to stabilize and volatility will decrease. While the Fed does not hedge the SOMA portfolio, private investors will and this shift in duration and related hedging activity will help to stabilize markets. The Street will start to repackage this low-coupon MBS into interest-only and principal only bonds. Problem solved.

But even as the FOMC forces investors off of the public teat and back to the market, it must shoulder another burden, namely helping banks to deal with the funding mismatch between the Treasury and MBS issued in 2020-2021 and the current production issued today. Just by way of comparison, the average coupon for all $13 trillion in outstanding MBS is a 3% coupon. Ginnie Mae 3s were trading around 90 cents on the dollar this AM.

The FOMC should order the FRBNY to offer term repurchase agreements to banks and dealers for any Treasury note or bond, or agency/govt MBS, that was issued during 2020-2021, at par. The rate charged should be <= the debenture rate on the security. This facility should be rolled every 30-days until the bond price reaches 5 points from par.

If the Fed helps banks to avoid most of the cost of QE/QT, the savings in terms of bank failures avoided will be considerable. The cost of this operation to the Fed will be enormous, swelling the negative equity position of the central bank. The political cost of revealing this colossal expenditure of public funds will also be enormous, but the time for hiding the losses incurred by the Fed as a result of QE is at an end.

As Robert Eisenbeis taught readers of The Institutional Risk Analyst years ago, the Federal Reserve System is always a net-expense to the U.S. Treasury. Fact is that the Fed’s purchase of Treasuries bid up bond prices and put downward pressure on interest rates. Now is the time to reverse this trade.

The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.


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