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April 19, 2023 | Premium Service | In this issue of The Institutional Risk Analyst, we review the latest earnings for banks and think about the next shoe to drop. One reader asked why JPMorgan (JPM) is paying 5% for one year deposits. The short answer is that JPM and Bank of America (BAC) are competing for funding in a shrinking market. The funding crisis affecting US banks is not over and very definitely not limited to smaller banks.
CNBC World Wide Exchange (04/17/23)
Every time a Treasury bond matures in the Fed’s portfolio, the Treasury refinances that piece of debt (since the US is running a massive deficit) and an investor buys that bond. A bank deposit disappears and an asset is acquired. And given the growing crowd of investors dumping commercial real estate exposures, the demand for risk free collateral is brisk.
The same math does not apply to mortgage-backed securities (MBS), sadly. Since the mortgage finance industry is barely producing $400 billion in new loans each quarter in 2023, the Fed would need to sell $50-$100 billion per month just to compensate for all redemptions globally. Net, net, the mortgage ice cube is melting. The MBA estimates only $1.8 trillion in production in 2023.
By not selling MBS from its portfolio, the Fed is causing distortions in the Treasury yield curve and arguably is forcing down mortgage rates and long-term yields generally. As new MBS production dwindles and the Fed sits on its growing pile of duration represented by the MBS in the system open market account (SOMA), the net effect is to make MBS scarce and drive down yields. Even with banks backing away from 1-4s, the net effect is still to make MBS collateral ever more scarce.
As liquidity runs out of the system, the FOMC ought to be providing risk-free collateral to enable private counterparties to raise cash. One of the little market details that seems to always evade economists is the link between liquidity and risk-free collateral like Treasury bonds and Ginnie Mae MBS. If collateral is tight, then raising cash is also more difficult and expensive. After December 2018, you’d think that the Fed understands this connection by now.