A great deal of attention has focused on the bailout of SVB depositors, but the bigger story is the bailout of other banks. (At least bigger as of today, there are rumors the government may extend the over $250,000 deposit bailout to all banks. You can imagine what I think of that idea.)
David Beckworth has a podcast where Steven Kelly discusses how the new Fed loan facility works. Here’s David:
Beckworth: Daniela Gabor, she wrote something in a similar vein. She said, “Forget about SBV liabilities for a second. The real bailout story is the regime change in the Fed’s treatment of collateral. Par value goes against every risk management commandment of the past 30 years. It turbocharges the monetary power of collateral.”
Kelly explains the problem by considering a situation where banks paid $90 for bonds with a par value of $100, and then the market value fell from $90 to $80:
Kelly: So not only did they say, “Well, we’ll give you the 80 and we’ll calm things down. We’ll replace the 80 that you lost from uninsured depositors being flighty. Nor will we give you 90, which is what you’ve been carrying your books at, so you don’t have to recognize the loss of funding there. We’re going to give you 100, which can solve other problems on your books too.” So that’s super unique. And Daniela’s language is more dramatic than mine and more eloquent than mine, but that’s exactly the point she’s making.
The Fed’s treating these bonds as $100 worth of collateral, despite the fact that the banks paid $90 and the market value is only $80.
But I slightly disagree with Kelly’s framing here:
Beckworth: So I like the framing you just made, that this is effectively a capital injection, because they’re paying above par. Well, they’re paying par which is above market value, so it’s effectively a capital injection. I also heard someone else put it this way on Twitter, “The Fed is effectively doing unsecured lending.” Is that also another interpretation?
Kelly: So it is if you think, okay, you’re getting 90 bucks of collateral for a $100 loan. I mean the Fed’s not totally bound by those values. The Fed’s legal mandate, especially with 13(3), is that it does not expect losses ex ante. There’s really no reason to expect loss if you’re the Fed. You’re talking about treasuries… There’s no reason to expect a loss if you hold this stuff to maturity, which is typically how they think about it, and they have 25 billion from the Treasury, I would argue unnecessarily, but I don’t think the Fed needs to think about this as unsecured. It looks like a loan against underwater collateral, but they’re going to get paid back, which is sort of their floor for secured to satisfaction.
He’s probably correct that the Fed won’t end up losing money here. But it’s not quite correct to imply that holding these depressed bonds to maturity solves the problem. The Fed is already likely to incur some very large losses from its current holdings of Treasury bonds. In previous posts, I’ve explained how those losses cannot necessarily be avoided by holding the bonds to maturity.
Of course it’s very possible that these bank loans do get repaid, and it’s also very possible that we have a recession and interest rates fall sharply, boosting the value of the Fed’s long-term bond portfolio. So I’m not predicting big Fed losses from these particular loans. But there’s no getting around the fact that if you treat $80 bonds as representing $100 worth of collateral, you are giving the banks a gift. And someone must bear the cost if those loans default.
We are adding moral hazard to the system so rapidly it’s making my head spin. And not just in finance. Think of the Covid bailouts of many businesses, or the student loan bailouts. The more safety nets we add, the less incentive people have to be careful.
READER COMMENTS
Philo
Mar 22 2023 at 2:04am
“The more safety nets we add, the less incentive people have to be careful.” This is contrary to the whole spirit of the Welfare State. Talk about swimming against the tide!
robc
Mar 22 2023 at 12:01pm
As usual, the tide is wrong.
Dylan
Mar 22 2023 at 2:31pm
That’s what I’ve been saying about gravity, but for some reason I keep falling down.
Spencer
Mar 22 2023 at 11:10am
The economy is in a highly inflationary environment. When Continental Illinois was bailed out, reserves were “washed out”. Powell blissfully added them.
Economists have been moving in the wrong direction for a long time. Powell and Selgin think banks are intermediaries between savers and borrowers. Selgin cites borrowing short term to lend longer term as proof. The banks are losing money on their time deposit business. Monopoly power has its consequences. There is a one-to-one correspondence between time deposits and demand deposits, as time deposits grow, demand deposits shrink pari-passu.
