We are approaching the tipping point where the US economy and banking system rolls off the edge and back to safety or falls off the cliff and into a full fledged banking crisis.
The Federal Reserve could solve this problem in one step: cut interest rates at its meeting this week.
Still, the chances of the Fed taking that step are slim. While most forecasts now call for the US central bank to delay a rate hike, a pause is simply not enough.
Reducing rates releases an economic pressure valve. As temporary as this movement is, the respite is necessary for the health of financial markets and the banking system.
Yes, the Fed wants to tighten the leash on inflation and, no, a rate cut will not help on that front, but someone needs to tell Fed Chairman Jerome Powell that this is not not a “kill at all cost” mission, because none of us can afford the stability of the banking system to be the price paid in the effort.
squeeze and bleed
So far most of the coverage of the Silicon Valley Bank SIVB collapse,
Silvergate Bank SI,
and Signature Bank SBNY,
— and the instability at First Republic Bank FRC,
and others – focused on how these banks managed to navigate their way through difficulties. He did not carefully examine the pressure these companies faced.
Here’s the problem that many experts tell me are being ignored, summed up by Bryce Doty, senior portfolio manager at Sit Investment Associates: “Most banks are insolvent right now.”
Sounds awful, but it’s more about regulatory rules and interest rates than a complete inability to pay all debts.
Read: From SVB’s sudden collapse to Credit Suisse fallout: 8 charts show financial market turmoil
To bring it home, consider if you took out a long-term fixed rate mortgage on a home about 10 years ago, when the average mortgage rate was around 3.6%. It was roughly double the 10-year Treasury rate TMUBMUSD10Y,
at the time, which meant that an institution wanted to buy your loan rather than settle for a safer treasury.
These days you’re still paying 3.6% on the mortgage, but that’s about what the 10-year Treasury pays. As a result, the value of your mortgage on your lender’s books is lower than it was ten years ago. In the banking world, such events are not a problem until the paper has to be “marked to market”, as if it were being sold today.
Federal regulations allow banks to plan to hold a portion of their assets to maturity, allowing them to offset temporary losses on paper, since securities to be held forever are not marked-to-market (remaining in the books at the value they had when purchased). This gives banks the flexibility they need, but can create “not a problem until it becomes a problem” type of problem, predictable only if you pay close attention.
While the 2008 financial crisis was caused by banks taking losses by default, the current problem in the system is not worthless paper (at least not yet). This time the rates rose so quickly that it created paper waste.
“ The Fed should have seen it coming.”
The Bloomberg US Aggregate Bond Index fell 13% last year; previously, its worst year was a 3% loss in 1994. Since 1976, the index has declined in just five calendar years, including the last two years.
The Fed should have seen it coming; its own track record shows that about $9 trillion of bonds lose north of 10% of their value during rate hikes. “The Fed kept rates so low and then raised them so fast that no [financial institution] could eventually readjust their bond portfolios to avoid losses,” Doty said in an interview on my Money Life with Chuck Jaffe podcast.
Off-air, Doty estimated that if the Fed cut interest rates by 100 basis points – one percentage point – “it would eliminate half of [the banking industry’s] unrealized losses all at once. This would make the banking crisis the easiest and shortest in history.
Moreover, it would guarantee the absence of “contagion” from imploding banks; keep in mind that it was the banks that came to the rescue of the First Republic this week, sowing the seeds for one bank’s market valuation issues to become the default loss of the next institution.
That’s how you turn a problem into a disaster. If the Fed pushes rates higher without allowing time for relief, it dramatically increases the risk of a liquidity crunch and a credit crunch.
Hello Recession, your table is ready.
Read: “We have to stop this now.” First Republic support spreads financial contagion, says Bill Ackman.
Jurrien Timmer, director of global macro at Fidelity Investments, said in a recent interview on my show that he doesn’t see the Fed giving up, noting that no one wants to be the next Arthur Burns, the infamous Fed Chairman during the great inflation of the 1970s.
Timmer said: “They pledged never to repeat those mistakes, which in the 1970s was to keep policy too loose for too long, letting the genie of inflation come out of the bottle.”
But this isn’t the 1970s, and anyone who thought the Fed was too lax on inflation then – which is why it’s taking a tough stance today – should consider that the central bank may have backed down. at the time because higher rates were causing widespread systemic problems.
The Fed should solve problems, not contribute to them. If that means living with higher inflation for longer, it’s still a better bet for the country than to turn a contained banking problem into a global liquidity crisis and a hard landing for the economy.
A cut does not end the war against inflation, it simply interrupts the battle to strengthen and secure its combat position. Sometimes the best way to move forward is to start with a step back. Let’s hope the Fed has the guts to do it.
Read: What it may take to calm the nervousness of the banking sector: time, plus a rate hike from the Fed.
More: The First Republic was saved by rivals. Silicon Valley Bank was abandoned by its friends.
