The Liquidity Mess - Ending with a Bang, Someday

The Situation:

  • Today hundreds of banks are insolvent on a balance sheet basis (liabilities exceed their assets), but the FDIC defers formally shuttering them in hopes that containment of inflation and a return to low interest rates would recover a large share of banks’ losses and avoid the crisis.  Banks’ initial losses originated from:

 

    • Mortgages issued when rates were below 3% around 2019-2021.  As market mortgage rates are now above 6%, the older mortgages have lost an enormous share of their value.
    • Longer dated Treasury bonds issued around the same time also lost a great deal of value. 

 

Note, banks hold mortgage-backed securities (MBS) and Treasury bonds in accounts deemed “Held to Maturity” where they value those securities at amortized book value and therefore avoid showing losses on their books – this helps cover up any crisis.

 

  • As the financial regulators take the gamble to defer shuttering insolvent banks, a Commercial Real Estate (CRE) crisis grows, further harming the balance sheets of banks generally.  Recognition of these losses varies as banks have some accounting flexibility, and work out processes are slow, so losses in this category show slowly over time, but the rate of loss is increasing.

  

  • As working-class jobs, middle management jobs, and white male professional job losses all take hold, bank auto loan portfolios suffer increasing strain.

 

  • Given assurances that the largest banks will be bailed out in a crisis, deposits tend to shift from the smaller banks to the larger ones in uncertain times.  The near zero cost funding via bank deposits is the lifeblood of a bank’s competitive position.  As the largest banks win these deposits through their government backstop, smaller less competitive banks will need to borrow at much higher rates and undoubtedly will fail.

The Fed, Treasury and various agencies work to cover up and drag out this crisis so that the banking system remains functional and seemingly solvent.  The agencies manage facilities to fund banks, financial institutions, and markets when they are short of capital such as the:

  • Bank Term Funding Program (BTFP)
  • Fed discount Window
  • ON RRP that lends securities and then buys them back primarily to Money Market Funds
  • Federal Home Loan Bank (FHLB) loan program. 

Additionally, the Fed performs Quantitative Easing (printing money to buy debt securities), and when possible, reverses this through Quantitative Tightening (selling securities and deleting printed money) as well as its original primary duty of setting of the overnight federal funds rate.  Finally, the Treasury now manages the targeted duration in its borrowing plans to help manage rising concern for the US credit quality by offering more debt at the short end of the yield curve.

A Brief History:

The dangers we now witness in this financial endgame were largely set into motion during the W Bush administration when Government Sponsored Entities (GSEs) known as Freddie Mac and Fannie Mae grew massive “Retained Portfolios”.  These GSEs borrowed funds near the government’s cost of money as investors viewed GSEs as backed by the government.  High on moral hazard, GSEs recklessly and increasingly bought mortgages for their own account to drive up homeownership – a government subsidized path to the American dream.  

Along-side this travesty that misallocated capital away from more productive uses, banks and broker dealers made markets for lower credit mortgages knows as Alt-A and No Income No Job loans (NINJA) that eliminated requirements for proof of any ability to repay the loan.  

When liquidity dried up as credit risk began to be realized, the dominos fell, Lehman and Bear Stearns failed and the financial crisis drove the Bush Administration into a grand conspiracy to marry banks to investment banks, massively expand systemic risk, and fundamentally diminished competitive capitalism.  The government largely avoided fault – instead, derivatives suffered the brunt of the blame; and with that, under Obama, Dodd-Frank was born – a law written by communists and introduced by Barney Frank and Chris Dodd, two beloved yet weak minded members of Congress with no understanding of finance, who drove propaganda to pass Dodd-Frank on a partisan democrat basis.

The goal of Dodd-Frank was to manage systemic risk by imposing margin and clearing requirements on most swaps and related derivatives.  Dodd-Frank also restricted the reuse or rehypothecation of collateral posted as margin or clearing – to in effect “cookie jar” the collateral.  Note, the entire premise of banking is to lend what is deposited – this is what drives the money multiplier to enable the private sector to grow.  Dodd-Frank diminished private capital formation by disabling part of the money multiplier and then a few years later replaced it with government money creation through the Fed’s Quantitative Easing.  