Spencer
Mar 22 2023 at 11:25am
See WSJ 3/17/23 “Another Banking Crisis Was Predictable”
The original sin was monetary policy, Thomas Hoenig says, but regulators failed to heed the warning signs of a disaster in the making at SVB and elsewhere.
“The Fed knew the duration-risk problem was developing long before SVB hit the panic button. A second-quarter 2022 report from the Kansas City Fed notes that “since year-end 2019, U.S. commercial banks increased securities holdings by $2.0 trillion. . . . The increased holdings were in longer-dated maturities, extending portfolio duration and exposing banks to heightened interest rate risk.” The report notes that rising interest rates have “led to historically high unrealized losses on banks’ available-for-sale (AFS) securities portfolios.”
vince
Mar 22 2023 at 4:30pm
The Fed shouldn’t have to lend anything to SVB. According to the SVBFG 12/31/22 balance sheet, the FDIC shouldn’t lose a penny. SVBFG has cash of 14 billion, AFS securities worth 26 billion, HTM securities worth 76 billion, accrued interest worth 3 billion, and net loans of 74 billion. That’s 193 billion of liquid assets at market value. Total deposits were $173 billion.
What’s the problem? Sell the assets, pay the depositors, and shut down.
Spencer
Mar 22 2023 at 7:47pm
“Yellen said the administration was not considering “anything having to do with blanket insurance or guarantees of deposits.”
She said the Treasury Department was working to restore the Financial Stability Oversight Council’s (FSOC) ability to designate non-bank financial institutions as systemically important…”
Steve S
Mar 23 2023 at 12:43am
This is a primer course in how the Fed will value unrealized capital gains if Congress ever passes a wealth tax. The Constitutionality question aside, one of the unanswered questions out there is “if the economy goes south, do I get a refund for the wealth taxes paid before it went bust?” This simply tells us all that they will value the unrealized capital gains at whatever value is politically convenient to them at the time.
Steve S
Mar 23 2023 at 12:45am
That is, if your asset is currently worth $80.00, but was worth $100.00 two years ago when you paid the tax, then it is still worth $100.00. No refund is due.
Arqiduka
Mar 26 2023 at 5:38am
If the market if valuing a 100 dollar asset at 90 or 80, that’d be due to default risk. If the Fed always buys these assets back at what the market values them, it is saying that there is no defaul risk except what the market makes. Hence, next time around, all such assets will trade at par. So, it’s all the same really.
Ryan Baker
Mar 27 2023 at 8:40pm
Feels like an issue you have to look at from every angle, rather than just one, but you have to be careful when doing so to keep each angle separate, unless there’s a good reason to link them.
Is Fed taking not getting enough collateral? By their standards, yes. By any normal bank, no. But they aren’t normal.
Is Fed losing money? Not unless there is a default on these loans and they add them to their balance. If there was a default, then the Fed loses money because it assumes ownership of assets that are worth less than the money loaned. But if there isn’t a default they get paid back at loan value.
Is Fed giving money away during a default? No, because for the Fed to lose money, the partner bank must have defaulted, and you can’t really make money by defaulting. So long as shareholders are wiped out, there’s no one standing to gain from the assumption. They only point where a bank’s shareholders comes out ahead is a situation in which they would have failed, but didn’t.
Is the Fed giving money away via risk reduction? Maybe? This is the best argument against this policy. More on this later.
Is the Fed losing money in a default without this policy? Maybe? A related question is, are Americans overall losing money in a default without this policy? When you consider the likeliness that a default would either result in some other form of bailout or economic consequences, it seems easy to justify the possibility that in a default the Fed would take ownership of assets where the market value was less than the par value loaned.
So, that’s the general justification, and the unresolved question is, does this create an incentive to assume risk? In the pre rate rise time, there will be a less resistance to taking on bonds that might be at risk to market rate risk, since you can no longer be forced to sell them at market value to satisfy liquidity requirements. But a bigger risk is what if loans are used for something other than liquidity requirements? If the margin is great enough, why not take a loan on below par bonds, and use the loaned money to buy at more bonds?
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