March 23, 2023 | Years ago, when there were no personal computers or smart phones, we worked as an analyst at the Federal Reserve Bank of New York. First we worked in the Bank Supervision function, reporting to Chief Leroy McNally and Manager Gerry Minehan in the foreign bank applications function. William Rutledge was the Vice President for Bank Supervision.
When we joined the bank, Anthony Solomon was the President. By the time we moved across Maiden Lane to the Foreign Exchange Department under Gretchen Green, Gerald Corrigan had moved from the Minneapolis Fed to the New York bank to cover the flanks of his mentor and long-time friend, Paul Volcker. Tall Paul, a family friend and member of The Lotos Club, moved from New York to Washington in 1979 to become Fed Chairman. We had an opportunity to talk about those years and his relationship with Corrigan at lunch in Volcker’s hideaway at 30 Rock in 2017.
In 1985, the Fed of New York was engaged in an extensive effort to devalue or at least slow the appreciation of the dollar. On behalf of the Treasury using the Exchange Stabilization Fund, and the Fed’s own account, the desk sold dollars and bought foreign currencies.
“In what became known as the Plaza Accord, the officials agreed to an unprecedented joint intervention in currency markets, the Wall Street Journal wrote. “Ultimately, it worked. The dollar fell sharply over the coming decade while the Japanese yen soared.” But now many economists wonder if this massive intervention did not doom Japan to economic malaise for the next decade.
One of the more active defensive efforts conducted by the FRBNY was to support the Canadian dollar against persistent short-selling. The spot market in the Maple Leaf was a mere fraction of the offshore forward market and the futures in Chicago. Traders shorted the Canadian dollar and went long yen, netting out the margin cost. So in response, our traders called a couple of futures dealers and told them to buy Canadian dollar futures contracts, in their name, until we told them to stop.
During this period, President Corrigan would come into the foreign exchange room before 7 AM after a meeting with the NY Fed's bank supervision function across Maiden Lane at Jim Brady’s. Like the Fed in those days, Jim Brady's was essentially open 24/7 to serve the liquidity needs of the cash and check clearing personnel working at the Fed. Our responsibility was the futures desk.
Corrigan’s first question to the spot traders and analysts every morning was whether our market intervention the previous day had caused any collateral damage to the primary dealers or traders in the street. If we did, an out of market trade was executed to make the counterparty whole. And none of this was documented or disclosed.
Today, sadly, the Federal Reserve Board seems to have forgotten that monetary policy is executed through and with banks in the bond market. By doubling the Fed’s balance sheet between 2020-2021, from over $4 trillion to now $9 trillion in nominal dollars, the FOMC has injected vast amounts of market risk into the US banking system.
What few members of the FOMC seem to appreciate is that in duration-adjusted dollars, that $3 trillion in mortgage-backed securities (MBS) owned by the system open market account (SOMA), is today more like $12-15 trillion in terms of the risk to US banks and the Fed itself that own these low-coupon securities.
Below is a snapshot from Bloomberg showing the market prices for Fannie Mae securities for delivery in April, what is known as "TBAs" in the bond market. This market not only prices your residential or commercial mortgage, but it is also the foundation of the US Treasury market and is a primary avenue for interest rate hedging. In Q3 2022, those Fannie Mae 2s that banks purchased at 103-104 in 2021 were trading in the high 70 cents on the dollar of face value.
As we’ve noted in earlier comments, the massive amount of refinancing that occurred in 2020-2021 has concentrated the coupons of about three-quarters of the $13 trillion market for mortgage securities between 2% and 4.5%. The average coupon is about 3%, which today is trading at a ten-point discount to par. Most of the production in that period is found in the 2s and 2.5% MBS, a ghetto of highly volatile securities that are now points under water vs SOFR funding costs.
Given the market distortions of QE, how much can the Fed raise interest rates from 2021 levels before holders of those 2 and 2.5% MBS are insolvent? About 300bp or 3%. But the FOMC has already moved the FF rates nearly 6% in 18 months. Likewise with bank deposits, the Fed's 600bp move in FF rates has destabilized those heretofore stable business deposits at banks, large and small.
"Banks often assume that retail term deposits are stable, because individuals would forego all the accrued interest as penalty for early redemption," our friend Nom de Plumber observed overnight. "However, for example, if a seasoned one-year deposit has been paying only 0.25%, but money-market mutual funds, short-maturity Treasuries, or new deposits are paying 4% or more, the customer will readily terminate that seasoned deposit and roll the funds to elsewhere. Hence, banks have been losing huge amounts of 'stable' funding as the Fed quickly raised interest rates."
Strangely, no significant questions about these issues of liquidity were asked yesterday during Powell’s press conference, specifically about the impact of the Fed’s actions on banks and markets. As writers and journalists, we are embarrassed for the profession. Not a single challenge was made of Chairman Powell as to whether he felt responsible for the failure of three large banks in a week. It’s as though the Fed’s public affairs staff writes all the questions.
The key question for Powell is why he thinks the FOMC shift in monetary policy is credible without explicit asset sales at the same time? Given the change in the effective average life of its mortgage portfolio, for example, the Fed ought to be selling the MBS from the SOMA and allow the balance sheet to shrink. But the same concentration of bond and loan coupons that is causing trillions of unrealized losses for banks has also tied the Fed’s hands when it comes to fighting inflation.
Treasury Secretary Janet Yellen and Fed Chairman Jerome Powell are another bank failure or two away from returning to the private sector. Many banks with large, unrealized losses on the books are going to become targets for short-selling and rumor mongering, precisely what led to the collapse of Silicon Valley Bank and Signature Bank (“Who Killed Silicon Valley Bank?; The IRA Bank Book Q1 2023”). Banks that have weak funding or poor asset-liability management will become targets.
The good news is that the modest rally in the bond market from March 2nd, when the 10-year bond touched 4%, will force down the unrealized losses disclosed by banks in Q1 2023 earnings. Do you think anybody at the Fed understands that the 10 yr Treasury is unlikely to rise and remain above 4% until sales from the SOMA begin?
The bad news is that there is still a huge chunk of mortgage, corporate and Treasury securities that are under water in terms of funding costs. Weaker banks may be forced to sell these money-losing securities out of held-to-maturity portfolios later this year, provoking a revaluation of all such assets owned in portfolio by banks. In the event, the Fed will have created the very 1930s style debt deflation that the central bank has pretended to hold at bay via QE for a decade.
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