When is a bailout not a bailout? When the nation’s financial stability is at stake, it seems.
Apparently, the federal government this past weekend worked on three problems facing Silicon Valley Bank all at once:
looking for a buyer
backstopping uninsured depositors
launching a new emergency lending facility at the Fed, called the Bank Term Funding Program.
The Fed has been eager to reiterate it’s “not a bailout,” but how you define a bailout is relative.
The program went into effect Sunday and will offer bank loans for up to one year if the institution pledges eligible securities as collateral, which includes U.S. Treasuries, agency debt, and mortgage-backed securities. So it seems the Fed is simply giving small and medium banks a cash lifeline if and only if they ended up buying a large portion of Treasuries, which now are worth a lot less than they bought them for thanks to the Fed’s very own interest rate hikes.
Even more beneficial to the Treasury owners, they will accept loan collateral at “par” value. This means the amount of money the government promises to pay at the bond’s maturity rather than market value, which would be decidedly lower. Given that long-term bonds often trade at much lower prices than par, i.e. as much as 50 percent lower, this is a very generous offer. The Fed’s choice in what it takes as collateral is a key determinant in how punitive - or charitable - its “bailout” money is given out. After all, had SVB had access to such a program, we would not be here today, so what we’re seeing has to be defined somehow as … well … a bailout, even if the targeted group is depositors rather than equity holders. It seems the Fed is admitting its interest rate policy has been harsh but then only selectively helping a lucky few.
Despite this, the consensus is this will help most small and medium-sized banks in only small ways. Mainly because most small and mid-sized banks don’t often have large portfolios of securities to pledge. Most just give out loans and mortgages to their community instead. Most operated differently than Silicon Valley Bank, which was larger and thereby had a larger portfolio of U.S. Treasuries.
Instead, the Fed’s messaging to the market is simple: small or mid-sized bank liquidity is a NON-ISSUE. Even if a bank has a large Treasury portfolio that is underwater now, there is no reason to think these banks can’t access liquidity needs.
Despite this, other small and mid-sized banks are still being punished in the market. Banks under the spotlight now are those servicing corporate and wealthy clients who tend to have more than $250,000 in deposits and thereby aren’t insured by FDIC. Serving the rich used to be a marker of success. Now, it seems it’s the scarlet letter. And the rich are shifting their funds to larger banks with stricter capital requirements that thereby are less likely to suffer bank runs.
First Republic Bank is the latest bank to get into trouble. Founded in 1985, First Republic began as a lender that made jumbo loans to homeowners in the Bay Area. It focuses on wealthy clients offering personal and business money-management services. Because of its size, it’s now in the market’s crosshairs. Currently, several banks including JPMorgan, Bank of America, and Citigroup are set to deposit $30 billion total in the bank to stem the bank’s outflows. If markets are still sound, this should reverse the tide, but in this environment, it’s tough to say.
Other banks are still seeing huge declines in their equity values, including Zions, Western Alliance, and PacWest. Meanwhile, Credit Suisse - a massive bank with $569 billion in assets - had its shares tumble 24 percent yesterday after its largest shareholder (the Saudi National Bank) said it would not put more money into Credit Suisse. The price of the bank’s credit default swaps has risen rapidly over the last 48 hours, a sign investors are increasingly viewing the bank as defaulting on its debt. The bank’s woes are linked more to poor managerial decisions related to scandals and involvement in money laundering in recent years rather than rising interest rates. But my guess is investors have lost confidence in management to act appropriately in a crisis and are punishing it through its stock price.
All this highlights a few things going forward, some of which may end up creating more volatility in the weeks ahead:
The rollback of regulations on mid-sized banks, thanks to excessive lobbying by the banking industry in 2018 and 2019, was certainly a contributor to this problem. We should expect further regulatory action to regulate this segment in the future.
The Fed’s emergency program is a good idea in the short term. But longer-term, it will create a moral hazard for banks in dealing with interest-rate risks. Now that these risks have been taken off the table, banks have the incentive to become reckless in their interest rate management. Customers, too, seeing the Fed stepping in once, will not have much reason to discriminate between differing banks.
The Fed’s program creates disincentives for U.S. Treasury holders. As economist Daniela Gabor concisely stated on her Twitter feed, why sell U.S. Treasuries when you can monetize them at the Fed at par value? This means the entire inventory of Treasuries held by banks has been taken “offline” from the U.S. Treasury market. While this amount is not huge - only 3 percent of U.S. debt holders are depository institutions - even a three percent decline in inventory can cause stress, particularly in an inverted yield curve environment.
Instead of the yield curve normalizing, we’ve seen the inversion only steepen over the last week. Yet while mid-sized bank stocks have been tanking this past week, the broader market reaction has been subdued. And tech stocks in particular have even seen pronounced gains, on the hopes financial instability will slow the path of rate hikes already baked in. Ultimately, investors are left asking - will the Fed continue to hike rates and risk further clobbering the small and medium-sized banking sector? Or not, and risk stoking inflation? Markets are very confused right now, and we should expect a lot of rate and market volatility going into next week’s FOMC meeting on March 21-22.
More regulatory changes need to be done to help corporations. FDIC insurance for deposits of $250,000 or less is too small for most corporations. Something will need to be done to backstop deposits for larger customers.
America’s capital requirements do not require most banks to account for the falling prices of bonds. Only large banks with large portfolios need to do this. But in a scenario like this, where bonds must be sold to shore up capital for depositors, capital requirement regulations may need adjusting. Expect more work on this front.
In short, this is an evolving scenario, the implications of which we still need more time to figure out.
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