Another 15 years or so pass, and another Fed-induced financial crisis/system meltdown is at hand. They seem to like the attention of market meltdowns so much that we are starting to think the institution has Munchausen By Proxy.
According to WebMD, Munchausen By Proxy is a psychological disorder marked by a caregiver’s attention-seeking behavior through those in their care. In the case of the Fed, it seems they want the patient, the U.S. & perhaps the global economy to be sick but not too ill to die. They want the patient to be sick enough to scare the daylights out of everyone so they can come in and save the day. It’s all about the attention and accolades they get by saving those they hurt.
There was a time when the Fed operated in the shadows. They wanted to do their thing without the world noticing what they were up to. But now, not a day goes by when they are the talk of the town. In good times, the financial media give them an hour or two of attention each day as journalists, investment practitioners, economists, and academics opine on monetary policy. They heap on the praise for their excellent job managing the economy. But actions have unintended consequences, unleashing the boom-bust cycle. When the fertilizer hits the air conditioners, the world turns its attention to the Fed. In times like these, it, or perhaps the people running the joint, gets almost continuous attention in the 24-hour news cycle. Nobody wants to suffer the slings and arrows of outrageous fortunes (i.e., recession, depression, inflation, deflation, etc.). So when the wheels fall off the economy, everyone unwittingly looks to the entity that caused the problem in the first place to be their savior.
So how did their latest episode of MBP manifest? The lockdown was a self-inflicted wound that slammed the economy and almost everyone who participated in it. Layoffs and threats of layoffs were everywhere. Peoples’s bank accounts were about to deplete, and big and small companies were losing business. In comes, the Federal Government, the entity that imposed the lockdown in the first place, decides to hand out $5 trillion to people and businesses to keep them afloat.
Government causes a problem. Then the government solves the problem. Only where does the government get the money to pass out? There is not a sudden burst of savings to borrow. The government would have to compete with private industry in a free market. This means they would have to pay a higher interest rate than the going rate. Borrowing $3 and ultimately $5 trillion would cause interest rates to rise by 2% or 3% or perhaps more. This would hurt businesses when they need lower costs, not higher ones.
In comes the Fed to save the day. They immediately printed $3 trillion and another couple trillion dollars more in the following few years. In the mind of the Keynesian economist, the economy is saved, at least in the short run, and everyone heaps high praise to the Government and the Fed. The Keynesian solution to all economic problems is to print money. But there are always unintended consequences to market intervention. This time it was to weaken the banking industry. That weakness showed up first in the regional banks. Time will tell if they infect the money center banks. But we suspect they will catch pneumonia as well.
So what did the Fed do to trash the regional banks? When the Fed printed $5 trillion, it had to go somewhere. That somewhere was the banks. Banks, big and small, saw massive deposits flow in, but unfortunately, there were few profitable lending opportunities for that money. Banks make money by borrowing at one rate and lending at a higher one. One of the objectives of the Fed’s money printing program was to drive interest rates down. Yields on one-year U.S. Treasury securities went as low as 0.05%.
A bank cannot pay its bills with a 0.05% return on investment, so it bought longer-dated Treasurys and fixed-rate mortgage-backed securities issued by Freddie and Fannie to earn a higher yield. People thought this was a low-risk strategy because credit risk is nil with these securities. Higher yields were necessary even though banks did not pay interest on depositors. Running bank branches, managing the loan portfolio, complying with all the laws and regulations, etc., is expensive.
The monetary theory of the economy tells us money printing eventually causes higher prices. Eventually is the operative word because that could be the following year or ten years later. Money printing turns to higher prices when production is limited or social mood changes. Once people expect higher prices, they dump cash and buy stuff driving up prices. It is hard to put the inflation genie back in the bottle. To halt higher prices, the Fed must break the inflationary psychology, which is very difficult. The only tools they have is to mouth off and stop money printing. It may require going further and reducing the money supply. This process unleashes market forces that push interest rates higher.
When interest rates rise, the price of intermediate-term and long-dated bonds falls, even when investing in relatively short-dated securities. Assume one buys a 3-year U.S. Treasury bond at a yield to maturity of 0.5%. Now assume a year goes by and that three-year bond is a two-year bond that yields 5%. The market value of that bond falls by about 9% lower than the price paid. Since banks typically hold 8.5 to 10% equity, that 9% loss wipes out the bank’s capital.
If a bank reported the value of its assets and liabilities at market value, it would show a loss. However, banks do not report losses because accounting regulations allow them to hold these securities in a “held to maturity” account. This maneuver enables banks to price these bonds at book value, not market value. As a result, they do not show a loss in their books.
