March 15, 2023

What The Fed Knew

Is the management team of Silicon Valley Bank a confederacy of dunces?

I don’t want a cease-and-desist order from the estate of John Kennedy Toole, so let’s move along.  But it’s the wrong question.

By the way, across the 500+ stocks comprising the Financials sector, average daily Short Volume rose from 45% of trading volume Feb 3, to 52% by Mar 9. Eleven percent of the sector had Short Volume over 70%, a dozen were over 80% short.

Doom predictively loomed.

Illustration 139565815 © Maksym Yemelyanov |

Short Volume is the data set for the SEC’s modified uptick rule, Reg SHO Rule 201.

Fear fades fast when stocks rise.  Stocks rose the most since January yesterday and shorting in Financials dropped back below 50%.

It’s a respite not a remedy.

And it’s not like SVB took deposits and bought cryptocurrencies or stablecoins.  The Federal Reserve trades freshly minted dollars for US Treasurys and mortgage-backed securities, the same stuff SVB bought.

The Fed owns $2.55 trillion of mortgages with maturity dates longer than ten years. The same as it did in Jan 2022 when interest rates were near zero, mortgages near 3%.

And it owns $5.3 trillion of US Treasurys, $2.4 trillion of which have maturities more than five years out.

Call it $5 trillion of securities yielding way less than now, which means they’re worth a fraction – on paper – of what they were before.

The Dodd-Frank legislation – the eponymous Barney Frank sat on the Board of SBNY – requires banks to hold Tier 1 capital. The Basel Accords do the same internationally.  Tier 1 capital is generally government bonds, government-backed securities.

Which SVB and the Federal Reserve hold.

In September 2022, the Federal Reserve stopped making weekly remittances to the US Treasury, which you’d know only if you read this.  I believe it’s also the Dodd-Frank Act that requires The Fed to send its returns above operating expenses to the US Treasury.

In 2021, The Fed sent $107.4 billion in, and paid $5.8 billion of interest.  Jay Powell told Congress last week that the Fed had paid the Treasury about $1.2 trillion the past decade – interest on our own debt. Weird but true (and great for government).

In March 2022, The Fed started hiking rates.  By September, what it paid in interest on excess reserves and reverse repurchases surpassed interest income on long-dated securities.  According to the annual remittance report, The Fed paid rather than remitted $102.4 billion of interest in 2022.

Anybody want to do the math on that?

Rounding, it’s a 1,700% increase in interest costs. 

The Fed lost about $20 billion last year, not mark-to-market but on an operating basis. Expenses exceeded revenues.

Now sure, like SVB, The Fed intends to hold securities to maturity, not sell at a loss.

But if The Fed were marking to market, it would, like Credit Suisse just reported in its delayed 10K, likely be facing material financial weakness. The ratio of liabilities to capital at The Federal Reserve is 200. 

It’s levered 200-to-1.

The point?  Should not The Fed have known from its own experience what might happen to banks holding Tier 1 capital? 

All banks do it. Truth be told, it creates a built-in market for government debt.  Banks have to carry safe securities as capital. Presto! Governments can go on spending.

Cut rates near zero, require financial institutions to own government debt, and you’ve built large demand into the system.

Oh, but start hiking rates? 

In theory, the entire construct could be jeopardized.  Why own Treasurys if you can park your cash at a brokerage for 4%, as you can at, say, Interactive Brokers (my broker, and now a content partner for our sister company, Market Structure EDGE)?

SVB is the first to be found swimming naked as the tides of cheap credit recede. But it’s emblematic of the way our credit system works, all the way up to The Federal Reserve. 

An economy built on credit won’t carry on unfazed without it. 

And there must be failure.

If we can’t thin the economic herd of all the diseased crap grown out of the festering soil of cheap credit, the buck will stop, so to speak, at The Fed, which is nothing more now than the public’s balance sheet.

And it’s leveraged 200-to-1 with our collective borrowing that now costs 1,700% more than a year ago.

And over the weekend the government said – in so many words – that it would take that strapped balance sheet and use it to back up everybody’s deposits. 

Only a confederacy of dunces would do that.

To me, SVB is not the problem. It’s the first inkling of the coming consequence.

Remedy? Fix rates reasonably and leave them alone. Never cut to zero again. Stabilize the currency’s value, not prices. The Fed should lend only as a last resort and then only at high rates and on good collateral (the Thornton Bagehot model).

We can’t and shouldn’t save everybody. Or we’ll all go down together.

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