If Fed hikes blew up US banks, what’l l RBA hikes do?

Saturday, 20 May 2023 — South Melbourne

[11 min read]

Dear Reader,

I spent most of 2022 asking anyone who would listen a simple question: Why has nobody blown up yet? Why hasn’t there been a bank crisis? Why has no pension fund imploded? Why haven’t insurance companies gone haywire?

You see, we had one of the worst years ever for financial markets, in the US in particular. That was especially true because bonds and stocks had fallen together during a period of inflation.

A balanced portfolio of US stocks and bonds would’ve delivered the worst return since before the Great Depression, according to my calculations.

The result was unusually bad because stocks and bonds are supposed to offset each other. A bad year in stocks is supposed to be offset by a good year in bonds. That’s the whole point of owning such a diversified portfolio. But the theory failed in 2022. Both plunged, with inflation adding insult to injury.

And yet, no financial institution had blown up in spectacular fashion. There was no Lehman Brothers moment. No sovereign default or currency peg breaking. We couldn’t even come up with a proper name for the 2022 crash because there was no single — particularly noticeable — event to name it after.

This completely mystified me at the time. How could ‘risk free’, 30-year UK Government bonds crash 60% without sending UK financial institutions into meltdown, for example?

I asked a series of famous thinkers this question over and over again, usually in the moments after recording an interview with them on some other topic. They all told me a variety of reasons that weren’t very convincing.

Some said that banks had hedged their exposures and risks to the crashes in derivatives markets.

Others said that financial institutions didn’t hold the long-term bonds that had fallen especially badly.

Others said that the revenue benefits of higher interest rates outweighed the capital losses for financial institutions. (Higher interest rates mean more profits for banks and insurance companies.)

This all seemed fair enough. Even if I didn’t see how it could quite offset the vast losses that financial institutions must have suffered on the value of their assets.

For example, if you use derivatives to evade losses on bond prices falling, that merely transfers the loss to someone else. It’s still being suffered by someone.

Another reason experts frequently gave me to explain the financial system’s stability in the face of such losses particularly annoyed me. In fact, I remember losing my temper and interrupting one patient colleague about it in a rather rude way.

The former banker, who had quit his job in anticipation of the 2008 financial crisis, claimed the post-financial crisis reforms had made banks and other financial institutions less risky. They held more capital in reserves.

This seriously annoyed me because it was like claiming that banks were safe in 2006 because of securitisation. A claim that many people did make at the time, pointing to the AAA-rated mortgage bundles held by banks.

But the thing that was supposed to make them less risky in the eyes of regulators was precisely the thing delivering unexpected and unprecedented losses to financial institutions.

Instead of securitised subprime loans, this time around, it was government bonds at the centre of both the claim that banks were safer and the source of the losses in the crash.

People claimed that banks were less risky in 2022 because they held more liquid and less risky assets in reserves. But it was precisely those assets, government bonds, which had melted down so badly in 2022. The claim made no sense.

The issue almost drove me mad. How could the very bedrock of the financial system in government bonds be in meltdown without buildings toppling over?

But then, late in 2022, the meltdowns began. It started in the UK’s pension fund industry. And losses on UK Government bonds were the underlying issue.

The funds had held UK Government bonds for a particular reason. To be able to sell them quickly to meet redemptions. We call this liquidity. Just as you keep some cash in your bank account to meet expenses, financial institutions keep some government bonds that can easily be sold and used to meet payment demands.

But the poor returns from holding those government bonds during a period of low interest rates and high inflation had pressured the funds into doing deals in derivatives markets known as Liability Driven Investments.

These went belly up during the bond market crash, forcing the funds to dump government bonds as intended. But that triggered a self-sustaining spiral of having to sell the bonds to meet liquidity demands, which in turn crashed the bond prices even lower, adding to the liquidity demands and the need to sell even more bonds to meet them.

In the end, the Bank of England had to step in to prop up bond prices and thereby the pension system.

Next, although many months later, came US banks with a surprisingly similar iteration of the problem. Except the banks used an accounting gimmick instead of a derivative position to sabotage themselves.

Banks were required to hold large amounts of government bonds by regulation. This wasn’t quite an outright requirement. But banks were forced to hold a lot of safe assets. And government bonds were defined as safe by regulations because governments are so incredibly unlikely to default. (Just as AAA-rated subprime mortgage-related investments were deemed safe in 2006.)

This means that governments and central bankers loaded up banks with gunpowder and then lit the fuse by hiking interest rates rapidly, after promising not to.

Sure, default risk might be near zero on government bonds. But that’s not the only risk a bond faces. They also have price risk, meaning the price can go up and down. And when central bankers engineer high inflation and hike interest rates fast, bond prices fall fast. That loss can put a bank at risk of failure because they don’t expect it to occur on the asset they hold to protect them from risk.

The solution to this was supposed to be simple. If a bank simply assumes it’ll hold a bond to maturity (when the bond is repaid by the government) then there is no price risk.

