Doug Noland: Animals or Lab?

For years, we’ve been told the banking system is sound and highly-capitalized – that lessons were learned from the 2008 crisis. Importantly, the Fed would lean on “macro-prudential” measures (i.e., regulation) to safeguard financial stability, while employing aggressively loose monetary policy to bolster the economy.

Our system last month suffered two of the three largest bank failures in U.S. history. This year’s first four months could see three of the top four – with First Republic soon to supplant SVB for the number two slot. Meanwhile, the Fed on Friday released their “Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank.” The fourth sentence sounds familiar: “Our banking system is sound and resilient, with strong capital and liquidity.” The first three not so much:

“Silicon Valley Bank (SVB) failed because of a textbook case of mismanagement by the bank. Its senior leadership failed to manage basic interest rate and liquidity risk. Its board of directors failed to oversee senior leadership and hold them accountable. And Federal Reserve supervisors failed to take forceful enough action…”

There’s nothing “textbook” about either SVB or the macro backdrop. Let’s be clear: SVB had its share of idiosyncratic risk. But this is a systemic issue. Three major bank failures in seven weeks would speak for itself.

Federal Reserve comments and conventional thinking notwithstanding, the overarching issue in 2008 was not insufficient bank capital. Total mortgage debt had almost doubled (96%) in six years, with – as one should expect – loan quality deteriorating and speculative leverage ballooning over the course of the boom. In response to the bursting “tech” Bubble and severe corporate debt issues, rates were cut to 1.25% in 2002. The rate collapse fueled double-digit mortgage debt growth in 2002 – and for the next four years.

Not surprisingly, the role monetary policy played in fomenting the current crisis goes unmentioned in the Fed’s SVB report. No mention of the impact of years of near zero interest rates – or the historic $5 TN increase in the Fed’s balance sheet. Not a word of the banking system’s unprecedented $5.54 TN, or 27.6%, three-year growth. Nothing on the corresponding $5.16 TN, or 33.2%, surge in Bank Deposits.

The closest the report gets to key issues is within the “External Federal Reserve Risk Perspective” section:

“The Federal Reserve Board of Governors publishes a semiannual Supervision and Regulation Report each May and November to inform the public and provide transparency about its supervisory and regulatory policies and actions, as well as current banking conditions. The May 2022 report assessed banking system conditions as strong… Capital and liquidity were assessed as strong and ample… The November 2022 report assessed the financial condition of banks as generally sound. Expanding net interest margins were noted as a positive factor as interest rates rose, balanced by declining values of investment securities and the potential for rising credit risk associated with floating rate loans…”

This review of the Federal Reserve surveillance and analysis shows a broad-based approach that considers a wide range of traditional risks across portfolios. Overall, this analysis appears largely fit for purpose and consistent with the mandate of the Federal Reserve, with a strong appreciation of how macroeconomic and financial topics can impact traditional banking risks. The issues most relevant to the failure of SVBFG—rising interest rates, impact on securities valuation, and liquidity pressure—were identified, analyzed, and escalated. The reviews did not consider the potential for extreme tail events like a rapid outflow of deposits or the systemic implications of broad runs on uninsured deposits.”

Others would disagree, but I’ve yet to witness “extreme tail events.” If a bank triples assets in three years, funded chiefly by an almost tripling of deposits, there’s nothing extreme about this institution running into serious issues. Similar to 2008, the “extremes” presaged the crisis. There was a single overarching “extreme tail event”: monetary policy.

“SVBFG showed foundational weaknesses in its liquidity risk management.” “SVBFG failed to assess and manage the interest rate risk (IRR) in its rapidly growing securities portfolio.” “SVBFG management was focused on the short-run impact on profits… In sum, when rising interest rates threatened profits and reduced the value of its securities, SVBFG management took steps to maintain short-term profits rather than effectively manage the underlying balance sheet risks.”

