26. The Ides of March
A quagmire in this instance is a difficult, precarious, and entrapping position. So, what is the Federal Reserve's quagmire? Let’s take a look. In March of 2020, the Federal Reserve announced a reduction of reserve requirements for U.S. banks to zero. (1) [Source: Federal Reserve.gov, reserve requirements.] In March of 2023, the Federal Open Market Committee minutes removed the language “The U.S. banking system is sound and resilient.” (2) [Source: Federal Reserve minutes March, ’23.] On March 10, 2023, Silicon Valley Bank failed, followed by Signature Bank on March 12, and First Republic's failure on May 1, 2023, representing combined assets of more than $500 billion. (3) [Source: Michael Wilkerson, Stormwall.com.] This was followed by the collapse of Credit Suisse with over $600 billion in assets.
In response to these failures, Treasury Secretary Janet Yellen, in conjunction with the Federal Reserve, set up the Bank Term Lending Program (BTLP) for one year. The BTLP expired on March 11, 2024. It allowed participating banks to borrow money against the maturity value of their government-held bonds, even if the present value of the bonds had significantly declined. As of February 29, 2024, the total value of BTLP loans was $163,105,444,000. (4) [Source: Periodic Report: Update on Bank Term Funding Program, March 11, 2024.] The favorable terms of the BTLP, notably allowing loan collateral at “par” on bonds whose current value might have been 40% less, reduce the incentive of banks to manage interest rate risk. Why should they, if the Fed will lend to them regardless of the value of their collateral? Today, the banking system has a loss of one and a half trillion dollars that it is not being held accountable for because the value of its bond holdings declined as the Fed raised interest rates. By allowing bankers to pretend that the value of the bonds they own is not the severely discounted market value but the maturity value, the government has placed a moral hazard on the entire banking system. The question is, how will this moral hazard play out? But before we get there, let’s understand what moral hazard is and why it's bad.
Moral hazard in economics is a situation in which one party engages in risky behavior or fails to act in good faith because it knows another party bears the economic consequences of their behavior. In this case, the bankers are engaging in risky behavior, mitigated by the Fed, by transferring the costs to the public. "Since 2008, the U.S. financial system has qualitatively changed. Now any crisis or stressful periods have been and are pacified by the Fed - either by flooding the financial markets with ample liquidity or offering outright guarantees or protection to the market participants at risk." (Source: New Atlanticist, March 15, 2023, Hung Trong.) The long-term problem is that Federal Reserve intervention is selectively encouraging excessive risk-taking by entities by transferring the losses to the public. This form of dependence on the government is destructive and presents a moral hazard to the public, who are forced to bear the cost of the risky behavior. When a banker is allowed to act, knowing that the Fed will bail them out by a number of methods, then they will take additional risks. The additional risk a bank takes, believing the Fed will backstop their bad decisions, is defined in economics as moral hazard. It presents a moral hazard to the public when the Fed transfers the losses from the bankers' risky behavior to the public.
Moreover, in addition to the moral hazard creating losses that are transferred to the unsuspecting public, the risky behavior often creates future losses. Consider the BTLP program, wherein the government engaged in risky lending by under-collateralizing loans. It is more than likely that the public will face future losses for years to come.
From mid-March of 2020 until March of 2022, the Fed printed $4.6 trillion using the newly printed money to buy government bonds and mortgages. The program was called Quantitative Easing (QE) 4, the largest printing of money in our history. QE1 was launched in late 2008, QE2 was initiated in late 2010, and QE3 was conducted from 2012-2014, all products of Ben Bernanke. Quantitative easing is Fed talk for printing money, used to buy government debt and mortgages, creating inflation.
QE4 erased all the positive cash the Fed generated from 2008-2021 and created nearly a trillion-dollar loss. Before QE4, the Fed's balance sheet purchases through the first three QEs had profited $390 billion. After QE4, it turned into a loss of $800 billion (Mercedes Center, January 10, 2023, Andy Levin and Bill Nelson) and still counting, to be borne by the public. "Our analysis indicates that the continuation of QE4 beyond March of 2020 will incur a cost to taxpayers . . . and we do not find any significant evidence that those purchases (of bonds-printing $4.6 trillion) were effective in reducing borrowing costs or spurring a stronger recovery." (Mercedes Center, Levin and Nelson.)
In short, although the printing of $4.6 trillion by the Fed, in addition to massive fiscal spending, clearly caused inflation, requiring the Fed to raise rates which reduced the value of bonds held by the banks, causing the $1.5 trillion loss that the same Fed later ignored when taking low collateral to make many of the same bank’s loans. Although the Federal Reserve has a dual mandate to achieve maximum employment and keep prices stable, despite all their machinations, the one thing for certain is the moral hazards the Fed creates by facilitating or insuring risky behavior are always borne by the public. Unaddressed, the Federal Reserve's Quagmire goes on and on, and the public unwittingly bears all the losses, too often merely addressing a theoretical problem.
Have a blessed week and good St. Patrick’s Day!
Tony Christ