Is There Motive Behind the Fed Making Such a Mess of the US Bank Wobbles?

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Yesterday Mr. Market got word that yet another bank had gone wobbly, shortly after the Fed announced it was putting through another interest rate increase and only considering pausing next month. From CNBC:

PacWest Bancorp shares tumbled 56% in extended trading on Wednesday following news that the bank is weighing strategic options.

The regional bank is assessing options, including a possible sale, and bringing in advisors to evaluate longer-term plans for the business, CNBC confirmed, according to one person familiar with the matter. Piper Sandler and Stephens are the two firms advising PacWest, the person said…..

PacWest reported that total deposits declined more than $5 billion in the first quarter to $28.2 billion as of March 31. However, the company said that it saw a net gain of $1.1 billion in deposits from March 20 until quarter end.

PacWest also said that deposits grew by another $700 million from March 31 through April 24.

PacWest is not all that big a bank, with only $40 billion in total assets. Its market cap is currently only $750 million, meaning it should be digestible absent any really bad warts. But other regional bank stocks traded down again.

Nevertheless, the Fed is making clear that it is prioritizing fighting inflation rather than easing up on the pressure on banks that it created.

First, as we discussed a decade ago, sources told us the Fed had come to recognize its super low interest rate experiment had not only failed but was also creating serious economic distortions. But when Bernanke started trying to ease his way out, he quickly lost his nerve in the face of the so-called taper tantrum.

So having gotten banks and long-term investors deeply acculturated to cheap credit (remember, nearly a full generation of traders and managers have grown up under this regime), it was predictable that if the Fed moved quickly, it would create not just pain but actual distress. Raising rates was long overdue but that meant normalizing slowly would be necessary to avoid dislocation.

On top of that, it looks like the Fed was utterly incompetent at bank supervision. Managing interest rate and maturity risk (as in banks borrow short and lend long) is Banking 101. If you aren’t good at that, you shouldn’t be in business. Yet Silicon Valley Bank post mortems showed the Fed supervisors in San Francisco knew that the bank was using bad risk models that were telling it to do exactly the wrong thing…..and it was acting on those models. Oh, and it had no senior risk manager either. But the Fed just handwaved to management rather than telling SVB it would issue a warning letter in X days if it did not Do Something.

Put it another way: the way you normally have bank crises is when bunch of them follow a fad and make too many stupid loans, in the typical Minsky cycle. Even Volcker backed off when banks started looking like they would fall over during his extreme rate increases.

Yet the Fed has kept on bloodymindedly with its interest rate jihad, even as more and more evidence confirms that this inflation isn’t caused by too much demand or uppity workers succeeding in getting wage increases. Contacts say there’s still pent up demand for cars due to the prolonged Covid supply chain disruptions. Experts increasingly cite greedflation as a big contributor. As we said early on, the Fed can kill inflation, but for one produced largely by supply issues, it will kill the economy stone cold dead in the process?

The Fed is also doing a terrible job of managing the crisis. Being oracular is fine when discussing interest rate policy. It isn’t when banks are looking green the gills. The financial press is stoking fears with uninformed discussions of bank balance sheets. Banks have what is called “hold to maturity” portfolios. They get to hold them at their acquisition cost. There’s nothing nefarious about it since the bank really does intend to keep it to maturity, so the principal value will be 100%. Yes, they will lose money during the periods when their funding costs exceeds the interest income, but that shows up in the relevant income statement.

Now one can correctly point out that banks like SVB had too much in their hold to maturity portfolio given they had a lot of rich depositors who could and did pull their money out. But again, this is something the Fed and the banks themselves should have been on top of. It would really behoove the Fed to see if and where any of these hold to maturity portfolios are too large. And it ought to consider being more transparent, and having a geeky (make sure it’s geeky to discourage lazy reporters) briefing on how hold to maturity works. It’s much better to educate reporters when they seem to be going off half cocked that making airy statements about how everything is hunky dory, or go too quiet, both of which look guilty.

