3/17/23 – Participation Trophies for the Banking System

Anyone with children under 12 years-old understands the concept of the participation trophy (or has at least watched the Bluey Episode titled “Pass the Parcel”).  In an effort to make sure that all participants feel good about themselves, everyone gets a trophy.  For the younger kids, quite often the parents discourage keeping score or even declaring a winner.  This week felt like it was trophy day for the banking system.  The first trophy went to Silicon Valley bank for their mismanagement of their hold-to-maturity book, by establishing a duration that suffered a significant loss of value from the Fed’s draconian rate hikes to date.  The FDIC, which guarantees deposits up to $250,000, on Sunday evening announced that the guarantee would be extend to all depositors regardless of the size of their deposit.  As has been communicated, many of the deposits were the working capital of promising, albeit not yet profitable, start-ups.  Start-ups that should their break-through prove successful, hold the winning lottery ticket to hundreds of millions or billions of dollars.  So as to ensure that all financial institutions were treated fairly at trophy time, the FDIC effectively offered the same guarantee to all banking institutions, large and small.  Deposits in the U.S. banking system total approximately $20 trillion!

Not to be outdone by the FDIC, The Federal Reserve implemented the “Bank Term Funding Program”, which commits the Central bank to lend to financial institutions, for a term of up to twelve months, valuing their collateral at 100 cents on the dollar, despite what the current market value of that collateral.  Pledge the 1.125% August, 2040 long bond which is currently valued at about 67 cents and the entity can borrow at 100 cents on the dollar.  Arguably, this is the third iteration of Quantitative Easing.

Then, on Thursday, a consortium of banks pledged to deposit $30 billion at beleaguered First Republic Bank, in an effort to avoid what happened at Silicon Valley Bank.  First Republic, in similar fashion to SVB, had extended its hold-to-maturity portfolio and was facing a deposit run that they couldn’t meet.  We can only guess at the “arm-twisting” that Yellen and Powell applied in getting the usually quite competitive banking industry to support a competitor in time of need.

We get it!  No one is served by a massive run and potential collapse of the banking system.  That begets the question of why this happened, and the blame falls most squarely on the Federal Reserve.  After years of suppressed interest rates and irresponsible monetary policy, the Fed went in the opposite direction and yield-starved investors, both institutional and retail, pounced on the rising rates.  As a result, bonds of all stripes registered losses month after month in 2022.  It was headline news at least weekly throughout the entire year.  One would think, with that backdrop, the regulators would be extra sensitive to the hold-to-maturity accounts of the banking system with regard to investor confidence and liquidity of the banking system.  But it was missed entirely.

Next week’s FOMC meeting is likely to be a poignant gathering.  Will the Fed continue with their inflation fighting rate hikes or pause.  We are expecting the latter.  Less importantly is how Powell will be treated at the press conference.  The entirety of this mess should be laid at his doorstep, but the press core has historically loathed pinning him down on difficult topics. But Powell, himself, should offer an explanation!  The Fed is, after all, the Central Bank!