March 18, 2023: The Fed’s Interest Rate Hike Exposes Banking CrisisI was concerned that if the Fed increased rates beyond 5%, it could harm the economy severely. However, I didn’t fully understand how or when this would happen. The answer became apparent when a few greedy bankers bought long-duration fixed-income assets or took on crypto depositors in search of a higher return. As a result, when the Fed increased interest rates at its fastest pace in history, these securities declined in value, causing a banking crisis. This situation reminds me of Warren Buffett’s famous quote, “A rising tide floats all boats….. only when the tide goes out do you discover who’s been swimming naked.”
The Fed did not anticipate this banking crisis. Throughout my career, it has been the Fed that created every market bubble with easy monetary policy, eventually market speculation forced the Fed to pop the bubble. These bubbles are created when interest rates go down and popped when interest rates go up. One would expect that some of the portfolio managers at these banks would have known where we were in the interest rate cycle. The recent events have also highlighted the importance of having experienced risk managers on board at banks. Silicon Valley Bank, for instance, did not have a chief risk officer for much of last year, and many board members lacked sufficient banking experience.
In a highly volatile market this week, the 2-year treasury fell from 5.2% to 3.8%. The narrative of the market has shifted from fighting inflation to a banking crisis. Suddenly, inflation doesn’t matter as much if bankers are losing money. There has been debate on whether this rescue constitutes another bailout of bankers. Eleven of the biggest U.S. banks announced a $30 billion rescue package for First Republic Bank in an effort to prevent it from becoming the third bank to fail in less than a week. The banks are likely returning the $30 billion in deposits that First Republic Bank lost over the last few weeks. This backstop was not financed with taxpayer money, but the risk is that if this dam doesn’t hold, the Fed will have to step in to secure the entire system. In my opinion, this is a bailout because interest rates are dropping and the yield curve is flattening and this will help to relieve the pressure of the unrealized losses on the bankers balance sheets.
It is likely that the repercussion of this crisis will be tighter lending standards, as banks with unrealized losses are unlikely to take out any risky loans. Many banks have done a great job of managing the rising interest rate environment, and they are the ones that will benefit the most when depositors seek out larger “too-big-to-fail” banks.
Despite the market being under stress in recent weeks, some areas of the market have held strong. Technology has become a safe haven, and cryptocurrencies have rallied the most. The lower quality investments have done the best, which actually makes perfect sense. As we learned over the last few years, these investments are the most interest rate-sensitive and don’t trade on fundamentals. They rallied for the sole reason that interest rates have fallen. Some analysts speculate that the Fed might be compelled to lower interest rates to assist banks in recapitalizing and resolving unrealized losses on their balance sheets, which would end this banking crisis. However, the Fed is expected to raise rates 0.25% next week, but cut rates sooner than expected.
Looking ahead, the economy will likely slow faster than previously anticipated. The biggest risk is that if inflation does not drop, the Federal Reserve will be forced to decide whether to fight inflation with higher rates or bail out the bankers. With the recent drop in commodity prices, inflation is cooling, but it might not fall as fast as expected. The Federal Reserve’s next more will be to try to talk inflation down while signaling that they will no longer be raising rates.
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I was concerned that if the Fed increased rates beyond 5%, it could harm the economy severely. However, I didn’t fully understand how or when this would happen. The answer became apparent when a few greedy bankers bought long-duration fixed-income assets or took on crypto depositors in search of a higher return. As a result, when the Fed increased interest rates at its fastest pace in history, these securities declined in value, causing a banking crisis. This situation reminds me of Warren Buffett’s famous quote, “A rising tide floats all boats….. only when the tide goes out do you discover who’s been swimming naked.”
The Fed did not anticipate this banking crisis. Throughout my career, it has been the Fed that created every market bubble with easy monetary policy, eventually market speculation forced the Fed to pop the bubble. These bubbles are created when interest rates go down and popped when interest rates go up. One would expect that some of the portfolio managers at these banks would have known where we were in the interest rate cycle. The recent events have also highlighted the importance of having experienced risk managers on board at banks. Silicon Valley Bank, for instance, did not have a chief risk officer for much of last year, and many board members lacked sufficient banking experience.
In a highly volatile market this week, the 2-year treasury fell from 5.2% to 3.8%. The narrative of the market has shifted from fighting inflation to a banking crisis. Suddenly, inflation doesn’t matter as much if bankers are losing money. There has been debate on whether this rescue constitutes another bailout of bankers. Eleven of the biggest U.S. banks announced a $30 billion rescue package for First Republic Bank in an effort to prevent it from becoming the third bank to fail in less than a week. The banks are likely returning the $30 billion in deposits that First Republic Bank lost over the last few weeks. This backstop was not financed with taxpayer money, but the risk is that if this dam doesn’t hold, the Fed will have to step in to secure the entire system. In my opinion, this is a bailout because interest rates are dropping and the yield curve is flattening and this will help to relieve the pressure of the unrealized losses on the bankers balance sheets.
It is likely that the repercussion of this crisis will be tighter lending standards, as banks with unrealized losses are unlikely to take out any risky loans. Many banks have done a great job of managing the rising interest rate environment, and they are the ones that will benefit the most when depositors seek out larger “too-big-to-fail” banks.
Despite the market being under stress in recent weeks, some areas of the market have held strong. Technology has become a safe haven, and cryptocurrencies have rallied the most. The lower quality investments have done the best, which actually makes perfect sense. As we learned over the last few years, these investments are the most interest rate-sensitive and don’t trade on fundamentals. They rallied for the sole reason that interest rates have fallen. Some analysts speculate that the Fed might be compelled to lower interest rates to assist banks in recapitalizing and resolving unrealized losses on their balance sheets, which would end this banking crisis. However, the Fed is expected to raise rates 0.25% next week, but cut rates sooner than expected.
Looking ahead, the economy will likely slow faster than previously anticipated. The biggest risk is that if inflation does not drop, the Federal Reserve will be forced to decide whether to fight inflation with higher rates or bail out the bankers. With the recent drop in commodity prices, inflation is cooling, but it might not fall as fast as expected. The Federal Reserve’s next more will be to try to talk inflation down while signaling that they will no longer be raising rates.