Because SVB and First Republic had a lot of rich uninsured depositors, investors and banksters have called for all deposits to be guaranteed. I must note that all of this petitioning for a massive increase in bank safety nets has not been accompanied by any suggestions of how to increase bank supervision and more important, get regulators to use the powers they already have. Giving banks more government support after some badly run banks blew themselves up is simply enabling more bank incompetence.

Recall also that it’s the FDIC that has to do the nitty-gritty work of resolving banks. And accordingly, the FDIC is also trying to limit the further extension of deposit guarantees to have it cover only company deposits (as in protect payrolls and suppliers).

So it’s not hard to guess that the Fed would prefer more bank subsidies, here in the form of more deposit guarantees, because it can continue to do a terrible job of bank supervision and not have to deal wit the fallout. That would explain its indifference to this (so far) low-level bank crisis.

There actually is an elegant solution to the problem of moral hazard, but bizarrely it has never gotten traction. The idea, first proposed by ex-Goldman partner William Dudley when head of the New York Fed, would have the effect of putting bank executives on a similar footing to old Wall Street partners by having most of their pay tied up for a number of years and acting as subordinate equity. If the bank’s equity was wiped out in a liquidation or a subsidized sale, they would take losses first, ahead of shareholders.

This general concept was refined by emeritus London School of Economics professor Charles Goodhart, who set forth a detailed conceptual scheme of how and how much “insiders” should have their compensation taken or clawed back in the event of a failure. Goodhart was more draconian than Dudley, suggesting that CEOs should face the loss of three times their total remuneration, and board members, two times. It’s a clever proposal, which you can read here.

Sadly, the tracks look very well greased for banksters to get even more government support, further increasing an already too favorable risk-return tradeoff for them. And the great unwashed public isn’t complaining. I confess to finding it hard to feel sorry for willing victims.

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  1. griffen

    It’s the best of times in America. The sky is blue and the birds loudly chirp and sing! Wait, there’s bad news as well? ZOMG…I am coming around to a notional thought. The regulators, namely the FDIC, are possibly just not equipped with multiple regional institutions should they continue to flail (flailing for me, based on the daily equity performance or broadly the regional bank ETF)

    It’s like the year to date bank failures happened in a vacuum (which I find highly unlikely). Lending in various forms seems, to me, likely to become ever more constrained.

  2. Stephen

    So there is a regulatory moral hazard now. If deposit insurance is 100% in place then the Fed can regulate badly without consequence for itself?

    This all reminds me of the article you wrote earlier in the week, Yves, about the increasing lack of capability in the west. It almost feels as if the conditioned answer for any issue is not to resolve it but instead to figure out how to maintain the existing elites and their power structure in the state to which they have become accustomed. The banking crisis sums it up. Perhaps the root cause is the increasing oligarchic nature of our societies and the increasing lack of accountability of both private and public institutions to “the people”. As well as an erosion of the moral code that might ensure greater probity rather than cynicism and self interest.

    Moral hazard, graft and prevarication seem to be inherent features not bugs.

    1. eg

      I call it “American Mendacity” but I think prior generations of historians would recognize it simply as good old fashioned decadence.

    2. Janeway

      “maintain the existing elites and their power structure in the state to which they have become accustomed.”

      Exactly! My personal theory is that we are now entering that final phase where everyone everywhere will be bailed out if failure to do so means the existing elites and power structures would be at risk of failure themselves.

      That is, the printer will be running non-stop until the whole thing stops responding. There is a theory known as sudden stop, and although it applies to ‘developing’ economies, I think it can be tweaked to cover what we are starting to see here.

      Not that I expect this to happen this year or next, just that at some point you can’t finance a $50,000 vehicle at 9% (payment over 60 months would be $1,037.92 per month OR $804.45 per month for 84 months) and have much sales volume.

    3. Also Stephen

      The goal is not to solve any of the problems. It is, rather, to insulate themselves from the consequences of the problems. Make enough money so the problems don’t apply to you and yours. This has been the mindset for several generations now. With predictable results.

