by Bryan Perry
March 28, 2023
Yields on Treasuries have nosedived in a full-scale rebuke of Fed Chair Jerome Powell’s quarter-point rate hike, the ninth in a year-long string of increases. Far from being a cherry on top of the sundae, bond traders see Powell’s latest move as the straw that could potentially break the economic camel’s back.
Thankfully, long-duration bond yields have come down almost 1% since the first week of March, thereby pushing bond prices higher. But yields would have to fall much further to right the wrongs of poor risk management at banks that invested way too much in the long end of the curve when rates were far lower.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
A new report by researchers at New York University on March 13 found that SVB isn’t the only bank with unrealized losses on the balance sheet. Apparently, U.S. banks had unrealized losses of $1.7 trillion at the end of 2022. The losses were nearly equal to the banks’ total equity of $2.1 trillion, according to professors Philip Schnabel and Alexi Savov, and the University of Pennsylvania’s Itamar Drechsler.
Additionally, of the $17 trillion in total U.S. bank deposits, nearly $7 trillion are currently not insured by the FDIC, according to that paper. Unrealized losses aren’t reflected on the banks’ balance sheets due to an accounting practice where assets are held on banks’ books at the value at which they are bought, not their current market value. Back in 2015, the Financial Standards Accounting Board (FASB) determined, in the interest of reducing costly disclosures related to value of core assets and deposits, to invoke an accounting standard that limited its requirement for “mark-to-market” (MTM) accounting, saying:
“The final standard, ‘classification and measurement,’ became effective in 2018 and does not require MTM for loans or debt securities. It does, however, require all equity investments to be treated as trading securities, with changes in fair value recorded through earnings — an important concern for banks that hold significant levels of equity securities.” (ABA Banking Journal)
It seems almost impossible that the scenario of owning a disproportionate amount of low-yield, long-duration Treasuries and agency debt would not spark a run on deposits, if future rates on short-term Treasuries rose. Logic would have it that during the most recent stress test, this inherent risk of money leaving the bank’s low savings and money market rates for the higher-yielding short-term Treasury market that is correlated to Fed rate hikes, would have been identified as a potential tinder box, but no.
In late 2021 the Fed provided two “stress tests” on banks, one a “baseline” test and the other with “severely adverse” events, the “most negative future” the Fed deemed possible from the start of 2022 to the end of 2025. The Fed got the baseline basically right, “but it was spectacularly wrong on inflation and interest rates. Unbelievable as it seems now, the Fed’s most stressful scenarios had the CPI running at sub-2% all the way into 2025,” writes Fortune magazine’s Shawn Tully (in “How the Fed’s stress tests failed to stop a banking crisis,” March 21, 2023). The Fed completely ignored the stress THEY created!
The Federal Reserve employs just over 400 economists with PhDs, yet their most stressful bank scenario before 2022 had the CPI running at sub-2% all the way out to 2025? Maybe if the Fed plugged in some banking executives, they might see some reality. Fed Head Jerome Powell is not an economist. He’s a lawyer who made a lot of money at the Carlyle Group. He has an undergraduate degree in politics and went to law school. I guess the optics of pausing to see the implications of eight rate hikes might have on the economy and a severely flawed stress testing system were not in Powell’s or the Fed’s best interests.
So, while the Fed not only missed the fact that inflation was not “transitory,” their models also missed the potential damage that would be inflicted on banks by their most-rapid-in-history rise in interest rates.
What is widely apparent is that the market is suffering the pain of the poor oversight and management of monetary policy by the Fed, the FASB, and Treasury Secretary Janet Yellen for last week’s bungling of the deposit insurance dialogue. The Fed and the Treasury would be much better-served with seasoned bankers with real-world business experience – such as Bank of America’s CEO Brian Moynihan. Powell can’t be fired but it is already past time to discard the optics of replacing Yellen, a weak crisis manager.
It is up to the White House to make the change, but Joe Biden is siding with Yellen for political reasons. Maybe another domino (First Republic) falling might force his handlers to help him change his thinking.
Opening day for the 2023 baseball season comes later this week, and the Treasury already needs a relief pitcher to get in the game and rescue the struggling starting pitcher at Treasury. Just one man’s opinion.
Navellier & Associates Inc. does not own Silicon Valley Bank (SVB), or Bank of America (BAC), in managed accounts. Bryan Perry does not personally own Silicon Valley Bank (SVB) or Bank of America (BAC).