Yesterday Mr. Market got word that yet another bank had gone wobbly, shortly after the Fed announced it was putting through another interest rate increase and only considering pausing next month. From CNBC:
PacWest Bancorp shares tumbled 56% in extended trading on Wednesday following news that the bank is weighing strategic options.
The regional bank is assessing options, including a possible sale, and bringing in advisors to evaluate longer-term plans for the business, CNBC confirmed, according to one person familiar with the matter. Piper Sandler and Stephens are the two firms advising PacWest, the person said…..
PacWest reported that total deposits declined more than $5 billion in the first quarter to $28.2 billion as of March 31. However, the company said that it saw a net gain of $1.1 billion in deposits from March 20 until quarter end.
PacWest also said that deposits grew by another $700 million from March 31 through April 24.
PacWest is not all that big a bank, with only $40 billion in total assets. Its market cap is currently only $750 million, meaning it should be digestible absent any really bad warts. But other regional bank stocks traded down again.
Nevertheless, the Fed is making clear that it is prioritizing fighting inflation rather than easing up on the pressure on banks that it created.
First, as we discussed a decade ago, sources told us the Fed had come to recognize its super low interest rate experiment had not only failed but was also creating serious economic distortions. But when Bernanke started trying to ease his way out, he quickly lost his nerve in the face of the so-called taper tantrum.
So having gotten banks and long-term investors deeply acculturated to cheap credit (remember, nearly a full generation of traders and managers have grown up under this regime), it was predictable that if the Fed moved quickly, it would create not just pain but actual distress. Raising rates was long overdue but that meant normalizing slowly would be necessary to avoid dislocation.
On top of that, it looks like the Fed was utterly incompetent at bank supervision. Managing interest rate and maturity risk (as in banks borrow short and lend long) is Banking 101. If you aren’t good at that, you shouldn’t be in business. Yet Silicon Valley Bank post mortems showed the Fed supervisors in San Francisco knew that the bank was using bad risk models that were telling it to do exactly the wrong thing…..and it was acting on those models. Oh, and it had no senior risk manager either. But the Fed just handwaved to management rather than telling SVB it would issue a warning letter in X days if it did not Do Something.
Put it another way: the way you normally have bank crises is when bunch of them follow a fad and make too many stupid loans, in the typical Minsky cycle. Even Volcker backed off when banks started looking like they would fall over during his extreme rate increases.
Yet the Fed has kept on bloodymindedly with its interest rate jihad, even as more and more evidence confirms that this inflation isn’t caused by too much demand or uppity workers succeeding in getting wage increases. Contacts say there’s still pent up demand for cars due to the prolonged Covid supply chain disruptions. Experts increasingly cite greedflation as a big contributor. As we said early on, the Fed can kill inflation, but for one produced largely by supply issues, it will kill the economy stone cold dead in the process?
The Fed is also doing a terrible job of managing the crisis. Being oracular is fine when discussing interest rate policy. It isn’t when banks are looking green the gills. The financial press is stoking fears with uninformed discussions of bank balance sheets. Banks have what is called “hold to maturity” portfolios. They get to hold them at their acquisition cost. There’s nothing nefarious about it since the bank really does intend to keep it to maturity, so the principal value will be 100%. Yes, they will lose money during the periods when their funding costs exceeds the interest income, but that shows up in the relevant income statement.
Now one can correctly point out that banks like SVB had too much in their hold to maturity portfolio given they had a lot of rich depositors who could and did pull their money out. But again, this is something the Fed and the banks themselves should have been on top of. It would really behoove the Fed to see if and where any of these hold to maturity portfolios are too large. And it ought to consider being more transparent, and having a geeky (make sure it’s geeky to discourage lazy reporters) briefing on how hold to maturity works. It’s much better to educate reporters when they seem to be going off half cocked that making airy statements about how everything is hunky dory, or go too quiet, both of which look guilty.
Because SVB and First Republic had a lot of rich uninsured depositors, investors and banksters have called for all deposits to be guaranteed. I must note that all of this petitioning for a massive increase in bank safety nets has not been accompanied by any suggestions of how to increase bank supervision and more important, get regulators to use the powers they already have. Giving banks more government support after some badly run banks blew themselves up is simply enabling more bank incompetence.
Recall also that it’s the FDIC that has to do the nitty-gritty work of resolving banks. And accordingly, the FDIC is also trying to limit the further extension of deposit guarantees to have it cover only company deposits (as in protect payrolls and suppliers).
So it’s not hard to guess that the Fed would prefer more bank subsidies, here in the form of more deposit guarantees, because it can continue to do a terrible job of bank supervision and not have to deal wit the fallout. That would explain its indifference to this (so far) low-level bank crisis.
There actually is an elegant solution to the problem of moral hazard, but bizarrely it has never gotten traction. The idea, first proposed by ex-Goldman partner William Dudley when head of the New York Fed, would have the effect of putting bank executives on a similar footing to old Wall Street partners by having most of their pay tied up for a number of years and acting as subordinate equity. If the bank’s equity was wiped out in a liquidation or a subsidized sale, they would take losses first, ahead of shareholders.
This general concept was refined by emeritus London School of Economics professor Charles Goodhart, who set forth a detailed conceptual scheme of how and how much “insiders” should have their compensation taken or clawed back in the event of a failure. Goodhart was more draconian than Dudley, suggesting that CEOs should face the loss of three times their total remuneration, and board members, two times. It’s a clever proposal, which you can read here.
Sadly, the tracks look very well greased for banksters to get even more government support, further increasing an already too favorable risk-return tradeoff for them. And the great unwashed public isn’t complaining. I confess to finding it hard to feel sorry for willing victims.