      We must always keep in mind the nature of the decision makers in these scenarios. They are professional email writers and spreadsheeters. They perceive the world through that lense – words, narratives, PowerPoints, and the like. None of them have ever *built* or maintained anything. They start life in expensive boarding schools and end life in expensive board rooms, with nary an intervening moment spent in a warehouse or on a ship or in a tractor.

      For them, the gears of modern life exist in a sort of nebulous background hum. Water comes from the faucet. Meat comes from the grocery store.

      They are, largely, first-order thinkers for whom models of reality are more real than reality, for whom mathematical facsimiles are as equally valid as observed reality.

      Confucian societies believe that a ruler cannot be legitimate without also being virtuous. Ours is an anti-Confucian society.

      1. SocalJimObjects

        A quote from Neal Stephenson’s Diamond Age:

        “One of the great virtues of Confucianism was its suppleness. Western political thought tended to be rather brittle; as soon as the state became corrupt, everything ceased to make sense. Confucianism always retained its equilibrium, like a cork that could float as well in spring water or raw sewage.”

      2. Late Introvert

        Confucian societies believe that a ruler cannot be legitimate without also being virtuous. Ours is an anti-Confucian society.

        And those ignoramuses wear that like a badge of honor.

  3. NarrativeMassagerInc

    The Fed, as I recall, didn’t do so great in the year or two run up to 2008 either (let’s not discuss how they did after). We know who they work for so its not some mystery why they ignore plans like Dudley’s. What, are they only going to institute clawbacks for smaller banks (because they’re not going to do so for the big shots).

  4. SteveB

    So when the FED began the trek of raising rates and told the world (including Bankers) that they were determined to beat inflation wouldn’t the prudent thing to do be to take a small loss and reduce the size of the HTM portfolio and invest in shorter duration securities so as to minimize the longer term effect of the rate rise.

    But NO, they were “BETTING” on the FEd losing it’s resolve and stopping early then reversing and lowering rates… They held the long duration securities and lost the BET… This is gambling not managing…..
    Managements pay, wealth and pensions should be used to pay their depositors !!

    1. ChrisFromGA

      As someone who follows the stock market closely, maybe too closely, I have observed a constant chorus of begging from traders and the financial press (likely sponsored by these bankers) for a “pivot” since before New Year’s Day.

      To the point where Wolf over at WolfStreet coined the term “Pivot mongers.”

      I rather like the term.

      Maybe instead of focusing their energy on begging for Fed interest rate cuts, they should have done some proper risk management.

  5. Mikel

    Basically, as officials try to wind down the most ridiculous asset bubble of all time, the super rich are worried about all the stashed away cashed.

    When the prices go down, it’s not always “just evaporating.” Somebody often has sold a bag to someone else.

    And alot of the loans that SVB and FRC handed out were sweetheart deals to already wealthy people.

    The Fed is in a tight spot. On one hand, the rising interest rates hurt its wealthy friends who have a lot of debt. It’s especially hard on the over-leveraged gambling addicts – who for some reason have “freedoms” that mean more to the establishment than a sound, well-regulated financial system.

    On the other hand, the rising interest rates help their wealthy friends by allowing them to earn a bit more in savings accounts and less risky investments as they cash in on the winding down of the ridiculous bubble.

  6. Cetra Ess

    A bank or two or three failing will help slow the economy, right? And slowing economic growth is the declared purpose of their raising the interest rates? So is it possible they’ll view banks failing as a positive sign that they are succeeding in bringing economic growth in line with inflation?

  7. .Tom

    > “Experts increasingly cite greedflation…”

    At first the word, completely new to me, made me smile and then I wondered: Which experts? A web search revealed use of the word going back about a year. I guess it means businesses telling stories about inflation to excuse their price increases that are unrelated to cost increases.

    And I further guess this is only so easy to do under conditions of extreme market concentration (e.g. as in US food distribution) or cartel-like coordination among businesses in a given sector, or both.

  8. Wukchumni

    We are in the ‘Sinatra Doctrine’ part of the Bizarro World rules collapse game in the USSR & USA.

    Back then it referred to Gorbachev allowing Warsaw Pact countries to determine their own internal affairs, now it refers to Biden allowing FDIC Pact banks to determine their own internal affairs.

