November 27, 2023 | Updated | Our note last week in The Institutional Risk Analyst about yield curve normalization generated a lot of comments, mostly from aggrieved bankers who want to know why the vast moral hazard created by the FOMC’s interest rate policies should not be reversed immediately. For those of you who missed the S&L crisis in the 1980s and the 2008 financial collapse, moral hazard is when the government allows insolvent banks with federal deposit insurance to operate with nothing in the vault except the FDIC insurance logo on the bank window.
As we have noted in past commentaries, the Federal Reserve Board wiped out the capital of the central bank during COVID and continued to spend money that was never authorized by Congress. When our friends at CNBC once questioned why we thought the Fed’s actions were illegal, this was the point. But naturally, nobody in the world of global equities or media wants to talk about the fact that the Federal Reserve System and most US banks are now profoundly insolvent and will remain so for years to come.
Andy Levin and Bill Nelson wrote a paper for Mercatus Center in January:
“It might seem extraordinary that a US government institution could conduct any program that is likely to incur a cost of nearly $1 trillion to taxpayers. And it might seem equally extraordinary that such a program could be undertaken without congressional approval or even any forewarning about the magnitude of the risks. Yet that is the expected outcome of the Federal Reserve’s securities purchase program known as QE4 (its fourth round of quantitative easing).”
Quantitative easing is the most radical and irresponsible fiscal action ever taken by a federal agency, yet the Congress remains strangely silent. Not a single member of either political party has called for Fed Chairman Jerome Powell to explain his illegal expenditure of Treasury funds, even during appearances before Congress. Again, the Fed’s capital is authorized by law; QE is not because the Fed is spending the Treasury's cash.
We have noted previously in this space that the central bank cannot make a “profit” and is always an expense to the US Treasury on a net basis (See "The Interview: Bob Eisenbeis on Seeking Normal at the Fed"). The intellectual author of the Fed’s illegal actions is former Fed Chairman Chairman Ben Bernanke, who tours the country collecting kudos and speaking fees for saving the world after 2008, but in fact is a fraud.
Instead of seeking authority from Congress, Chairman Bernanke and other members of the FOMC merely turned on the public spigot. Chairman Bernanke at al made the problem of post-2008 deflation go away by spending tens of billions of dollars in funds that were never authorized by Congress. By the time that Chairman Powell took the helm of the FOMC, the Fed's staff merely added a “0” to its tab at the US Treasury and kept right on spending.
While the cost of QE to the Treasury is enormous, the impact of these actions on the private economy is far larger. Losses to US banks and investors stretch into the trillions of dollars and are causing vast dislocation throughout the US economy. These very real costs are considered collateral damage at the Federal Reserve Board. Yet for banks, pensions and other investors, the ultra-low interest rates of 2020-2021 represent a potentially fatal cancer eating away at the financial stability of the US economy.
“The unrealized loss problems, whether bonds or loans, is so large and widespread that the FDIC does not have the funds or human resources to handle properly,” writes Sam Moyer, CEO of Heritage Bank. "As you point out, many banks have zero or negative GAAP capital.” Heritage Bank of Wood River, Nebraska, is a well-capitalized community bank with a liquid balance sheet and a 30% efficiency ratio. The bank's negative mark-to-market losses are less than 15% of capital and the bank earns 3% on assets or 3x its larger peers.
Moyer and other bankers avoided the risk of interest rate volatility ℅ the FOMC by keeping their securities positions short and relatively small. These bankers wonder why the FDIC is not forcing large banks to take losses. By allowing large, insolvent banks to operate with little or no tangible capital, are the Fed and FDIC not encouraging massive moral hazard? A: Yes.
Unrealized losses are true economic losses, Moyer tells The IRA. The money is gone. The value of the cash flow stream on the bond or note has decreased significantly. It does not matter if you take present value today or the payments as scheduled over time, the diminution of value has already occurred. "Bankers and bank boards struggle with this," Moyer opines. "They have their heads in the sand. They are wishing away reality."
Does the FDIC Board and executives have fiduciary duty to protect the BIF fund such that they have to at least require these broke banks to unwind or otherwise hedge these asset/liability positions that caused the losses?, Moyer asks. “It is one thing to allow the broke banks to stay open being under capitalized, but quite another to allow banks in this position to take future risk on the direction of interest rates. The zombie banks are a moral hazard.”
If rates go down, the zombie bank shareholders win, Moyer notes. But if rates go up, the shareholders do not lose. They no longer have any capital at risk. So if the bank fails, the FDIC fund takes the hit. Allowing the zombie banks to maintain the long asset and short liability position that cost them all their capital over the past 18 months is imprudent. Is it a breach of duty for those on the Federal Reserve Board and FDIC board of directors to not require that such risk positions be returned to a neutral position???
The objections of Moyer and other bankers are especially relevant because market expectations about a decline in interest rates in 2024 or beyond may not actually include LT interest rates, which is how the losses to the Fed, banks and pension funds are calculated. As we noted last week, the FOMC believes that they control the short-end of the Treasury yield curve, but the markets control the long end.
Source: US Treasury
Our big worry is that short-term interest rates may fall in 2024, but long-term interest rates will rise due to the Treasury’s vast deficits and mounting interest expense. We estimate that the Treasury would need to pay 5.5-6% to sell new long bonds today. Because the Fed’s balance sheet is already polluted with low-coupon Treasury and mortgage debt, the central bank has little remaining flexibility to respond to a large bank failure or other contingency. In coming months, we may all get an objective lesson in why moral hazard is to be avoided.
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