July 26, 2023 | This week The Institutional Risk Analyst is in Washington, D.C. for meetings in the mortgage and banking channels. Below follows our comments to the Center for Strategic Tax Reform on Wednesday, 2:00 PM at the Tax Foundation in Washington.
Inflation is called a “hidden tax,” but lately the tax is not even barely concealed. Under the 1978 Humphrey Hawkins law, the Fed is supposed to work toward price stability and full employment. Yet precisely the opposite situation seems to be the norm. William Dunkleberg writes in Forbes:
“Did you realize that since 2020 we have all experienced an “across-the-board” tax increase of 15%? The prices of goods and services we buy are about 15% higher than they were in 2020. So, unless your income has risen by 15%, your real income, what you can buy with your 2020 income today, is much reduced. And, with inflation running at 7% you are still losing ground. If you had $10,000 in a savings account (IRA, 401k, etc.), it will buy only about $8,700 worth of stuff today. Rising income and/or returns on your investments could offset these losses, but not 100%, and for too many, not at all.”
How did the inflation happen? Simply stated, the Fed lost its nerve after the money market collapse in December 2018. Fed Chairman Jerome Powell and his colleagues decided to double-down on the pro-inflation policies of former Chairman Ben Bernanke and “go big” with reserves. Powell hugely inflated the Fed’s balance sheet and bank balance sheets too, and in the process pushed up home prices by a third. And all this started 15 months before COVID.
Since the end of 2021, the Fed gradually ended new purchases of Treasury bonds and mortgage securities and is now slowly allowing its portfolio to run off. The Fed has raised the target for federal funds to nearly 6%, imposing roughly $1 trillion in mark-to-market losses on securities held by US banks. This is a tax too, BTW.
In addition to imposing market losses on banks and other investors, the FOMC’s actions have badly disrupted the term structure of interest rates in the mortgage and asset backed securities markets. Home lenders face a contango market. Lender are losing money on every mortgage they make, both in terms of carrying costs and secondary market execution. This is also a tax. The chart below shows the losses being incurred by mortgage lenders per dollar of volumes from the latest MBA Performance Survey.
Source: Mortgage Bankers Association
Three large regional banks failed in Q1 2023 at the cost of tens of billions in investor losses on equity and debt securities. PacWest Financial (PACW) is reportedly in talks to be acquired by Banc of California (BANC) in a club deal with Warburg Pincus and CenterBridge Partners. In the event, PACW is likely to trade at a significant discount to book value. Another tax.
The loss to the FDIC’s bank insurance fund so far is about $30 billion in terms of the cost of liquefying the deposits of Silicon Valley, Signature and First Republic banks. Consider this a tax on bank investors. Just to add insult to injury, the Biden Administration is preparing to adopt the poorly considered 2017 Basel capital proposal.
Despite the narrative coming from the FOMC and the economist community about a “soft landing,” in fact the Fed has largely lost control of its balance sheet and thus inflation because of "going big." The Fed is losing about $1 billion per day on the interest rate mismatch on its portfolio, where is earns much lower yields than it pays on reserves and reverse repurchase agreements (RPs). Chairman Powell refuses to sell bonds at a loss, even to help normalize the bond and housing markets, thus the Treasury yield curve remains inverted.
Lenders should arguably be writing 8% loans or higher, but the Fed’s massive securities portfolio holds down LT rates. The table below shows TBA pricing from Bloomberg at the close yesterday. Notice that Fannie Mae 6.5s for August are trading at 102, implying at least 7.5% loan coupon rates for a profitable loan.
Source: Bloomberg (7/25/23)
Most striking, home prices in the US have started to rise again, this despite the fact that 30-year mortgage rates are up five percentage points over the past 18 months. The Fed may need to go back to double-digit levels of mortgage rates not seen since the 1990s in order to force home prices lower. This will be a tax too. Yet unless the Powell FOMC sells bonds, long-term interest rates will remain muted. Unless interest rates rise, home price inflation will not be tamed.
If all of this were not enough good news, the losses being incurred by the Fed means that the central bank will not be remitting any savings to the US Treasury for the next decade. This is another tax, of note.
"The Fed is on the way to operating losses of an estimated $110bn this year," writes Alex Pollock. "Its mark to market loss as of March 31 2023 was $911bn."
Indeed, the costs imposed by the FOMC's actions over the past five years total into the trillions of dollars. But the Fed and Treasury have added so much liquidity to the system, that the real economy is still not slowing down.
So while the FOMC is meant to be helping the economy and ensuring price stability, in fact the Fed has inflated home prices to record levels and has left the banking system capital impaired. The Fed is going to be a considerable expense to the US Treasury for the next decade as it slowly earns its way out of hundreds of billions in losses incurred by the FOMC under Jerome Powell.
On Sunday, June 25, 2023, the Bank for International Settlements released its Annual Report. The chapter on monetary and fiscal policy concludes with the following advice for central banks:
"Careful consideration should also be given to keeping central bank balance sheets as small and as riskless as possible, subject to delivering successfully on the mandate. This would have three benefits. First, it would limit the footprint of the central bank in the economy, thereby reducing the institution's involvement in resource allocation and the risk of inhibiting market functioning. Second, it would lessen the economic and political economy problems linked to transfers to the government. Finally, it would maximise the central bank's ability to expand the balance sheet when the need does arise. Given the costs of large and risky balance sheets, the initial size is a hindrance, not an advantage. The balance sheet needs to be elastic, not large."
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