I am
composing this blog while listening to 5 songs, playing loudly, Living the
Dream by Foreigner, Demolition Man by Sting, Bang a Drum by Jon
Bon Jovie, Wheel in the Sky by Journey, and Dr. Heckyll & Mr.
Jive by Men at Work. Mainly because they sound good loud, better louder,
especially with more bass. The lyrics are a good mix of some of my feelings regarding
the economy, economic policy and the people playing the various roles in this current
economic play (especially Bang a Drum).
I
haven’t said anything for a few weeks as I was waiting for the news noise to settle
down and we can pick through the points in a more reasoned manner. The Associated Press article titled Fed raises
key rate by quarter-point despite bank turmoil by Christopher Rugaber (3/22/23)
is a good summary of the past several weeks and may hold some insight into future
activities. I have put a link to the article at the end of this post.
First,
bank failures. The problem is 3-fold. One, with the Fed raising the Fed Funds
rates and attempting to dry out the economy by removing money from the economy,
all borrowing costs have increased as well as interest rates on all new debt
instruments. Treasury rates have changed wildly and are higher across the
board. Don’t worry about short term vs. long term differences, just know all
rates are up, up a lot. The purpose is to remove money from the overall economy
so that too much money is not chasing too few goods (one of the basic
definitions of inflation). The higher rates affect you in many ways but
especially if you have old bonds (bonds at old, lower rates) and you need to
get the principal before the bonds naturally mature. Remember, interest rates
and principal value are inversely related. If rates go up principal value goes
down. However, this only happens if the bonds are sold before their maturity
date. If the bonds don’t need to be sold early then no foul, no harm. When they
talk about bonds losing or gaining value it only relates to having to sell them
before maturity. It’s only a paper change based on current conditions. It is a
way of looking at current opportunities vs. what was spent / invested previously.
If you have an existing, older mortgage you are saying, boy what I deal I got.
If you are looking at invested funds you are saying I wish I had my money free
right now because I could earn a lot more if I invested now. You don’t owe any
more interest on your mortgage or have fewer dollars coming in from your invested
bonds. Now, if you need to borrow new money or invest some current excess funds
then the current rates will apply. That is where you will see the impact of
higher rates, on any new debt you want to acquire or new investments which will
give you more earnings. If, however, you need to get the money out of your
current investments you will have a problem which is what all the current news
is talking about as lost money. Remember, there is an inverse relationship between
rates and principal, as rates increase, principal decreases and vise-versa. In
order for you to get your money back early (i.e., sell your current debt/bond)
someone else will have to buy it and they are not going to want your old
interest rate bond because it has a lower interest earnings rate than what that
person can get if they were to take their money into the market today and buy
a new debt instrument. In order to make it attractive to the new investor you need
to make your old debt equal to the current debt they can get. Debt is equal to
the value of the stream of remaining interest payments plus the principal
payment. So if the interest payments are lower than current interest payments
you have to take less principal to make up the difference (not quite that
simple because compounding is also included). So, if current interest rates are
higher and you have to sell your old debt then you will get less than the
stated principal to make up the difference. If you were counting on that total
principal amount you now have less.
That
leads to the second part of the bank failure problem. Banks make money by
lending out their deposits and funds to borrowers (no problem). Banks learned a
long time ago that they can’t lend all their deposit as they need some funds to
cover regular transactions. If people can’t get their money in a timely fashion
they won’t invest in the bank. The Fed has set various rules for how much banks
must maintain in cash and cash equivalents to meet short term demand. (A
discussion for another time is why does the Fed have to set the rules thus
removing the need for banks to be their own monitors. That is why we have too big
to fail banks and other problems, banks aren’t responsible for their poor
decisions because the Fed picks up the responsibility, and cost.) One of the
cash equivalents allowed by the Fed is the bank can hold Treasury bonds and
high quality municipal debt (bonds). The bank should always be monitoring the
impact of changing rates and if rates are moving then what is the value of the
principal if the debt has to be sold immediately (can’t wait for maturity). Usually
the bank will “hedge” the debt meaning they have various financial products
that will allow them to cover the loss in having to sell before maturity. These
instruments are not perfect and can have problems themselves.
