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Powell and Yellen put a system in place over the weekend where all banks can borrow against their bonds at par, thereby preventing any other bank runs. The dur

by gizmo 4y ago

Powell and Yellen put a system in place over the weekend where all banks can borrow against their bonds at par, thereby preventing any other bank runs. The duration problem is that banks have bonds/CDOs on their books marked-to-maturity, but when faced with outflows banks are forced to sell them at market prices (much lower because interest rates went up). This turns an illiquidity problem into an insolvency problem if a bank bought too many low interest long duration bonds. Last week, when a bank had balance sheet consisting of bonds with a market price of $75 but valued at $100 marked-to-maturity they would get into trouble when faced with too many withdrawals. Today, they can borrow $100 from the Fed at a modest interest rate with the bond worth $75 as collateral. This fixes the bank run problem, because the bank can go to the fed to get the money they need to cover any outflows. This deal only covers quality bonds and only those bought before last week. This fix is not an invitation to start lending recklessly, it's just a stopgap measure to allow banks to lose money slowly on the bad debt they already have. This all means Powell can continue to raise interest rates without having to worry too much about bank failures.

bcrl 4y ago
So, the solution to bad assets is more debt? How are the banks going to cover that debt when their customers are fleeing and interest rates are rising? I fear this is only kicking the can down the road by a few months (or years) before even worse fallout occurs when the failed banks have to make substantially larger interest payments. Edit: a better term might be Zombie Banks.
- mnky9800n 4y ago
  Welcome to Japan circa 1990s which is now why Japan has the economy it does today.
- gizmo 4y ago
  The idea is that when customers know a bank has effectively an unlimited line of credit to pay for outflows that there is no reason to panic. Conceptually, the credit line works perfectly even if it's never used. I agree it's not a solution, but it's smart and effective stopgap measure.
- HDThoreaun 4y ago
  Why would customers flee if there's no risk of the bank running out of money?
- hmoodie 4y ago
  In a constant intereest rate environment the bonds' market value will tend towards par value the closer they get to maturity
BlandDuck 4y ago
I disagree. I worry that this structure may effectively tie Powell's hands and prevent him from raising rates further. As you describe it, banks can post collateral with a market value of $75 in return for $100 of loans from the Fed. This is not a panacea. There is a reason why this is not normally done. The problem arises when this loan has to be repaid. At that point, the bank will have to repay $100 to recover $75 worth of collateral. There is a gap between what the bank must repay and the value of the collateral it gets back. This means that, at that point, banks may find that they are insolvent and unable to repay the loans. This is the banking version of "jingle mail", sending the bank's keys to the Fed instead of repaying the loan. The higher the rates, the lower the value of the collateral, the greater the gap, and the more likely the banks are to default on their loans when they come due ... ... silly me, of course not ... at that point the banks will expect the Fed to bail them out again and cover the gap through some "repurchase" voodoo where the banks can "repurchase" their collateral at market value and have their loans forgiven.
- gizmo 4y ago
  Banks generally do well in higher interest rate environments. It's in a ZIRP climate that banks struggle. By kicking the can down the road banks can use the profit they're making from the business they do today to pay off the dumb debt they acquired in the past couple of years. In the US alone banks are underwater to the tune of 650bn (that we know of). It will take a while to pay off. The banks might get an outright bailout -- it wouldn't be the first time -- but nobody wants that. Not Powell, not Yellen, not Biden, and certainly not you or me.
  - runeks 4y ago
    > Banks generally do well in higher interest rate environments. It’s not about a high vs low interest rate environment. It’s about a falling versus rising interest environment. In a rising interest rate environment, a banks bond holdings is continually losing value.
- FooBarBizBazz 4y ago
  > The problem arises when this loan has to be repaid. At that point, the bank will have to repay $100 to recover $75 worth of collateral. This is not much of a problem if the Fed allows the loan to be rolled until the bond matures. Then, at maturity, the loan's principle is paid by face value of the bond. The only issue is that, in the meantime, the bank does have to pay interest to the Fed on the loan. This is a tightening; it's just not as tight. The face valve of the bond cancels the principle, the bond's coupon cancels some portion of the loan interest, and the only thing left at the end is a cashflow from the bank to the Fed representing the remaining interest. Heck, the Fed could make this cancellation explicit, create a bond representing this cash flow, and sell it to somebody else. This also doesn't prevent Powell from raising rates further. If anything, it eliminates a reason why he couldn't.
runeks 4y ago
> This deal only covers quality bonds and only those bought before last week. > This all means Powell can continue to raise interest rates without having to worry too much about bank failures. Do you think banks will stop buying bonds? Otherwise I don’t see how the latter follows from the former.