Another devious element to Dodd-Frank was to initially restrict most collateral except for cash or government debt securities (mainly Treasuries) to be posted as collateral for derivative transactions, e.g., interest rate swaps.  Even later when other forms of collateral were permitted, the hair cut applied for inferior forms of collateral caused banks to continue using Treasuries and agency debt as collateral.

The vast amount of collateral to be posted as margin or for clearing of derivatives required enormous quantities of Treasuries.  This increased demand for US Treasury bonds would enable the government to grow massively while maintaining low borrowing costs.  Brilliant! Err not.

However, the government was not satisfied with the level of demand for Treasuries.  They needed to increase demand and take full control of the yield curve as well.  This called for Quantitative Easing (QE) – or the idea that the Fed creates dollars electronically, with a keystroke, and uses the newly created dollars to buy Treasury bonds and other securities from Bank-Broker-Dealers; then Bank-Broker-Dealers could go out and buy more Treasuries.  The dollars that flow into the banks provided them the sought after dollar liquidity while the Fed demand for Treasuries kept interest rates low – a Win-Win! Cough.  

And Back to Today:

However, today the Fed tries to reverse QE somewhat through Quantitative Tightening, but as it does, liquidity tightens up very quickly.  It appears the banking system now requires the level of liquidity the Fed created with Quantitative Easing and its many liquidity facilities as ever higher capital requirements, liquidity requirements, stress tests and collateral/margin/clearing requirements, largely due to globalist BASEL, tied up too much capital as dead money, so banks need the extra money the Fed whips up just to do ordinary business.  

Under Quantitative Tightening, currently under way to a limited extent, as the Fed sells bonds to the bank-broker-dealers and then deletes the dollars it previously created, the loss of cash reduces liquidity in the banking system.  See the green line in Figure 2 for the historical size of the Fed Balance sheet and the limited extent of Quantitative Tightening that occurred.

Meanwhile, the ON RRP program initially reflected the Fed taking in cash from Money Market Funds as it would lend securities via repo transactions, creating a reserve of sorts, but now the Fed has almost returned all the cash, so this facility that stored cash has limited further capability to return cash to the markets.

Where Do We Go from Here:

A paragraph from Bank of America’s uniquely honest economist – Michael Hartnett’s February 1st, 2024, weekly report known as the Flow Show: 

Tale of the Tape: US regional banks -9% in 2 days but unlike Q1’23 zeitgeist now bank deflation is contagiously liquidity positive for risk assets (especially IG & monopolistic tech...so 2010s “QE bull”) until bank deflation causes jump in credit spreads (P&G just issued 10-year bond at tightest 37bps spread to UST of all-time) and/or jump in unemployment.

Loose translation: pending bank doom drives investment to riskier assets (such as the Magnificent 7 – META, AMZN, GOOGLE…).  Or basically his sarcastic way of highlighting that we are in a bubble where Wall Street finds an excuse to buy despite flashing red lights.  

Sadly, we can wait for a reckoning – but given the extent of control the government has taken over the pricing of private market assets, the purported can will be kicked for a while longer.

In his last public speech, Fed Chair Powell stated that the Fed will discuss Quantitative Tightening in greater detail March 2024 – apparently determining to maintain whatever limited tightening path until then.  Meanwhile, liquidity is tightening as regional banks once again start to price in a broad-based risk of failure.  Nonetheless, we can be confident that upon greater evidence of regional and small bank failures, the Fed will rapidly return to Quantitative Easing, protecting this administration from a financial crisis during an election year.  

However, the Limit to the Fed’s capability lies in inflation.  As the Fed again boosts liquidity through the printing of dollars for the banking system, inflation will likely return, and ultimately, inflation will reap what the Fed has sowed – but for this we must wait – and given BLS’ ability to manipulate inflation data through its perverted expansion of hedonics and substitution, the idea is that we never see the truth, but have our pockets perpetually picked.

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