The
third part of the bank failure. Silicon Valley and Signature Bank had depositors that
included venture capitalists and other very sophisticated investors. The
investors realized that the bank was either not hedging their funds properly or
had lent out too much in relation to what they needed to cover their short term
needs. The investors fairly quietly started taking their deposits back. Problem
is many watch venture capitalists very closely. It took only a few days for a
run to start on the bank meaning not just a few but lots of people want their
money back, now. The bank had to sell their cash equivalent funds (because they
didn’t have enough cash) which were in treasury bonds, considered very safe (and
they are because the federal government will always pay what they owe) but they
had to sell in a rising interest rate market. Investors won’t pay the full
principal amount because interest rates are higher than the rates on the bonds.
Hence, less principal coming back. The
bank sold something like $21 billion in securities and lost $1.8 billion. They
needed to make up the difference and tried to sell new stock to raise it. That
sent more shockwaves through bank customers which led to a run on the bank. No
one wanted to buy the stock. The bank was overwhelmed by withdrawals and couldn’t
meet the demand. The Fed stepped in and closed the bank.
Many
are suggesting that the Fed’s interest rate policy led to the bank failures.
High interest rates certainly caused the problem of the lost principal when the
bank was forced to sell before maturity. The bank was supposed to be monitoring
such things. According to reports, the bank’s mix of securities and cash was
substantially different (worse) from industry averages.
The Fed this week increased the Fed
Funds Rate by only 25 basis points, recently it was expected to be 50 basis
points. There is news noise that the Fed should stop, increase, change. There
are calls for Congress to do something (more regulation), again news noise.
There may well be new regulations but let it sit a bit before you start looking
/ commenting. Previous Federal policies and regulations made much of this mess,
they may or may not be able to do some good. I am not particularly hopeful but
one never knows. There is much noise around the Treasury and Federal Reserve’s
move that guaranteed all deposits not just those of $250,000 or less (FDIC
insured) at the failed banks. That move was to keep the bank runs from
spreading to other banks. It seems to have worked at this point but things are still
dicey in the banking sector. Questions are being asked about what other banks
may have similar situations to SVB and Signature bank. There have been
rumblings in other parts of the country. We have had many public officials making
official public announcements. Remember news noise, we don’t know yet in spite
of all the words. Back to the guaranteeing of all deposits. That releases all
responsibility of the banks and the big depositors. The system wasn’t designed
to cover those types of costs. Biden and Yellen have promised that taxpayers
won’t cover this cost. There isn’t enough money in the FDIC funds to cover the
cost of insuring those uninsured deposits. The insurance premiums are collected
from bank fees to all banks. You and I pay those fees. I don’t see how we aren’t
going to pay the costs. Unless public officials come up with some other plan, we
can hope they will. Now we have another precedence set for banks to rely on the
Federal government to bail them out, tying them closer still to the government.
A recession is still very much on the table. The Fed needs to balance the problems caused by tighter policy (higher rates) with the expected problems generated by those policies, yes expected (the problems aren’t new). They also include stalled growth (which is needed but how long might it last), increasing unemployment, higher borrowing costs. Markets really, really hate, loth, fear, you name it, all this uncertainty. They don’t like it and tend to rebel (do things that the Fed isn’t expecting or prepared for – like bank failures). Expect to see this continue. It’s all part of the process. Remember, we have survived this sort of thing before (recession). It is NOT the end of the world as we know it. It is NOT going to go on forever. The sky is NOT falling. (Things you will hear in the news noise.) It is part of the process of getting the economy back on track and working better. It is going to work, it has worked before and it will work again. Hang in there. Remember what is important and that important things are NOT found in news noise. They are found in friends, family, loved ones and enjoying life. It is doing things together and learning new things. It is in seeing all the beauty around us and enjoying that. It is found in loving and caring more.
I am now stepping off my soapbox and turning down the music
volume.
AP news article -
https://apnews.com/article/federal-reserve-inflation-banks-interest-rates-jobs-91a9185ebce972bbf5ab1f46654f1a53