    What could go wrong?

  9. juno mas

    RE: FDIC

    A new banner in my local (WFB) bank: “FDIC deposits are insured to at least $250,000.” Not “up to”, but “at least”. Seems like an attempt to stifle depositor flight. The banner appeared to be an FDIC initiative not a WFB idea.

    1. Karen's hubby

      Depositors arent leaving because they are afraid FDIC wont cover them.
      Interest rates banks are paying on your money are 0.01% when a treasury bill will pay you 5%.
      That is the reason of this turmoil. Let banks increase rates to 5% and you will see that this will end but then their profits will take bigger hits, its what happens when your business model is based on free money.

  10. ChrisFromGA

    What strikes me is that after the GFC, Dodd/Frank and all the talk of the banking system being more resilient, we have managed to eclipse 2008 in terms of bank failures in dollar amounts (assets under management.)

    That implies a total failure to get away from risk concentration, and too-big-to-fail. Not a big shocker in this circle, but still quite depressing.

    A lot of us warned about this including Yves and co.

    In 2008-2009 we had IIRC over 100 banks fail, but the total amount of deposits has a

    1. ChrisFromGA

      Sorry for premature post. Last sentence was meant to end as “the total number of bank failures in this year has only been 3 (so far.)”

  11. Glen

    All this mess just to screw American labor.

    Have they looked at the country’s demographics? The state of American public education? Health after never ending waves of CV? The state of health care in general? This is the world they created, that they wanted.

    The days of an ever increasing supply of cheap labor are over. Even as America on-shores industries, they still somehow think it’s good to crush labor. The companies and countries that figure out this new world are going to be way ahead of the rest. I trust American elites to NEVER figure it out. (“Nothing will fundamentally change…”)

  12. TomW

    I thought the Milken interview on CNBC was good.

    Interesting points:

    1. Your point: “Managing interest rate and maturity risk (as in banks borrow short and lend long) is Banking 101. If you aren’t good at that, you shouldn’t be in business. ” He used the term Finance 101. He said these lessons were learned over and over in the 70’s and 80’s. But there are no longer senior regulators or Bank executives that worked during those years. They are dead or retired.
    Also banks are designed, with a lender of last resort and deposit insurance to do a moderate amount of ‘maturity transformation’. They bought ‘risk free’ mortgage bonds, and 10+ year treasuries, fixated on their risk based capital designation as risk free. So instead of matching, they need to skillfully manage a mismatch.

    2. $5-$6 trillion in money market funds. Which is a large slug of liquidity.

    3. Banks hold 20% of the country’s loans. And he sees non bank lending growing. So, maybe regulated banking just isn’t as important as it used to be.

    1. Mildred Montana

      “Borrow short, lend long.” That’s the bankers’ equivalent of the roulette player’s martingale. The martingale? Keep doubling down on red or black until you win and get everything back plus a small profit.

      Works until it doesn’t, and on a bad series of outcomes losses can be catastrophic. But that’s banker logic for ya, picking up pennies in front of a steamroller, chasing yield, doubling down on bad bets, always confident that their low-return, high-risk “strategy” will eventually work.

      They’re happy as long as the pennies keep rolling in but when they don’t, when the steamroller looms and threatens their dollars, they run to the government for help. Which unfortunately is all too willing to subsidize stupidity and greed.

      1. Yves Smith Post author

        You forget the yield curve is positive the significant majority of the time and most banks do manage interest rate risk successfully.

  13. polar donkey

    A bank merger here in Memphis between First Horizon and TD Bank got terminated this morning.

  14. Arul

    Let me ramble a bit:

    1. Monetary policy maneuvers alone cannot fix inflation when Government is doing nothing to address the key issues – restraining corporate price gouging, checking megamerger-driven monopolies that lead to the aforementioned price gouging, and conducting sensible diplomacy and trade policy to cushion the impact of global commodity price shocks (TPTB are presently doing a splendid demo of How to not do these).

    2. The “Economists” managing the Monetary policy seem to have forgotten their undergrad MacroEcon. I haven’t heard a word of them mentioning point 1 above in any of their speeches or Congressional hearings (Maybe I something).

