The Garrote
Whatever macroeconomic data was released this week was overrun by the gravity of the decision on interest rate policy by the U.S. Federal Open Market Committee (FOMC) on Wednesday. In the end, Federal Reserve Chairman Jerome Powell, and his colleagues on the FOMC choice course number two of the three I outlined on this page last week.
The Fed did not follow through on its ample guidance that the Fed Funds overnight policy rate would rise 0.5%. Nor did it bow to the reality that the monetary substrate of the financial system is under stress and leave rates unchanged or lower them. Instead, the FOMC took the middle course by raising Fed Funds by 0.25% and cinching the garrote tighter around the necks of U.S. banks.
That garrote was apparent, once again, in the 4-week T-bill auction. The stress banks are under could be the reason for the second week running, there were bidders for T-bills at par implying a 0.0% interest rate for the issue. Lower rates are often characterized as an easing of credit. But they can also mean tightening conditions due to solvency concerns, with banks reluctant to lend to all but the most credit-worthy counterparties. It looks like there were $3 billion of those in the auction.
There is blood in the streets. There are fingers being pointed. And there is disdain emanating from dilettante economists giving harsh critiques of the risk management policies of failed banks. The opinion of this dilettante economist is that all these things will continue, for a simple reason that was observed by “The Matt Levine of Crypto” Byron Gilliam: banking is unprofitable when short rates are higher than long rates.
This has been the case in the U.S. since July.
The idea that banks make money by borrowing short to lend long is an oversimplification, but largely true. And if their borrowing costs exceed their lending income, they are losing money. Borrowing in the form of demand deposits can be called at any time. Bank lending, whether via mortgage issuance or purchases of Treasury bonds, generally cannot, and are subject to the winds of the market. A curve inversion is an index of bank bleeding.
For banks, the last 12 months have been a perfect storm.
Banks took in a huge wave of new deposits in 2020 that they paid nearly zero interest on.
The Fed assured anyone who would listen that they had no intention of raising the risk-free overnight rate from near zero.
Reluctant to take risks with depositor money, many banks bought “risk-free” government and agency securities.
The Fed changed its mind in 2022 and raised rates at the fastest pace in its history.
The bond market sold off leaving banks with enormous mark-to-market losses on their books.
According to the Fed, $600 billion in deposits have been withdrawn in the last 12 months. Even if depositors are not concerned about bank failure, the Fed itself is now paying 4.8% overnight which is 1.4% higher than the risk-free 10-year bond yield.
Three banks have been devoured by this sequence of events so far. I doubt they will be the last. The report on bank portfolio losses mentioned last week has since been mostly agreed by other banking experts. The punchline: “The market value of U.S. banking system assets is $2 trillion lower than suggested by their book value. Interestingly, SVB does not stand out as much in the distribution of marked-to-market losses, with about 10% of banks experiencing worse marked-to-market losses on their portfolio.”
What is going to become of those $2 trillion in losses? Nobody knows. But it will not hurt the prospects for G-SIBs, Globally Systemically Important Banks.
“Let everybody else waste money and do stupid things; then we’ll buy them.” -JP Morgan CEO Jamie Dimon
Yeah, JP Morgan is about to become bigger.
Guidance
This begs the question of what banks should have done to mitigate their losses.
Could banks have hedged their risks? Yes.
Would it have been practical? Probably not.
The Fed’s rate hikes were unprecedented and unexpected. I will take a beating for that statement, but I cannot see it any other way.
In response to a question at the press conference following the move this week, Powell defended the Fed’s guidance on rates saying: “…our rate hikes were well telegraphed to the market and many banks have managed to handle them.”
I beg to differ.
The December 2021 “dot plot” published by the Fed had the median 2023 Fed Funds rate at 1.6%. Three months later, after the first rate hike in March 2022, it was pegged at 2.75%. The actual March 2023 rate is 4.75 – 5%.
And now, less than one month after warning that rates will go higher and stay there, Powell let slip in his press conference that a pause in rate rises was considered.
During the black-box tenure of Fed Chairman Alan Greenspan, Fed watchers were reduced to gauging the thickness of his brief case to ascertain the course of interest rates. I am not sure we are any better off today.
And Do What?
The decision by Silvergate, SVB and Signature to take on duration risk and not hedge it out has wiped out shareholders. I am sure there are regrets over that. But those hedges would not have been easy – or cheap.
Banks are short optionality. On the short end, depositors can withdraw on demand. On the long end, mortgage borrowers can choose to repay. That means both rising and falling rates can adversely affect profitability.
The right move would have been to plow all those new deposits into 6-month T-bills at 0.60% and keep rolling them over for three years. Easy, right? It looks like many banks chose to follow the Fed’s guidance instead. In any case, as a long-time options trader, I am aware that hedging out those portfolio risks between March of 2020 and March of 2022 would have cost more than 60 bips.
By raising rates, the Fed caused markdowns in banks’ portfolios of $2 trillion, and with short term rates at 4.75% the Fed is now swiping their deposits. What should banks do next? Put some ice on that eye and get back in the ring, borrowing short at 5% to lend long at 3.5%?
Theoretical Versus Actual
Crypto markets took the Feds rate rise in stride, selling off on the news like other risk assets before recovering.
This is despite continuing pressure on the crypto industry from the U.S. Securities and Exchange Commission (SEC). The latest salvo fired was targeted at exchange operator Coinbase, which received a “Wells Notice” warning of impending enforcement action by the commission. In a statement, Coinbase said that certain unspecified elements of their activities in staking, wallet and exchange services will be cited for possible violations.
The news is surprising considering the kicking the SEC took last week from the judge presiding over the Voyager Digital bankruptcy sale of asset to Binance. At the very least, Coinbase has a legal leg to stand on. It looks like the commission is either highly confident in taking on yet another well-funded opponent, or a glutton for punishment.
An eventual victory by Coinbase, and the resolution of the commission’s legal battles with Ripple Labs, Grayscale and Paxos, could set the industry on a steadier course. But crypto advocates would prefer that the SEC move on from possible theoretical legal arguments and concentrate on actual legal violations.
Authorities will have the opportunity do just that with the arrest in Montenegro of Do Kwon, the founder of Terraform Labs and the creator of the Terra Luna cryptocurrency.
After the $60 billion collapse of Terra Luna and its linked stablecoin TerraUSD, Kwon became the target of criminal investigations in South Korea and the United States. After at first rumored to be in the United Arab Emirates, it was widely reported that Kwon was living in the Balkans. Apparently working on open-source projects and planning a comeback, he was not particularly shy, appearing on popular podcasts and occasionally giving interviews. Now in custody, his next stop will depend on the results of a lengthy extradition process.
Intertwined with the Terra Luna debacle, the former managers of bankrupt hedge fund Three Arrows Capital (3AC) are brazenly plotting their own comeback. Kyle Davis and Su Zhu, whose $2.5 billion fund was wiped out following the collapse of Terra Luna, caused cascading bankruptcies that are still reverberating through the crypto ecosystem today. Their cheeky comeback project,OPNX, is an exchange to trade claims from crypto bankruptcy filings, including those from 3AC. Having recently given interviews in Bahrain, it does not appear to be difficult for authorities to locate them.
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