The Federal Open Market Committee of the Federal Reserve System settles down today for its regular two-day May meeting at which it will be obliged to carefully consider the hospital pass it has been handed. Whether or not it is as a collective prepared to acknowledge that it has itself executed the pass is a different matter entirely.
US monetary policy was without a doubt too loose for too long and now the FOMC is, from some quarters at least, faced with the accusation of being too tight for too long. Whether it should and will in fact add a quarter point to Fed Funds rate is moot although according to the forward rate curve the probability is high and there has been next to no rhetoric emanating from the more vociferous members which would suggest otherwise.
If the Fed’s objective is to fight fire with fire, then a further tightening, in this case to a target range for Fed Funds of 5.00% – 5.25%, is as good as given even though the March all items CPI reading was itself 5% year over year which would mean that for the first time in as long as most of us can remember there will be a positive real return on the policy rate. Not that that stretches into any other part of the yield curve which remains stubbornly negative but then Rome wasn’t built in a day. That’s the easy bit, for at the same time the FOMC will be convening in the aftermath of the collapse of First Republic Bank, the third major bank failure of the year and again one which was in essence triggered by the persistent inversion.
After a weekend of speculation as to who would step up and take over the crumbling First Rep, J P Morgan Chase always appeared to be the government’s favourite. Yesterday it duly panned out that way. JP famously got a real steal when it acquired the failing Bear Stearns in March of 2008. In the midst of the panic over the firm’s precarious position and under the SEC chairmanship of Christopher Cox, Jamie Dimon agreed to take over the Bear lock, stock and barrel at US$ 2.00/share. The price was so wrong that eventually the deal was executed at US$ 10.00, five times what had initially been announced. First Republic is set to become part of the Morgan empire for a knockdown price of US$ 10.6 billion in which the latter will acquire a loan book of US$ 173 billion along with US$ 30 billion of securities. Nice if you can get it.
First Republic was without a doubt too big to fail and despite Dimon’s rather trite comment that this rescue would mark the end of the banking crisis, the FOMC will have to begin to assess not only whether the 25 bp increase in the cost of money which is on the table will be the last one but when it might be safe to begin to ease again. Silicon Valley Bank and First Republic have both been knocked over by an excess of long dated fixed rate assets exposed to equally excessive variable rate short term liabilities. It’s easy for Dimon to blithely declare that his newest acquisition had failed due to poor management and a faulty business model – which is of course to a large extent true – but is he right to assume that the banking landscape is not peppered with dozens of regional banks sporting more or less the same problem? As a banker I hold Dimon in the highest regard. He is without a doubt the outstanding executive of his generation but I do take issue with his sage opinions on anything and everything. I think if we look back over the past couple of years, he has at one time or the other predicted everything ranging from a deep and enduring recession to no recession at all. The same rules apply to him as to all of us: If you offer up enough predictions, sooner or later one of them will of course be right.
Senator Elizabeth Warren, the Massachusetts Democrat who like our Jamie appears to have an opinion on more or less everything, is quoted as having said “A poorly supervised bank was snapped up by an even bigger bank — ultimately taxpayers will be on the hook.” and went on “Congress needs to make major reforms to fix a broken banking system”. I guess Senator Warren has yet to grasp that banking begins to go wrong when politicians decide that they know more about how to run a lending business than do bankers. Not that there have not been credit crises before but it remains a bankers’ instinct only to lend to those who they believe will be able to repay their debts. Since the introduction in 1977 of the Communities Reinvestment Act, the provision of credit has become a tool of social engineering. It is of course said that a banker is a person who lends you an umbrella when the sun is shining, only to ask for it back when it begins to rain. If Elizabeth Warren were to seriously want to have an effect, then she would lobby for a tax regime which does not benefit share by backs over dividend payments or, in other words, capital gains over income.
This morning HSBC reported its Q1 figures and what a sight for sore eyes they were. Q1 profits came in at US$ 12.9 billion as opposed to US$ 4.2 billion for the same period last year and way ahead of the consensus forecast of US$ 8.64 billion. US$ 2 billion of the figure was a windfall in as much as the bank had provided that sum in write-downs associated with the prospective sale of its French business which has, however, been shelved and which permitted the reserve to be brought back out and added in. For the first time since 2019, HSBC will resume paying a dividend. But the issue which troubles me is that recurring old chestnut of share buybacks. As the numbers were about to appear on screen and whilst I was making my first cup of coffee, the TV pundits were already speculating on how much of those US$ 2 billion were going to be recycled into buying back shares.
I might be a bit of an idiot – okay, thank you, that’ll do – but I just don’t get share buy backs. When I was at high school where I was taught the basics of accounting, it was drummed into us that at the base of the capital structure stood common equity. It benefitted from the increased value of the enterprise but at the same time was low cost in that dividends could be varied and adapted to the performance of the business. Debt, on the other hand, bore an unavoidable cost which could eventually drain liquidity to such an extent that it could lead to the failure of the business. Not to make too fine a point of it, it was debt that sunk both SVB and First Rep, not non-performing loans. It would be fatuous to suggest in their respective cases that a broader equity base and a thinner debt base would have saved them but there is no doubt that across the economy businesses have by way of tax treatment been encouraged to gear up their balance sheets and to replace equity with debt.
This encouragement has received a further boost in the arm by way of Credit Suisse’s AT1 notes having unexpectedly found themselves subordinated to common equity. Even more motivation to replace equity with debt? The asymmetric risk profile of AT1s which are exposed to all the downside whilst enjoying none of the upside is of itself incongruous and can, please excuse me, only be the invention of some bureaucrat with a pen, a pad and a slide rule but imbued with no common sense. That said, nobody forced anybody to buy the junk. That is of course other than the central banks which by way of ZIRP and NIRP and enduringly low interest rates left institutions with fixed liabilities and a portfolio of assets providing insufficient returns to meet requirements or, in other words, the exact opposite of the problems in a rising interest rate environment which brought SVB and First Rep to their knees and which are surely still stalking many others.
I well remember polishing my shoes, brushing my hair and going to see the manager of my local Barclays branch in order to beg for a mortgage to buy my first home. The question to which I had carefully prepared the answer was “How do you intend to repay?” If Senator Warren really wants to make banks safer, then she might suggest that loans are only made to those who are known to be able to repay, although I’d suggest that that is not what is printed in her playbook. I don’t think it’s in any politician’s playbook. I do recall observing when in 2008 the US national debt broke above US$ 10 trillion and 60% of GDP – it is now above US$ 30 trillion and 120% – that the only way it could ever be brought back under control would be by way of a prolonged period of inflation which would debase the value of the debt relative to the value of the assets it had financed. It’s not a quiz but it is also not a painless solution. I wrote last week that the FOMC will at its two day meeting not be juggling three balls but half a dozen chainsaws. JP Morgan having swallowed up First Rep will not have made it any easier.
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