SVB management and board of directors were extraordinarily poor risk managers. The same can be said for Signature Bank, First Republic, and many others. Was it from Animals or a Lab? What was the source of the current pandemic of afflicted risk management disease?

The Fed’s SVB report is another largely wasted effort. I’m not expecting much better from any possible “independent” reviews. Clearly, regulation was pathetic. Politics played a predictable role in loosening the regulatory environment. But the Risk Oblivious Pandemic originated in the Federal Reserve’s lab – our central bank’s historic multi-decade experiment in activist inflationism.

Why would SVB management focus so keenly on their compensation, rather than effectively managing risk? Well, SVB’s stock price was around $200 when the Fed restarted QE in late-summer 2019. It was above $700 by October 2021. The incentive structure had become grossly distorted. And surely management was confident that the Fed would resolve any macro risk. Of course, they would cut rates and employ QE when necessary. Never would they raise rates to the point of risking acute systemic stress. Make hay while the sun shines.

But this key moral hazard issue is not limited to happenings within the Marriner S. Eccles Federal Reserve Board Building. SVB’s management and board knew it always had the easy access to the Federal Home Loan Bank’s (FHLB) liquidity backstop. Why worry about your asset/liability mismatch and uninsured deposits when the FHLB will gladly wire your institution as much money as you think you might ever need (no questions asked and, better yet, no Fed discount window stigma)?

FHLB Q1 data was released this week. Total Assets surged an unprecedented $317 billion, or 102% annualized, to a record $1.564 TN. This places one-year growth at a staggering $802 billion, or 105%.

The FHLB has been around since the Great Depression. Most of its assets are loans, or “advances,” to member institutions. Advances surged a record $225 billion during the first quarter. Moreover, the past year saw four of the six largest quarterly increases in “advances.” The $165 billion Q1 2020 pandemic response was previously second to the subprime eruption Q3 2007’s $180 billion.

I am compelled to again draw attention to the close link between the FHLB and the money markets. Money Fund Assets surged $500 billion during Q1, or better than 40% annualized. The money funds are a key source of liquidity that the FHLB uses to finance “advances” to member institutions. Especially for the problem banks (i.e., SVB and First Republic), FHLB advances provide bank liquidity to fund deposit flight, deposit liquidity flowing briskly into money funds – where this liquidity is available to be borrowed again (and again) by the FHLB.

April 22 – Bloomberg (James Crombie): “Add central banks to the wall of worry for global credit markets. This year’s rally in risk assets is more to do with a $1 trillion central bank liquidity injection than any improvement in the economic outlook, according to Citigroup Inc.. That massive tailwind… may soon become a huge drag as policymakers get back to quashing inflation, having extinguished the banking-sector fire. ‘With peak liquidity past, we would not be at all surprised if markets were now to experience a sudden pressure loss,’ Matt King, Citi’s global markets strategist, wrote… ‘Keep watching the liquidity data — and buckle up.’”

April 26 – Bloomberg (Alexandra Harris): “Issuance from the Federal Home Loan Banks climbed as concerns about First Republic spurred member institutions to tap the system to shore up funding. FHLBs issued $33.3 billion of overnight and term discount notes Wednesday, in addition to another $9.266 billion in floating-rate notes… It also issued about $11 billion of discount notes via auction on April 25…”

Understandably, the stock market now sees bank instability as ensuring oodles of additional Fed and FHLB liquidity. First Republic’s stock sank 75% this week. Buy big tech stocks.

