Why Didn’t the Fed Hedge
Interest Rate Risk to Prevent Losses?
By the
Curmudgeon with Victor Sperandeo
Fed Says SVB Didn’t Effectively Manage Interest Rate
& Liquidity Risk:
Fed Vice Chair for Supervision Michael S. Barr
Tuesday, March 28th testimony before the U.S. Senate Committee on
Banking, Housing, and Urban Affairs, Washington, D.C.:
“SVB failed because the bank's management
did not effectively manage its interest rate and liquidity risk, and the
bank then suffered a devastating and unexpected run by its uninsured depositors
in a period of less than 24 hours.”
“The bank invested the proceeds of these deposits in
longer-term securities, to boost yield and increase its profits. [The duration
portfolio of SVB was reported to under 9 years.] However, the bank did not effectively
manage the interest rate risk of those securities or develop effective
interest rate risk measurement tools, models, and metrics.”
“I anticipate the need to strengthen capital and
liquidity standards for banks with over $100 billion,” Barr said, responding to
a question from MA Senator Elizabeth Warren.
Curmudgeon/Sperandeo Rebuttal:
In last Sunday’s column, we wrote in our Conclusions:
“For sure, the banking problem is due to the Fed’s irresponsible
monetary policy; NOT banks failing to hedge interest rate risk. The Fed deserves 95% of the blame here, as no
one could have confidently hedged interest rate risk.”
Moreover, interest rate risk to prevent bank runs
were never a problem in all of U.S. history.
-->Why didn’t the Fed identify a possible bank run
at SVB?
Lawmakers pressed Barr repeatedly during Tuesday’s
hearing on whether he believed the Fed had failed to do its job as
supervisor in the case of Silicon Valley Bank. “By all accounts, our
regulators appear to have been asleep at the wheel,” said Senator Tim Scott,
the top Republican on the committee.
1. The Federal Reserve's stress tests assesses whether
banks are sufficiently capitalized to absorb losses during stressful conditions
while meeting obligations to creditors and counter-parties and continuing to be
able to lend to households and businesses.
Why didn’t those stress tests identify an impending problem with SVB?
2. We submit unequivocally that the rapid and
aggressive Fed rate rising campaign made it impossible to hedge interest
rate risk. The basic method used to
do that is to execute a credit swap -a fixed long term rate security swapped
for a floating short term rate note.
Let’s look at what a bank risk manager might have
done to hedge interest rate risk in March 2022, when the Fed started to raise
rates at its FOMC meeting that month.
One year T Bills yielded 1.35% and 10-year T Notes
yielded 2.19% on March 16th. So, what would you do as risk manager or CEO of
SVB over the next 12 months?
The average yield paid to depositors in 2022 was 55
bps. American Express Bank paid 50 bps (Victor received this amount in March
2022). Thereby, of the 219 bps SVB received it gave depositors a minimum of 50
bps. The Net estimated interest rate received was 169bps. The swap fee is
dependent on size, credit rating, and market conditions. It very easily
could’ve been 30 bps in March 2022.
In doing many swaps, we estimate 20 bps to be
conservative. So, you are working with a net fixed 149 bps swap to get 128 bps
floating. The one-year T Bills started the year at 40 bps, and you get 128bps. Obviously,
it’s not worth doing such a swap!
What if yields declined? You’d lose on the swap, but you have the
banks expenses too, and owe 50bps to your clients … at 40bps you have a huge
loss!
More importantly, no one expected Fed Funds yields to
rise by so much and so quickly, especially after a decade of ultra-loose
monetary policy. One year before its
historic March 2022 rate rising campaign, the Fed said they “would keep
interest rates lower for longer.”
Who would’ve expected that Fed rhetoric would change
to rates will stay “higher for longer?”
Bottom Line: Any
rational risk manager could NOT assume the extent of the Fed’s attack on
interest rates, especially since the CPI was declining in the latter half of
2022 and into early 2023.
Why Didn’t the Fed Hedge Interest Rate Risk on its
Bond Portfolio?
Like all central banks, the Federal Reserve is
expected to make money for the government from its portfolio of securities and
its open market operations. The Fed generated profits, which it sent to the U.S.
Treasury (after deducting 6% for its secret shareholders), every year from 1916
until last fall. In a development
previously unheard of, the Fed has suffered operating losses of about $42
billion since September 2022!
How is that possible?
Very simple: a colossal mismatch between the Fed’s asset-liability
interest rates!
The Fed’s trillions of dollars of long-term investments on
its balance sheet yield ~2% while the interest rate it pays on member bank reserve balances (IORB
rate) is currently 4.9%. The Fed also pays interest on overnight reverse
repurchase agreements which now total $2.232 trillion. The Fed’s losses now average $7 billion a
month, according to a WSJ editorial.
Is the Fed the rock, the hard place, or both?
Avoiding credit losses is a requirement Congress added to the
Federal Reserve Act in 2010. Section 1101 of the Dodd-Frank Act
requires the Federal Reserve Board to establish “policies and procedures...
designed to ensure that any emergency lending program or facility... protect
taxpayers from losses.” Federal reserve banks are also mandated to assign “a
lendable value to all collateral for a loan executed by a Federal reserve bank...
in determining whether the loan is secured satisfactorily.”
While the Federal Reserve Act requires the Fed
to avoid taking credit related losses that could have an impact on taxpayers,
it makes no mention of losses from interest-rate risk exposures. That’s because
the act’s authors never imagined such losses. Monetary policy was all but
assured to generate Fed profits prior to 2008. That changed once the Fed
started paying banks interest on their reserve balances and making large open
market purchases of long-maturity Treasury’s and mortgage-backed securities.
Conclusions:
1. The longer high short term interest rates (e.g.,
Fed Funds rate) continue, the more the Fed will lose. Keeping rates “higher for longer” will result
in much greater losses.
2. As the Fed
is losing money and not sending dollars to the U.S. Treasury, the budget
deficit will be higher than it otherwise would’ve been. That means higher national debt, more U.S.
government borrowing and/or higher taxes!
3. A critical question is as the Fed was raising
rates, why didn’t they anticipate losses from its interest-rate-risk exposures
(unrecognized taxpayer losses) and hedge interest rate risk?
4. It’s chutzpah for the Fed to blame SVB for
not “effectively hedging interest rate risk,” when the U.S. central bank did
not do that to prevent losses it’s now sustaining.
……………………………………………………………………………………….
Be well, stay healthy, wishing you peace of mind.
Please email the Curmudgeon (ajwdct@gmail.com) if you have any comments,
questions, or concerns. Till next
time…...
The Curmudgeon
ajwdct@gmail.com
Follow the Curmudgeon on Twitter @ajwdct247
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies, and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
Copyright © 2023 by the Curmudgeon and Marc Sexton. All rights reserved.
Readers are PROHIBITED from duplicating, copying, or reproducing article(s) written by The Curmudgeon and Victor Sperandeo without providing the URL of the original posted article(s).