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Monday, March 13, 2023


The U.S. Treasury, Federal Reserve, and Federal Deposit Insurance Corp banded together to create the Bank Term Funding Program (BTFP — the bureaucrats are going for the laughs with the acronyms at this point), which gives 1-year financing to eligible banks against Treasury/mortgage-backed security collateral at par. They also announced that uninsured depositors at two failed banks (the known failure Silicon Valley Bank, as well as the newly-shuttered Signature bank) will be made whole.

At the time of writing, I have not seen any announced results for the auction of Silicon Valley Bank’s assets (or entire balance). This lending facility seems to be the replacement.

Unlike the 2008 bailouts, bank equity and bond holders have been zeroed out (unless future asset sales do a lot better than expected). To the extent that this is a bailout, it is a bailout of the depositors of those banks. The announcement is that the FDIC will be levying fees to make up for any losses, so the bailout is going to be paid for by other banks (who are going to try to pass them on to customers).

Bye-Bye Priced Fed Hikes

At the time of writing, future rate hikes have rapidly been priced out of the yield curve in. This was always the risk scenario for bond bears who were focussing on slow-moving inflation news: financial instability moves a lot faster than Owner’s Equivalent Rent. This is no exactly news to bond market participants: the yield curve was inverted for precisely this reason.

I have always argued that the Fed hikes rates until something breaks, and since the early 1990s that “something” has always been the financial system. (This was somewhat true in earlier eras, but there might have been exception in the 1980s with its high policy rate variability.) The closest to a “non-crisis” end of cycle in this era was the 2000-2001 cycle, since the equity market losses do not count, and technology debt losses were relatively well contained.

Things breaking in the financial system is a surprise from the perspective of neoclassical business cycle models, since they assume that cycles are driven by optimising decisions of households. Post-Financial Crisis models have thrown in random “financial stress” variables, but it is hard to see how a bank with $220 billion in assets completely ignoring interest rate risk for years while under the eyes of the San Francisco Fed is “random.”

Popping up with a non-mainstream model that “predicted this crisis” raises the question: did you short Silicon Valley Bank into oblivion? The reason why I am skeptical about the predictive ability of mathematical economic models is once again illustrated: if you could predict these events, you could make a lot of money shorting the financial institutions that blow up.

Since I do not offer unsolicited financial advice to strangers over the internet, I leave the assessment of the durability of this Treasury rally to my readers. One needs to drop an obsession with the innards of the CPI/PCE and instead dig into the situation at U.S. banks. So far, the visible problems are with non-global banks that were allowed to operate under a farcical regulatory regime. The problem with being too bearish on such credits is that they can easily be saved by deep-pocketed investors buying something like a convertible preferred share.

Will the BTFP (Lol) Affect Treasury Pricing?

There was a lot of discussion on Twitter about the effect of the new BTFP facility on Treasury pricing. I am unconvinced how measurable it will be. From the term sheet (linked to on the announcement page):

Eligible Collateral: Eligible collateral includes any collateral eligible for purchase by the Federal Reserve Banks in open market operations (see 12 CFR 201.108(b)), provided that such collateral was owned by the borrower as of March 12, 2023 [emphasis mine].

Banks cannot run out and buy low coupon Treasuries and borrow against them (since they will have the lowest market price), they already had to have them on the balance sheet.

I have also seen people insinuate that banks lending above the market value of debt is somehow free money. The original loan has to be paid back, and the collateral is just the first line of credit defence of the facility.

Recourse: Advances made under the Program are made with recourse beyond the pledged collateral to the eligible borrower.

Everything beyond the collateral value is an unsecured loan to the borrowing bank. I am unaware of the legal priority of this facility, but my guess would be that it is senior to everything below the depositors. Since the entities backing the facility are regulating the banking system, they should be willing to make senior unsecured loans to said banking system.

The interest rate looks somewhat reasonable, other than the fact that it probably does not accurately price the value of the prepayment option.

Rate: The rate for term advances will be the one-year overnight index swap rate plus 10 basis points; the rate will be fixed for the term of the advance on the day the advance is made.

The thing to keep in mind is that banks can always borrow against Treasury collateral in the repo market near the OIS rate. The main advantages of this program:

  1. prepayment probably not adequately priced (10 bps seems cheap to me);

  2. guaranteed availability at a long term (by repo market standards) at a fixed price in size;

  3. they encumber less collateral than would be required in repo transactions to get the same amount of cash.

The focus is on #3, but from the perspective of the bank, they should have unencumbered Treasury collateral lying around the balance sheet anyway (if they have grownups managing their liquidity risk). If the bank is above regulatory minimums, it is not in a radically different position than before the existence of the facility.

Meanwhile, there is the question of how much size a bank Treasury desk will be allowed to arbitrage other sources of funding. On one hand, the regulators probably want a diffuse group of users to reduce the stigma of using the facility. On the other hand, regulators will probably stigmatise banks that go to town on the facility. So, bank treasurers will have to keep their snarfing at the public trough at a socially acceptable level.

Concluding Remarks

It is too early to draw any strong conclusions about what is happening going forward. Everything depends on one’s assessment of the status of the banking system.

As a final note, reader Antti-Juhani Kaijanaho pointed out that my arguments in the banking primer about banks taking interest rate risk seriously need to be re-written. I always had disclaimers about amateurish risk management at American mom & pop banks, but it turns out that those amateurish banks can amass $220 freaking billion in assets. My main message is unchanged, but I now have a horrible recent example of what happens when regulations let liquidity and rate risk management to be ignored. (At this point, I do not blame the regulators — they have to enforce the laws that they are given, not what they would like regulations to be.)

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(c) Brian Romanchuk 2023

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