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April 15, 2024 | Watching investors struggling with a confused economic narrative c/o the FOMC, we remind ourselves daily that the view of the US markets reflects an equity market perspective as seen by young adults. Anyone who grew up during the peak years of the baby boom believes that interest rates always fall, equities always rise and Treasury paper rallies just in time. But it was not always so. In 1934, FDIC Chairman Leo Crowley reported:
"The Temporary Insurance Fund has been in operation since January 1, 1934 There are now 13,870 banks which are members of this Fund. Since January 1st not a single depositor has lost a penny in a bank which is a member of the Temporary Fund. It is well to give this a moment’s thought. I do not believe it possible to point to any other period in the history of the United States when for over three and a half months not a single dollar of deposits has been lost amongst so large a group of banks as are represented by the members of the Temporary Insurance Fund. On the other hand, there have been during this same period approximately 60 suspensions of banks which were not members of the Fund. Such facts speak for themselves."
There was a time in the US when markets controlled interest rates, not appointed officials at the Federal Reserve Board. The Fed uses the prospect of cheaper credit to manage public confidence. Yet hope for higher earnings was dashed by the big banks on Friday, when the perception of rising interest rates caused some people to hope. Rising market interest rates do not always lead to higher net interest income, as we discussed last week on Bloomberg Radio with Tom Keene.
In fact, falling interest rates over the past three months drove volumes up, coupons down and generated a bit more fee income than some expected. Total non-interest revenue at Citigroup (C), for example, almost reached Q1 2023 levels, but still helped to push the bank to a decent quarter. But net-interest income was down as yields fell and funding costs continued to rise small. Same basic story at JPMorgan (JPM) and Wells Fargo (WFC).
So with inflation indicia headed back up and Fed governors waxing hawkish, is there any likelihood of a Fed rate cut? Is that even the right question?? The Fed Board is preparing to slow the rate at which it sheds Treasury securities from its balance sheet. Reuters reports that policymakers generally favor “cutting the recent pace by roughly half in an effort to extend the process of shrinking holdings and reducing the risk of market trouble.”
As we’ve noted previously in The IRA, bank reserves at the Fed have been rising for the past year, adding an even more interesting twist to the Fed’s pending decision to slow the runoff of the system open market account (SOMA). Bank deposits were growing through year-end, but have been falling since January. By tapering the runoff of the Fed's balance sheet, bank deposits will start to grow, illustrating the connection between bank deposits and the Fed's purchase of Treasury debt. The chart below shows the Treasury General Account (TGA) at the Fed and $17 trillion in bank deposits.
The fact that Dallas Fed President Lorie “Repo” Logan has been making positively hawkish comments about monetary policy while calling for a slowdown in QT strikes us as a bit confusing. Is Lorie more worried about liquidity or inflation? Even with reserves rising, falling bank deposits suggests that the Fed needs to start buying more Treasury debt soon to avoid another 2018 market snafu.
When you look at the sharp increase in bank reserves starting in 2019, months before the onset of COVID, and then accelerating in 2020, we see the great Powell inflation. But what investors still don’t seem to understand is that the Fed’s ability to lower interest rates is compromised by rising federal deficits. The weak auction of new Treasury debt last week saw the yield on the 10-year note rise to 4.6%.
Given that bank reserves have been rising for a year or more, it seems like Lorie Logan is not so much worried about bank liquidity as liquidity for the Treasury. The move by the Fed to start reinvesting cash redemptions from the SOMA seems like a pretty obvious admission by the Fed that market interest rates will rise further without an increase in explicit debt monetization by the FOMC.
Thus we come to the final piece of the interest rate puzzle, namely the building crisis inside some of the largest banks due to volatile interest rates. Last week saw a bizarre announcement by the Federal Deposit Insurance Corp of a report on the “Orderly Resolution of Global Systemically Important Banks.” Chairman Martin Gruenberg said at the Peterson Institute:
“The ability of the FDIC and other regulatory authorities to manage the orderly resolution of large, complex financial institutions remains foundational to U.S. financial stability. An orderly resolution is far preferable to the alternatives, particularly resorting to taxpayer support to prop up a failed institution or to bailing out investors and creditors. With this paper we are reaffirming that, should the need arise, the FDIC is prepared to apply the resolution framework that the FDIC and many other regulatory authorities in the U.S. and around the world have worked so hard to develop.”
The only problem with Chairman Gruenberg’s statement is that the FDIC and other regulators have never actually performed an orderly resolution of a large bank. Never. The notion that the FDIC can liquidate a systemically significant bank without public expense is absurd. Gruenberg’s statement will come as a surprise to Moody’s and other rating agencies, which give large US banks a full notch of uplift in credit ratings based upon the assumption of sovereign support.
If we are to believe Chairman Gruenberg, the FDIC will wipe out the shareholders and debt of a public bank holding company, move the operating units to a newly chartered holding company and eventually sell the new company. The US banking industry will apparently take the resulting loss.
You cannot have financial stability and also avoid a taxpayer expense. When the FDIC takes control of a large failing bank (after handing equity and debt investors 100% loss), there will be no bid for US bank equity. The US stock and equity markets will have collapsed and Chairman Gruenberg or his successor will be looking at an empty room.
