The Fed is still in a hole, but digging less quickly
The Fed's ability to commit financial seppuku, and get away with it, is an underappreciated fact of our great recovery
Fed’s audit is here, and everything is “fine”
losing money hand o’er fist
Fed does PiK lending with aplomb (and you’d never guess who’s holding the IOU)
the underappreciated secret to our post-pandemic recovery is a Heath Ledger-tier performance
the undisputed beneficiary of rate cuts (reprise)
👉👉👉Reminder to sign up for the Weekly Recap only, if daily emails is too much. Find me on twitter, for more fun. Fed’s still in a hole, but digging less quickly
Remember ~2 years ago when Silicon Valley Bank (and then First Republic, plus some others) went belly-up because suddenly higher interest rates made all the low-interest loans they owned relatively worthless?
And then everyone alternatively laughed at, and/or scolded them for being so stupid and reckless. I’m paraphrasing, but this was the gist of it:
How could you not hedge interest rate risk? Lol. How reckless, how irresponsible, how foolish to issue all those super-low interest rate loans without considering the possibility that rates might go up!
I mean, sure there’s some truth to that.
If rates suddenly go up, not only do all the low-interest loans lose value, but they’re also not going to generate enough yield to pay depositors what they need park their cash at your bank. When savings accounts suddenly demand ~4-5%, but you’ve lent out billions of dollars to homeowners and Treasury at ~2%, as a bank, you’re going to paying more interest than you’re collecting, and that’s pretty much the opposite of what banks must do to survive.
So, they should have planned for that, I guess. Losing money is bad, after all.
Fed enters the PiK loan business
Unless, of course, you’re the Federal Reserve, in which case you can hemorrhage money to your heart’s content:
The Fed’s net losses on its loans were ~$80B last year.
$80B in losses is an improvement from the ~$115 in 2023, but it’s still a lot of losses.
What that means is that the Fed is paying out ~$80B more in interest payments than it’s collecting. Or, more accurately, the Fed is sending IOUs to Treasury (a.k.a. all present and future taxpaying Americans) to the tune of $80B.
The Fed is self-funded, meaning it doesn’t receive money from Congress. Instead, it covers all operating expenses out of the income it earns on securities and sends the rest to the Treasury. . . .
Unlike federal agencies, the Fed doesn’t have to go to Congress hat in hand to cover operating losses. Instead, the Fed created an IOU in 2022 that it calls a “deferred asset.” When the Fed is no longer running losses, it will pay itself back first and extinguish the deferred asset before resuming its previous practice of sending profits to the Treasury.
Someday, the Fed will get back in black, but that day is not today.
I guess it’s only reckless when SVB does it, amiright?
It really makes you wonder where SVB got all that free money to park in low-interest loans to begin with.1
Financial Seppuku continues to be a winning strategy
No.
I mean, we know exactly where SVB got its risk management from. The Fed has been the wildest n’ craziest of ‘em all (and it’s all working out great).
As Random Walk wrote at the time (and again), for federal officials and regulators to criticize SVB for its “risk management failures,” is a bit like saying “you should have known we might do something wild and crazy like, idk, devalue our own balance sheet and start losing billions of dollars”:
The Fed has drastically devalued all the loans it facilitated during the free money era (and it facilitated a whole lot of loans).
It did that on purpose because it doesn’t want money to be free anymore—because free money makes prices go up—so it has declared “woe unto free-money lenders.” It’s financial seppuku—sand in the gears of the “overheated economy”—which the Fed itself can withstand (we hope), but other banks, not so much . . .
. . . Deposits aren’t fleeing because of crypto or risk management; they’re being summoned by their maker, who regrets having given them out in the first place . . .
. . . [criticizing banks for their risk management is] a bit like criticizing the maintenance of a 12ft flood wall because it got crushed by a 100ft tsunami. Could the masonry and oversight have been a bit better? Probably. But, the bigger issue likely had something to do with the HISTORICALLY GIANT TIDAL WAVE DELIBERATELY UNLEASHED BY YOUR BOSSES
TO CAUSE PAIN AND DESTRUCTIONfight inflation“Oh don’t take our money, let alone lend it back to our colleagues at Treasury, because what if we suddenly decide to make all lending on these terms look incredibly stupid” just doesn't seem like fair proposition, that all or most firms should have been expected to take. It seems reasonable that at least some would respond “OK, I accept these free money terms, Mr. Fed, and I will not assume that you will turn around 18 months from now and stab yourself in the eye.”
Sorry, SVB et al. The Fed can, in fact, stab itself in the eye and live to tell the tale. You should have anticipated that.
Banks got rugged, except it’s the kind of rug pull where the puller takes himself down with the ship. Is that the kind of thing risk managers should have planned for? Perhaps.
Anyways, that the Fed has acted like a Heath Ledger-tier lunatic, and gotten away with it—not once, but twice—is a very under-appreciated fact of the Great American Exceptionalism Recovery Tour.
At some point, though, rates are going to have to come down because the Fed can’t keep sending IOUs to Treasury, and Treasury can’t keep blowing an additional $1T/year on interest expenses.
Or maybe they can, but there is no doubt as to who stands as the Undisputed Beneficiary of Rate Cuts.
The hard part of figuring out how to get the Fed behaving responsibly again is figuring out how to get Uncle Sam behaving responsibly again. Unless and until Treasury stops hogging all the debt, the only path forward for lowering rates is the Fed loading up on low-interest loans, and that would put us right back where we started.
Other links
Why a Las Vegas parking lot is a red flag for America’s largest DIY chain. FT tries to blame Home Depot’s 2-year rate-driven sales slump on tariffs. Lol. The worst part about Trump is how stupid everyone becomes. Falsely claiming that tariffs have slowed the economy to the brink of recession has become an obligatory coda to literally every article.
The many faces of Affirm. Nice rundown on the shimmies and shakes of the ecommerce lender.
Gov’t borrowing costs soar. It’s probably because of the tariffs.
A model of Ponzi. “We develop a model of Ponzi schemes with asymmetric information to study Ponzi frauds. A long-lived agent offers to save on behalf of short-lived agents at a higher rate than they can earn themselves. . . A key feature of Ponzi frauds is that the long-lived agent builds trust over time and improves their reputation by keeping the scheme going.” A bit too on the nose.
Previously, on Random Walk
Volatility begets volatility, and other sundries
Vol begets vol (and the analysts get it wrong, a lot)
Healthcare makes all the jobs . . . but maybe manufacturing too? Other labor market desiderata
healthcare jobs replaced all the manufacturing jobs (much to the benefit of women and aides)
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Random Walk made this point at the time, but SVB’s “recklessness” was the mistaken assumption that
I’m not sure it makes sense to look at the fed in isolation. The fed and the treasury are both ultimately just the federal government and so they need to be looked at in aggregate. For example, treasury could sell a 30y bond, and the fed buys it. Or treasury can sell a bill. These are economically equivalent to the govt in aggregate. In the first case the fed will have some pnl but it doesn’t really matter.