HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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May 3, 2023

The Fed Will Need a Bigger Broom

Miniature,Janitors,Faced,With,Broken,Raw,Egg,On,Kitchen,Table.

When things break

In 2020, the Fed caused the most significant growth in money supply since the 1940s. By dropping interest rates to zero and implementing a vast QE programme, the Fed assured us that any inflation would be temporary. Fed Chair Powell said in June 2020 that he was “not even thinking about thinking about raising rates.” The Fed’s stance remained unchanged as inflation rose and energy prices spiked the following year.

Pretend it didn't happen

However, in March 2022, the mood changed. Suddenly freaked out about the threat of persistent inflation, the Fed raised rates at the sharpest pace ever witnessed, and the broad money supply fell at its fastest rate since the early 1930s. The consequences of these Fed actions and inaction will prove devastating.

This is not a drill

Financial market volatility has caused havoc in the US banking sector. Three of US history’s four largest bank failures have occurred in the last six weeks. As this systemic credit event unfolds, it reveals flashbacks of the Savings & Loan crisis, the commercial property recession of the early 1990s and the Global Financial Crisis.

Fetch the broom

Any banking crisis is a moment to consider deposit insurance. Following many bank failures in the US, the Federal government established the Federal Deposit Insurance Corporation (FDIC) as a temporary government corporation in 1933. Its establishment helped stop the contagious bank runs that ripped through the 24 000 US regional banks of the day.

Trying to help

However, the FDIC is not a typical insurance company. Author Edward Griffin has likened federal deposit insurance to a compulsory scheme for drivers to contribute to a mutual fund to pay for its contributors’ parking violations. A deliberately simplified analogue to illustrate the outcomes of underwriting moral hazard. Spoiler alert, the practice doesn’t foster good behaviour.

This one didn't

While the FDIC covered the Federal Reserve System banks, until the 1980s, another deposit insurance provider, the Federal Savings and Loans Insurance Company (FSLIC), provided deposit insurance to many regional and community thrifts, known as Savings & Loans (S&Ls). However, the FSLIC did not survive the 1980s. Its incompetence was only exceeded by its sustained level of insolvency.

Hidden losses

Interest rates spikes in the 70s and early 80s rendered many S&Ls insolvent. They had to pay higher short-term interest rates to attract deposits, but their interest income from long-term, fixed-rate mortgages was unchanged and then fell as payment defaults rose. The market value of mortgages (their assets) plummeted. However, to most people, the S&Ls appeared solvent. They had enough resources to pay interest and meet withdrawals primarily because they did not have to write down their mortgages to market value. Remind you of anything?

Losses grow

Had the S&L losses been recognised, the FSLIC’s reserves would have been vaporised. Instead, fearing financial contagion, personal embarrassment and their nice jobs, FSLIC officials not only permitted insolvent S&Ls to continue operating but contrived with them to falsify asset values to maintain their solvency facade and continue to grow their loan books and asset bases. The can was kicked down the road and allowed to get much bigger.

Run

The presence of the FSLIC changed the dynamics of bank runs. The runs on S&Ls involved deposits moving from safer S&Ls into riskier ones. As the safety net of deposit insurance covers all players, regardless of solvency, the most insolvent S&Ls could attract funds by paying higher interest rates to risk immune savers on their federally insured deposits.

One last shot

But it got worse. To give the insolvent but growing S&Ls a shot at financial redemption, the FSLIC lobbied Congress to deregulate the industry so the S&Ls could buy higher-yielding assets to make back their mortgage losses. If the S&Ls’ risky bets paid off, they kept the profits. If not, the FSLIC and the US taxpayer would pick up the tab. This history of gambling woe often recurs, and it never ends well, and this time was no different.

Job done

Between 1986 and 1995, a third of all S&Ls failed. As the US government belatedly realised the extent of the horror story, the FSLIC was closed down and replaced by the Resolution Trust Corporation in 1989. In 1996 the Government Accountability Office estimated the total cost of the S&L crisis at $160bn. The FSLIC had made the S&L crisis bigger and last longer.

Never again

The FDIC assumed the final independent FSLIC vestiges in 2006, and today the FDIC runs all US deposit insurance. Its most recent accounts show a deposit fund value of $128bn, standing guard over total US bank deposits of circa $19tn, of which about $7-8tn is in uninsured accounts, much of which is now flowing into higher-yielding money market funds.

But wait

On the assets side of bank balance sheets, there is a matter of about $750bn of unrealised bond losses and an expected $1.5tn of commercial real estate loans estimated to require refinancing by the end of 2025. Here, the doom loop death spiral of forced asset sales is primed and ready. At this point in the commercial real estate office bubble of the early 1990s, Donald Trump filed for bankruptcy protection, and in the UK, Canary Wharf developers Olympia and York went bust. Their shining edifices remain as monuments to interest rate risk.

Damage done

The Federal Reserve meets to opine on the new policy rate level today. However, whether the vote is for an increase or a pause no longer really matters. It is too late to change course and manage the soft landing rhetoric of just a few weeks ago. Milton Friedman’s long and variable lags mean the damage is already done. Like fishing with a hand grenade, the bodies take time to float to the surface.

New broom

Where will it end? As any addict knows, the first step is admission. And for the Federal Reserve, any admission that they have a banking problem will likely manifest at the FDIC, the Fed’s broom used to sweep away the pain. If you think the politics of extending the debt ceiling will be intense, wait to see what the government bail-out of the FDIC brings.

Jeremy

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