Chairman Gruenberg was sharply critical of Swiss authorities for merging the crippled Credit Suisse with UBS AG (UBS) as though there was an alternative. But was there really a choice? As with many large bank mergers in the US going back to the acquisition of Manufacturers Hanover by Chemical Bank in 1991, when large banks stumble the only practical alternative is to merge the inferior bank with a stronger institution.
By definition there is no bid for the assets of a dying bank. When Chase Manhattan was crippled by the failure of Penn Square Bank in 1982, it was eventually merged with investment bank JPMorgan in 2000. Could the FDIC have liquidated Chase, especially after it repudiated billions in loan participations originated by Penn Square Bank? No.
Like many other parts of the 2010 Dodd-Frank legislation, the prompt resolution provisions regarding troubled banks are entirely unworkable. When you recognize that the American system is based upon steady asset price inflation, the notion of liquidating a large bank after wiping out the equity and debt becomes truly laughable. But this is not really very funny.
If we consider the failures of Silicon Valley Bank, First Republic Bank and Signature Bank, in each case the FDIC was forced to sell the banks to other institutions at a discount to net asset value and impose the cost on the surviving banks in the system. The FDIC did not follow the procedures outlined in Chairman Gruenberg’s report and, in fact, had to borrow over $100 billion from the Fed to finance these transactions.
Progressives in Washington led by Chairman Gruenberg give speeches about prompt resolution of large banks even as the credit standing of the US slides into the toilet. Question for Chairman Gruenberg: Why didn’t the FDIC put Signature Bank into a conservatorship as the FDIC describes in the report?
Why did the FDIC sell the assets of Signature Bank to New York Community Bank (NYCB), creating another bank crisis less than a year later? The fact that Chairman Gruenberg is hiding billions in toxic Signature Bank assets inside the bank insurance fund suggests that the approach outlined in the FDIC report is unworkable. But the real question is why is Marty Gruenberg rejecting the views of his hero, former FDIC Chairman Leo Crowley.
In the hallway outside of Gruenberg's office at the FDIC in Washington, there is a portrait of Leo Crowley, who was the second Chairman of the FDIC and organized the corporation as it functions today. Along with Jesse Jones at the Reconstruction Finance Corporation, Crowley restructured the US banking system. But like most politicians, Crowley was far from perfect.
Critics of President Donald Trump should consider the example of Crowley. FDR quashed a federal indictment of Crowley in Wisconsin, who went on to run the Lend-Lease program during WWII. Stuart Weiss wrote in his 1996 biography "The President's Man: Leo Crowley and Franklin Roosevelt in Peace and War":
"Crowley was confirmed as chair of the FDIC in 1934 despite a charge, unknown to President Roosevelt, that Crowley had committed fraud as a banker in Wisconsin. Crowley then served with distinction for more than eleven years as the administration twice buried a 1935 Treasury Department report that, had it been handed to Wisconsin authorities, could have sent him to prison: Roosevelt valued Crowley’s political and administrative talents too highly to allow that to happen."
Crowley and his contemporaries understood the rule of benevolence that we discussed in "Financial Stability: Fraud, Confidence and the Wealth of Nations." Catching a failed bank and avoiding a debt deflation is always the best route in terms of avoiding public panic and preserving long-term wealth. In the 1930s, Crowley and Jesse Jones preached tough love to US banks, demanding salary reductions and dividend limits to ensure bank safety and soundness.
In 1939, however, the New Deal was failing and the prospect of a generalized economic contraction loomed despite years of effort by the Roosevelt Administration. By early 1939, the New Jersey Title Guarantee & Trust Co failed, threatening depositors and the State of New Jersey with total loss. Crowley flew to Jersey City and over a weekend the FDIC merged over a dozen banks together to protect depositors.
In mid-1939, The New York Times wrote that the bank mergers engineered by Leo Crowley and the FDIC during that terrible year "aroused little public interest," which is of course the idea. The agency's swift action to consolidate a number of failing banks prevented a large financial crisis, wrote the Times, and that "the public has regained its confidence" as a result. Crowley was protecting FDR as much as the depositors of dozens of banks in New Jersey.
The fact that FDIC Chairman Gruenberg would publish a report so clearly at odds with the wisdom learned during the Great Depression by people like Leo Crowley is cause for concern. Progressives like Chairman Gruenberg can stand up and give speeches about resolving zombie banks without public subsidy, but never once talk about the impact of the budget deficit and inflation on banks.
Most people don’t realize that the US banking system has grown deposits by 300% since 2008, a rather stark description of the systemic inflation coursing through the US economy. As the size of US banks has grown, the ability of the FDIC and other agencies to manage a large bank failure has been greatly diminished. But the single biggest risk to the US banking system comes from the confused thinking of officials in Washington.
If we followed the advice of Chairman Gruenberg and tried to resolve a large bank w/o public subsidy, the result would be a financial market collapse and a vast debt deflation a la the 1930s. Giants like Leo Crowley and Jesse Jones knew this. The fixation within the G-10 nations with resolving large zombie banks without public expense, this even as the unpayable public debt of these nations grows to the sky, will be seen in years hence as evidence of our collective delusion.
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