May 1, 2023 | Watching the collective train wreck around the failure of First Republic Bank (FRC) over the weekend, we take a moment from book editing to ask five questions about the common (and largely false) narrative surrounding this event.
1. Did a lapse in management and/or prudential regulation cause the failure of FRC?
No, the Fed’s excessive open market intervention from 2019 through 2022 was the primary cause of the failure of FRC as well as Silicon Valley Bank and Signature Bank. Specifically, starting in 2019 the Federal Open Market Committee deliberately manipulated the bond market down to zero and thereby concentrated massive amounts of risk in a narrow band. The FOMC then raised interest rates more than 500bp starting in 2022, rendering most banks in the US insolvent on a mark-to-market basis by the end of Q3 2022.
2. How large is the capital deficit of US banks due to the Fed’s actions?
Last year, in Q3 2022, all US banks reported a mark-to-market deficit of almost $1 trillion on available for sale (AFS) and held-to-maturity securities. The chart below from the FDIC illustrates the aggregate position of all US banks.
If you include the loan portfolio of US banks in the capital calculation, then most US banks today are insolvent on a fair value, mark-to-market basis because of the FOMC’s actions. The general surrogate for the M2M losses of US banks on securities holdings is the 10-year Treasury note. In Q3 2022 when the M2M losses of US bank securities positions approached a trillion dollars, the 10-year was over 4%. Our general measure for gauging the M2M loss is the GNMA 3% MBS, which currently trades around 90 cents on the dollar.
3. Why did the Powell FOMC decide to massively expand open-market purchases of securities in 2019, a year before COVID?
We have attributed the decision by the Fed to “go big” with providing additional reserves after the December 2018 money market collapse to both Chairman Powell and his predecessor, Treasury Secretary Janet Yellen. But perhaps we are too hard on the old girl. Lee Adler of Liquidity Trader writes:
“Everybody blames Yellen, but Powell was the one who went big. Yellen shrank the Fed's balance sheet. She started the "normalization" policy. Powell was the one who panicked and reversed course when they had a problem in the money markets because of it. And Chairman Ben Bernanke knew he was setting a trap for anyone who would dare to try to reverse his money printing. He's a financial war criminal.”
Lee continues:
“The villains are Greenspan, Bernanke, and Powell. Yellen is the only one who tried to do the right thing. Yet the rabid right loves to lump her in with the real bad guys. They even make her the primary villain. It's wrong. You're better than that, Chris. You have the ability to sift through the facts to get at the underlying truth. Don't let your bias cloud your vision.”
Point taken.
Claudio Borio, Head of the Monetary and Economic Department of the Bank for International Settlements, recently rebuked the Fed on its use of abundant reserves:
"Since the Great Financial Crisis, a growing number of central banks have adopted abundant reserves systems ("floors") to set the interest rate. However, there are good grounds to return to scarce reserve systems ("corridors"). First, the costs of floor systems take considerable time to appear, are likely to grow and tend to be less visible. They can be attributed to independent features of the environment which, in fact, are to a significant extent a consequence of the systems themselves. Second, for much the same reasons, there is a risk of grossly overestimating the implementation difficulties of corridor systems, in particular the instability of the demand for reserves. Third, there is no need to wait for the central bank balance sheet to shrink before moving in that direction: for a given size, the central bank can adjust the composition of its liabilities. Ultimately, the design of the implementation system should follow from a strategic view of the central bank's balance sheet. A useful guiding principle is that its size should be as small as possible, and its composition as riskless as possible, in a way that is compatible with the central bank fulfilling its mandate effectively."
4. Is it wrong for JPMorgan to buy FRC?
No, the progressives led by Senator Elizabeth Warren (D-MA) as usual don’t understand banking. JPM CEO Jamie Dimon really had to buy FRC because he had enabled this odd business to flourish in the first place. The analogy here is Bear Stearns, where JPM was the clearing bank. Nobody else could or would buy either business.
FRC had made much of its money selling private label jumbo mortgages, production financed by JPM as warehouse lender, even as FRC pretended to be an asset manager. As we wrote earlier (“Who Killed First Republic Bank?”), FRC really did not make much money off of that $280 billion in assets under management (AUM). Investment banking fees were a significant source of income for FRC.
It is poetic justice that JPM has to actually pay money for branches it probably does not want and AUM and deposits that will probably walk out the door in the next year. The loan portfolio, even with the loss-sharing agreement, may still end up costing JPM money. Looking at the growing traffic jam in the secondary market for mortgage assets with stories, the FRC portfolio does not strike us as particularly good value.
Critics of big banks should instead become critics of stupid and self-serving monetary policy. Were it not for the massive balance sheet inflation caused by the FOMC after December 2018, US banks like JPM could be a third smaller than they are today. And given that the banking system is running off at $50-100 billion per month thanks to the latest gyration in Fed monetary policy, JPM and other banks will get smaller -- whether they like it or not.
5. Will More Banks Continue to Fail?
Yes is the short answer. Until Chairman Powell comes clean with the Congress and the American people about QE, more banks will inevitably fail. The huge swing in asset prices caused by the actions of the Powell FOMC basically has left US banks and bond investors like pension funds and insurance companies holding the bag on $5 trillion in losses. If you haircut the $25 trillion in loans and securities priced during 2020-2021, that is the conservative estimate of loss.
Since US banks only have about $2 trillion in tangible equity capital, you can see that we have a problem. Outliers among bank business models will fail first, followed by more mainstream banks on up the food chain. Until the Fed 1) admits that going “big” with open market intervention was a mistake and 2) drops federal funds 100bp, more banks will fail. The sad truth is that buying $9 trillion in securities not only left the banking industry insolvent, but it now ties the Fed’s hands in terms of fighting inflation.
Powell et al at the Fed don’t want to admit that they have a problem with monetary policy, but they are more than willing to throw federal bank regulators under the bus for now three major bank failures and over $100 billion in losses to the FDIC's bank insurance fund. Some media wondered at the Fed’s willingness to quickly take the blame for these bank failures, but wonder no more. The Fed is more than willing to take a beating on Capitol Hill for bank regulatory lapses. Yet the Fed’s Board of Governors will watch several more large US banks fail before Chairman Jerome Powell takes the blame for his intemperate monetary policy actions following December 2018 and resigns.
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