by gizmo 4y ago

bcrl 4y ago

So, the solution to bad assets is more debt? How are the banks going to cover that debt when their customers are fleeing and interest rates are rising? I fear this is only kicking the can down the road by a few months (or years) before even worse fallout occurs when the failed banks have to make substantially larger interest payments. Edit: a better term might be Zombie Banks.

mnky9800n 4y ago
Welcome to Japan circa 1990s which is now why Japan has the economy it does today.
gizmo 4y ago
The idea is that when customers know a bank has effectively an unlimited line of credit to pay for outflows that there is no reason to panic. Conceptually, the credit line works perfectly even if it's never used. I agree it's not a solution, but it's smart and effective stopgap measure.
HDThoreaun 4y ago
Why would customers flee if there's no risk of the bank running out of money?
hmoodie 4y ago
In a constant intereest rate environment the bonds' market value will tend towards par value the closer they get to maturity

BlandDuck 4y ago

I disagree. I worry that this structure may effectively tie Powell's hands and prevent him from raising rates further. As you describe it, banks can post collateral with a market value of $75 in return for $100 of loans from the Fed. This is not a panacea. There is a reason why this is not normally done. The problem arises when this loan has to be repaid. At that point, the bank will have to repay $100 to recover $75 worth of collateral. There is a gap between what the bank must repay and the value of the collateral it gets back. This means that, at that point, banks may find that they are insolvent and unable to repay the loans. This is the banking version of "jingle mail", sending the bank's keys to the Fed instead of repaying the loan. The higher the rates, the lower the value of the collateral, the greater the gap, and the more likely the banks are to default on their loans when they come due ... ... silly me, of course not ... at that point the banks will expect the Fed to bail them out again and cover the gap through some "repurchase" voodoo where the banks can "repurchase" their collateral at market value and have their loans forgiven.

gizmo 4y ago
Banks generally do well in higher interest rate environments. It's in a ZIRP climate that banks struggle. By kicking the can down the road banks can use the profit they're making from the business they do today to pay off the dumb debt they acquired in the past couple of years. In the US alone banks are underwater to the tune of 650bn (that we know of). It will take a while to pay off. The banks might get an outright bailout -- it wouldn't be the first time -- but nobody wants that. Not Powell, not Yellen, not Biden, and certainly not you or me.
- runeks 4y ago
  > Banks generally do well in higher interest rate environments. It’s not about a high vs low interest rate environment. It’s about a falling versus rising interest environment. In a rising interest rate environment, a banks bond holdings is continually losing value.
FooBarBizBazz 4y ago
> The problem arises when this loan has to be repaid. At that point, the bank will have to repay $100 to recover $75 worth of collateral. This is not much of a problem if the Fed allows the loan to be rolled until the bond matures. Then, at maturity, the loan's principle is paid by face value of the bond. The only issue is that, in the meantime, the bank does have to pay interest to the Fed on the loan. This is a tightening; it's just not as tight. The face valve of the bond cancels the principle, the bond's coupon cancels some portion of the loan interest, and the only thing left at the end is a cashflow from the bank to the Fed representing the remaining interest. Heck, the Fed could make this cancellation explicit, create a bond representing this cash flow, and sell it to somebody else. This also doesn't prevent Powell from raising rates further. If anything, it eliminates a reason why he couldn't.

runeks 4y ago

> This deal only covers quality bonds and only those bought before last week. > This all means Powell can continue to raise interest rates without having to worry too much about bank failures. Do you think banks will stop buying bonds? Otherwise I don’t see how the latter follows from the former.