This makes sense and I’ve advocated that investors do much the same thing in their personal portfolio by building what’s called a bond ladder. If you buy bonds that mature when you need the money, you don’t face price risk. Unless you have to sell out early to meet an unexpected bill.

But a bank is not the same as a personal portfolio. It has vast liabilities that are ‘on call’. Meaning that a lot of people lent banks a lot of money under the agreement that they can withdraw that money at any time. Those people are called depositors.

In order to meet depositor’s redemptions, the bank must sell something to raise the money to give to depositors. And they tend to sell things that are easy and quick to sell — government bonds.

Indeed, a good chunk of the whole point of having banks hold so many government bonds is that they can sell them easily to meet rapid withdrawals of deposits quickly and easily. It’s not like they can sell your home loan tomorrow.

But do you see the contradiction? It’s a three-way contradiction, making things confusing, but it’s an important one, so let’s review…

Banks hold a lot of easy-to-sell government bonds in order to shore up their reserves and to meet deposit withdrawals by selling those bonds.

But government bonds have price risk, which can put the bank at risk if they hold too many bonds and those bonds fall in value.

This price risk can be overcome by simply assuming the bonds will be held to maturity, meaning they won’t be sold.
The three factors, each designed to reduce risk, actually increase it on an overall basis once you combine them.

The combination encourages banks to hold too many government bonds, encourages them to presume they won’t need to be sold, and then encourages them to sell quickly when there’s a deposit flight, which tends to happen when bond prices have fallen.

The line of dominos is lined up perfectly. Banks hold too many government bonds and assume they won’t have to sell them. When the price of the bonds fall, the bank gets into trouble because the value of their assets has fallen. This is precisely when they do have to sell the bonds in order to meet deposit flight.

In other words, the bonds which are supposed to derisk the bank actually add risk precisely when you need their low-risk characteristics to shine.

It’s the ultimate house of cards, just waiting for a spark. And rapid interest rate hikes from the central bank was precisely that spark. They both crashed bond prices and encouraged people to move their deposits from the bank into bonds and funds that earn the central bank’s higher interest rate.

Now, if you accept all this, you need to reach a rather intriguing conclusion about our own banking system here in Australia. Not to mention others around the world.

Central banks in many nations continue to hike interest rates. They started later than the US Federal Reserve. And often hiked slower. But the same damage applies to local bond markets.

The harshest example comes from the UK. Which is why the pension drama unfolded there.

But who might be next?

Australia, despite lagging on interest rate hikes and experiencing a less severe bond crash too, may not be so far from the top of the list for a simple reason. The RBA effectively promised not to hike rates until 2024. That makes its hikes since especially unpredictable, and thereby dangerous.

To be fair, there are factors in Australia’s favour too. Our mortgage interest rates rise with interest rates, keeping banks’ incomes and expenses better balanced than in the US. But, again, this only transfers the burden and risk to someone else — homeowners.

My point is that the underlying issue of losses on assets presumed to be safe (government bonds) are the cause of the crisis. The pension fund meltdown in the UK and the bank crisis in the US are symptoms. And those symptoms are likely to spread as central bankers continue rate hikes.

Until next time,

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend

Dear Reader,

What is the debt ceiling?

It’s a numeric limit on the total debt that the US Treasury is allowed to issue. There’s no debt ceiling in the US Constitution. Instead, it’s imposed by statute.

There’s no legal requirement for that statute. The debt ceiling could be repealed by Congress, at which point there would be no limit on the size of the national debt.

Still, Congress likes the idea of a debt ceiling. It forces the White House and Treasury to come back to Congress from time to time to request increases as needed. This gives Congress some leverage to ask for political concessions in return for raising the debt ceiling.

So, the debt ceiling is really a political football rather than a serious macroeconomic policy tool. In the end, Congress always approves the ceiling increases. In a way, the debt ceiling debate is all for show.

To be clear, the debt ceiling does not mean the Treasury cannot issue any new debt. It means that Treasury cannot issue debt that increases the total outstanding above the ceiling.

Getting around the debt ceiling — a shell game of dodgy options

Treasury is at the ceiling now.

The US is still running deficits. How are the new deficits being financed? The Treasury has to resort to ‘extraordinary measures’ to keep paying the bills. Let’s look at some of their options.

The Treasury has several slush funds, such as the Exchange Stabilisation Fund, that it can tap into to pay bills without Congressional approval. Believe it or not, the Treasury sometimes has positive cash flow even though the deficit is increasing. This happens around this time of year when more Americans are paying their taxes than are claiming refunds.

This positive cash flow can help the Treasury pay bills temporarily, even if a dry spell emerges late in the year. (This typically happens in the summer when tax payments slow down and ‘use it or lose it’ spending increases.) Finally, the Treasury can sell assets (Grand Canyon, anyone?) to put some cash in the till.

A trillion-dollar coin?

You may have heard of the trillion-dollar coin idea. It won’t happen, but here’s how it works.

The Treasury would ask the US mint to produce a solid platinum coin. The Treasury would give the coin to the Federal Reserve and simply declare that the coin was worth US$1 trillion. (Assuming it to be a one-ounce coin, the actual market price is about US$1,000.)