    3. On Banking, yes, a Bank exists to manage asset-liability duration mismatch — borrow short term and lend long term plus maintain enough liquid reserves to cover demand. The failed banks seem to have forgotten the last part and put most of everything in long term, fixed rate sovereign debt. There is a two part failure. a) Fed failing to alert the banks that easy money policy won’t continue forever, b) Banks failing to imagine that easy money policy won’t continue forever. Had they invested in a judicious mix of short duration T-bills, medium duration T-notes and long duration T-bonds they would have survived. Return-chasing while neglecting the interest rate risk led to this.

    4. Interesting contrast with 2008. Then they all went after near-junk rated assets, and failed. Now they all went the opposite way and piled into gilt, and still are failing.

    What is really baffling is, they all seem like rookie mistakes, yet they are happening at this scale. I am seriously doubting the competence of the people in charge.

  15. Telee

    This is a society that, following the western tradition, has a creditor oriented state and religion. In view of this fact, a major requirement for those who are in positions of power is fealty to the wealthy. Competency takes a back seat.

  16. Jorge

    I’m deciding that a core problem here is the concept of regulating banks: by setting up regulatory bodies, customers are let off the hook from any responsibility to “Know Your Banking Vendor”. Sure, we need bank regulators, but the tendencies towards regulatory capture mean that they are not enough.

    Here’s a proposal: continue with the New Normal of total deposit insurance, but make total 99% instead of 100%. Roku had $465 million in SiVB uninsured. What if they got that back minus $4.65 million? Yes, they would stay in business, but someone would get fired.

    Some percentage of the responsibility to regulate banks should be pushed out to the big customers.

  17. Jeff Lill

    I understand the moral hazard issue, but I don’t understand why depositors should be the ones responsible for taking the loss. Having the stock and bond holders (and CEOs) take the hit makes perfect sense, they clearly know that they’re investing and should do proper risk analysis.

    Let’s assume that a smallish manufacturing business has a payroll bank account with with $1 million in it (quite a bit over the $250K FDIC limit). Does it really make sense to make the business’s account by responsible for evaluating the bank’s safety?

    Let’s say the answer to that question is YES, how can that accountant actually do an effective risk analysis. The day SVB crashed, I tied doing a quick risk analysis on the web. Moodys was still saying they were fine, and what limited data FDIC had was months old, and not terribly useful with just high level summaries. I couldn’t find any details on the ratio of insured to uninsured deposits, or asset details like interest rates and duration. Their year end report includes some of that, but that report was 2.5 months old when SVB failed.

    If you want depositors to be policing bank, I think the FED/FDIC needs to provide better tools. Perhaps a portal with far more detail that updates daily or weekly. The FED should also publicize when individual banks use facilities like the Discount Window, since that may indicate that the bank is stressed. Depositors could use this info to withdraw their funds or perhaps demand a higher deposit rate to compensate for the additional risk. It also seems like depositors could use a sort of stop-loss service, where the depositor could set risk criteria such that when the bank falls below this, their account balance is automatically transferred elsewhere.

    Of course, these ideas are the last thing the FED/FDIC wants. The FED doesn’t name banks that use the Discount Window for a decade or more after the fact because publishing in real time might cause a bank run. The stop-loss idea is even worse from the FED’s perspective since it’s essentially a bank run machine.

    So the regulators didn’t seem to have any idea the SVB was about to blow either, even though they have access to all bank info and even have supervisor actually embedded in banks. How can you expect an accountant at a SMB to evaluate individual bank risks when the regulators fail, with all of their advantages.

    I believe that all deposits should be insured or baring that, the limit should be raised much higher to something like $1billion, high enough so it’ll make economic sense for the depositor to hire their own specialized risk manager.

  18. LilD

    Our HOA banks with PacWest. I’m the treasurer… we have >$250k in reserves and will be switching to a tbtf bank today.
    I just want to buy treasuries but am outvoted… other board members are in a meltdown panic.
    The bank sent us a nice statement that they are not in any danger, but they can’t really know that, can they?

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