The bigger bailout

A great deal of attention has focused on the bailout of SVB depositors, but the bigger story is the bailout of other banks. (At least bigger as of today, there are rumors the government may extend the over $250,000 deposit bailout to all banks. You can imagine what I think of that idea.)

David Beckworth has a podcast where Steven Kelly discusses how the new Fed loan facility works.  Here’s David:

Beckworth: Daniela Gabor, she wrote something in a similar vein. She said, “Forget about SBV liabilities for a second. The real bailout story is the regime change in the Fed’s treatment of collateral. Par value goes against every risk management commandment of the past 30 years. It turbocharges the monetary power of collateral.”

Kelly explains the problem by considering a situation where banks paid $90 for bonds with a par value of $100, and then the market value fell from $90 to $80:

Kelly: So not only did they say, “Well, we’ll give you the 80 and we’ll calm things down. We’ll replace the 80 that you lost from uninsured depositors being flighty. Nor will we give you 90, which is what you’ve been carrying your books at, so you don’t have to recognize the loss of funding there. We’re going to give you 100, which can solve other problems on your books too.” So that’s super unique. And Daniela’s language is more dramatic than mine and more eloquent than mine, but that’s exactly the point she’s making.

The Fed’s treating these bonds as $100 worth of collateral, despite the fact that the banks paid $90 and the market value is only $80.  

But I slightly disagree with Kelly’s framing here:

Beckworth: So I like the framing you just made, that this is effectively a capital injection, because they’re paying above par. Well, they’re paying par which is above market value, so it’s effectively a capital injection. I also heard someone else put it this way on Twitter, “The Fed is effectively doing unsecured lending.” Is that also another interpretation?

Kelly: So it is if you think, okay, you’re getting 90 bucks of collateral for a $100 loan. I mean the Fed’s not totally bound by those values. The Fed’s legal mandate, especially with 13(3), is that it does not expect losses ex ante. There’s really no reason to expect loss if you’re the Fed. You’re talking about treasuries… There’s no reason to expect a loss if you hold this stuff to maturity, which is typically how they think about it, and they have 25 billion from the Treasury, I would argue unnecessarily, but I don’t think the Fed needs to think about this as unsecured. It looks like a loan against underwater collateral, but they’re going to get paid back, which is sort of their floor for secured to satisfaction.

He’s probably correct that the Fed won’t end up losing money here.  But it’s not quite correct to imply that holding these depressed bonds to maturity solves the problem.  The Fed is already likely to incur some very large losses from its current holdings of Treasury bonds.  In previous posts, I’ve explained how those losses cannot necessarily be avoided by holding the bonds to maturity.

Of course it’s very possible that these bank loans do get repaid, and it’s also very possible that we have a recession and interest rates fall sharply, boosting the value of the Fed’s long-term bond portfolio.  So I’m not predicting big Fed losses from these particular loans.  But there’s no getting around the fact that if you treat $80 bonds as representing $100 worth of collateral, you are giving the banks a gift.  And someone must bear the cost if those loans default.

We are adding moral hazard to the system so rapidly it’s making my head spin.  And not just in finance.  Think of the Covid bailouts of many businesses, or the student loan bailouts.  The more safety nets we add, the less incentive people have to be careful.