The Fed would put the coin in a vault and credit the US Treasury general account US$1 trillion. The Treasury could spend that newly printed money as it wished. The Treasury would not violate the debt ceiling because no new debt would be issued; the Fed would just create the dollars out of thin air. Easy breezy.

Of course, the trillion-dollar coin policy would be disastrous. The arbitrary valuation of the coin would show the true Ponzi nature of the Treasury market today. Fed efforts to supply the cash would radically increase the money supply and probably trigger more inflation. The Fed and Treasury would be laughingstocks.

That’s dangerous for two institutions that rely on public confidence to do their business. Only the simpletons in financial media believe this idea is worth discussing, but it’s good to understand it because you will be hearing more about it.

Revaluing gold?

There is another version of the trillion-dollar coin that is actually legal, is not hard to defend, and has been used in the past during the Eisenhower Administration.

In the 1930s, President Roosevelt ordered the gold held by regional Federal Reserve Banks to be transferred to the US Treasury. The regional Fed banks are privately owned, and the Treasury is an arm of the government. The Fifth Amendment to the Constitution requires that no ‘private property be taken for public use, without just compensation’. This requires the Treasury to compensate the Fed for the confiscated gold.

The Treasury’s solution was to give the Fed a ‘gold certificate’ in exchange for physical gold. That certificate is still an asset on the Fed’s balance sheet.

Here’s the catch. The certificate values the gold at about US$42 per ounce. The market value of gold today is about US$1,830. How much gold is involved? About 8,000 metric tonnes; almost exactly the amount of gold the Treasury holds in Fort Knox and West Point.

The Treasury can then call the Fed and ask them to revalue the existing gold certificate to US$1,830 per ounce and credit the gains to the Treasury general account. The gold certificate is currently worth about US$10.8 billion. At the revalued price, it would be worth US$470 billion.

The gain of US$459.2 billion would be in the Treasury’s account at the Fed. That’s enough to pay the government’s bills for about six months at current baseline rates.

The difference between the trillion-dollar coin and the gold certificate revaluation is that the coin involves a fake valuation, whereas gold involves a true valuation of current market values.

Also, the gold behind the certificate actually exists, and the gold revaluation method was used in the past, including during the Eisenhower Administration.

That said, the gold revaluation method will not be used, either. The reason is that neither the Treasury nor the Fed wants to call attention to the fact that the Treasury has the gold and that the gold certificate even exists.

No one in government wants to treat gold as a monetary asset because that would undermine confidence in the paper money Ponzi the US has been running since 1968. (That was the last year Fed money printing was constrained by the requirement to tie money supply to a fixed quantity of physical gold held by the Treasury. The so-called ‘gold cover’ ratio was one more victim of Vietnam War spending.)

Prioritisation?

Another technique favoured by some Republicans and rejected by Democrats and the White House is called ‘prioritisation’. In this scenario, Treasury would pay critical bills such as interest on the national debt, Social Security, and Medicare but would defer payment on other bills, such as defence contractors and non-essential workers who could be put on unpaid leave.

The defence contractors might get scrip in the form of ‘due bills’, basically an unsecured IOU, but not Treasury debt in the strict sense. When the debt ceiling issue is resolved, contractors could present the due bills and get cash. This method is admittedly a bit messy, but it could work.

Default?

Don’t buy into the claim that the US has ‘never’ defaulted on its debt. We do it all the time. In 1933, FDR devalued the dollar against gold, invalidated ‘gold clauses’ in contracts (a way to guarantee the value of a dollar by converting it into a weight of gold), and made gold itself contraband. From 1977–1981, the US dollar lost 50% of its purchasing power during the great inflation of those years.

Devaluation and inflation are just different ways to default because you receive payment in dollars that are not worth anything close to what you expected or bargained for.

US Treasury notes held by the Central Bank of Russia are now frozen and unavailable to the Russians. What is that but a default? The US offers a continuing master class on various ways to default.

Approaching the X-Date

How long can this shell game go on? No one knows exactly. There are estimates that are referred to as the ‘X-Date’. That’s the day the Treasury really does run out of cash and can’t pay bills or pay off Treasury note holders. Right now, the X-Date is estimated to be around 5 June 2023, but even that is a guess. The real X-Date will depend on how much positive cash flow the Treasury generates during tax season around mid-April.

What do Republicans in the House want in exchange for raising the debt ceiling? Here’s a short list:

It’s easy to see how this list of concessions would help Republicans, not only in the short run, but in all future debt ceiling battles. In particular, debt-to-GDP targets would act as a kind of debt ceiling (depending on growth) independent of the debt ceiling statute. Prioritisation would take away the scare tactics of bond default and Social Security recipients not getting their cheques.

With these tools in place, Republicans would gain the upper hand in future debt and deficit battles with the White House.

Naturally, the White House rejects all these provisions and demands a ‘clean’ debt ceiling raise with no strings attached.

All the best,

Jim Rickards,
Strategist, The Daily Reckoning Australia

This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events. Learn more here.