April 26 – Axios (Felix Salmon): “If First Republic Bank fails…. then the U.S. government is going to reward select financial institutions with billions of dollars’ worth of gains. Why it matters: Bank rescues are often seen as government bailouts, while bank failures are seen as being more punitive. In reality, however, the government invariably ends up being extremely generous to the banking sector whenever there’s a failure… It’s not just First Republic’s eventual acquirer who stands to make billions from the deal. A consortium of 11 banks has $30 billion on deposit at First Republic — all of which is uninsured by the FDIC. That money is theoretically at risk if First Republic fails. Realistically, the government will declare a systemic risk exception and insure all those $30 billion in deposits. Those billions will flow from the government — in the form of the FDIC — to America’s biggest banks: JPMorgan, Bank of America, Wells Fargo and Citigroup ($5bn each); Goldman Sachs and Morgan Stanley ($2.5bn each); and a group of regional banks, including Truist and PNC, getting $1 billion each.”

A First Republic failure could get messy. First of all, the $30 billion of “time deposits” provided by the 11 major banks is uninsured – so “theoretically at risk” is not how I would phrase it. And enormous borrowings from the Fed and FHLB funded a staggering $100 billion of Q1 deposit flight. The “good” news is that FRC uninsured depositors were surreptitiously bailed out. The bad news is First Republic ended the quarter on the hook to the Fed ($77bn) and the FHLB ($28bn) for a whopping $105 billion (approaching half total assets of $232bn). Why shouldn’t the big banks get in line with the remaining uninsured depositors and other creditors?

While ebullient stocks envision liquidity excess as far as the eye can see, bank CDS prices were not as complacent. Bank of America CDS rose seven this week to 107 bps (from 72 bps on March 8th), and Citigroup CDS gained seven to 96 bps (77bps). JPMorgan CDS rose four to 81 bps (69bps) and Wells Fargo four to 108 bps (66bps). The Treasury market’s view of the world seemed more aligned with bank CDS than equities. Two-year Treasury yields sank 18 bps to 4.01%, with five-year yields down 18 bps to a one-month low of 3.48%. And market pricing for the policy rate at the Fed’s December 13th meeting dropped 10 bps to 4.47%.

April 28 – Reuters (Greg Roumeliotis): “The U.S. Federal Deposit Insurance Corporation (FDIC) is preparing to place First Republic Bank (FRC.N) under receivership imminently, a person familiar with the matter said on Friday, sending shares of the lender down nearly 50% in extended trading. The U.S. banking regulator decided the troubled regional lender’s position has deteriorated and there is no more time to pursue a rescue through the private sector, the source told Reuters, requesting anonymity because the matter is confidential.”

April 28 – Wall Street Journal (Andrew Ackerman, David Benoit and Rachel Louise Ensign): “Big banks including JPMorgan… and PNC Financial Services Group Inc. are vying to buy First Republic Bank FRC in a deal that would follow a government seizure of the troubled lender, according to people familiar with the matter. A seizure and sale of First Republic by the Federal Deposit Insurance Corp. could come as soon as this weekend, the people said.”

It’s worth stating again: Major bank failures with unemployment at multi-decade lows, positive GDP, and buoyant securities markets are a harbinger of trouble ahead. I’ll assume a First Republic failure spurs more uninsured deposit flight from banks big and small. The plight of First Republic’s uninsured depositors – including the big banks – will be intriguing. With First Republic’s depositors tending to be upper income, a bailout comes with political risk. And as the stock market dismisses First Republic’s predicament – and with $100 billion of deposits having already exited – the case for arguing systemic risk implications is weak.

It’s worth noting that Q1’s GDP Price Index was reported at a stronger-than-expected 4.0% annualized, with Core PCE (personal consumption expenditures) gaining a stronger-than-expected 4.9%. The Employment Cost Index rose a stronger-than-expected 1.2% during Q1, or 4.8% y-o-y. The March PCE Deflater increased a stronger-than-expected 4.2% y-o-y. And the University of Michigan survey of one-year inflation expectations was unchanged from earlier in the month at 4.6%.

The Fed and FHLB’s huge liquidity injections come at a time of already loosened market financial conditions. The Federal Reserve has its hand full: an unfolding banking crisis and a slowing economy; now deeply rooted inflation; and dangerous market speculative Bubbles.

Original Post April 28, 2023

Categories: Doug Noland