Once people figured out the equity of some west coast banks had been whipped out, they moved their money to other banks that did not have the same problem. These withdrawals caused the west coast banks to sell their bonds at market prices, crystalizing the losses. The financial press wants to sell their challenges as a liquidity problem. It is not. It is a solvency problem. There are not enough assets to cover the liabilities. Once people fear they will not get their money back because the bank does not have enough assets, it becomes a race to get their money out. It’s first come, first served. The bank run revealed the true nature of the problem to those who were not paying attention (i.e., risk managers, regulators, the fed, etc.)
So, how can the banking system be saved? The solution to the problem is lower interest rates. If rates fall, then the market value of bonds will increase, giving banks the money they need to repay depositors. It also requires time. Banks need to hold on to their bonds, hoping to sell them later at a higher price. The Fed enables this process by allowing banks to borrow their discount window using their bonds as collateral. As you see, the Fed is lending to the banking industry at levels never seen before. In a matter of days, they lent $153 billion.
This shows up on the Fed’s balance sheet. The chart at the top of this note shows that the Feds was trying to unwind its balance sheet to reduce the money supply and bring inflation back to its 2% target. (No theory supports this target, by the way. Why is 2% optimal and not 0% or 1%?) You can see in that chart that the balance sheet is starting to grow once again. We think it is clear the Fed will give up on price inflation control to save a few banks.
We are pleased to see the banks kick in to protect the industry. We do not have an appetite for taxpayer-funded bailouts. The resulting higher taxes and inflation hurt working people and those who do not have assets, which is about 50% of the U.S. population.
First Republic Bank will receive $30 billion in deposits from 11 banks. Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo announced today that they are each making a $5 billion uninsured deposit into First Republic Bank. Goldman Sachs and Morgan Stanley are each making an uninsured deposit of $2.5 billion, and BNY-Mellon, PNC Bank, State Street, Truist, and U.S. Bank are each making an uninsured deposit of $1 billion.
This may be a good thing, or it may not. A dirty little secret is that all the banks have losses in their held-to-maturity portfolios.
This chart shows the banking industry’s losses in its bond portfolios. As of the end of 2022, it was about $600 billion. About $300 billion is unreported losses of bonds categorized as Held-to-Maturity, which is more than the industry’s reported profits in 2022. Said another way, the banking industry did not make money last year. Since rates are now back to where they were at the end of last year, more or less, this is still a reasonable estimate of the hole in the banking industry’s balance sheet.
The Fed has signaled that it prioritizes the industry’s health over inflation. As a result, one should not expect the inflation numbers (CCPI, PPI, PCE, etc.) to come down. Rising price inflation figures will likely put pressure on intermediate-term and long-term rates once people realize that inflation is here to stay. If this scenario plays out, we should see the bear market in bonds resume. How that flows through the stock market is a bit more complicated. Inflation typically causes profits to rise if a company can maintain its margins. If revenues and expenses increase by 100%, reported profits will also increase. This increases share prices. However, higher interest rates cause the discount rate on cash flows to rise. People demand a higher rate of return when inflation is high as compensation for the loss in purchasing power. This lower the value of corporate cash flow. One of those forces will win, and stock prices will move appropriately. At this moment, we put our money on lower stock prices.
In the near term, equity prices are at a critical juncture. The S&P tried to break the downtrend and failed. We interpret this as bearish. Our thesis is that the Fed will increase short-term rates by 25 basis points next week. Given the weakened state of the banking system, we think that would be a mistake. However, they have been telegraphing a rate increase for months, so they will likely follow through. They will say that employment and the economy are still strong, and price inflation is too high. But these are backward-looking measures, and we think the world changed with the collapse of five banks, three of whom are very important to the technology and growth company sectors.
If the Fed decides to keep rates the same, this will have a very uncertain effect. Many will think it is good, sending stock prices off to the races. However, it could signal that the Fed thinks the situation is worse than most believe, and people will ask, “what do they know that we do not?” This scenario could send stock prices down further.
Small-cap stocks are underperforming large caps. The downward move was steeper, and the bounce has been a sideways affair, not a bounce with an upward bias. It is essential to know that IWM has decent exposure to small and medium-sized banks as constituents who will remain vulnerable for the foreseeable future. Further, as money gets tighter, we think small-cap stocks will see the cost of borrowing rise more than large-cap stocks. Therefore, we continue to expect them to underperform.
Be careful out there. In the months ahead, your goal should be the preservation of capital. Many bargains will be there for the taking when this is all over. Until then, it is going to be a bit scary. Here is a word of wisdom that the financial press never tells you.
“To have money at the bottom, you have to have money at the top.”
Photo by David Dibert: https://www.pexels.com/photo/a-sinking-watercraft-in-the-sea-8017037/
