THE BANK TERM FUNDING PROGRAM & THE POWELL PUT

Following the failure of Silicon Valley Bank and Signature Bank, the Federal Reserve announced the Bank Term Funding Program.  According to the Fed’s press release, the BTFP was created to “support American businesses and households” and to “bolster the capacity of the banking system to safeguard deposits and ensure the ongoing provision of money and credit to the economy.”  Well, that’s one way of putting it.  A more cynical take is that the BTFP will once again protect large and gigantic financial institutions from the consequences of their mistakes.

There’s some history here.  The “Greenspan Put” relates to actions Alan Greenspan and the Fed took to prop up financial markets following the 1987 stock market crash and the 1998 collapse of Long-Term Capital Management.  A put option is a financial instrument that gives the right to sell an asset at a specific price, regardless of the prevailing market price of the asset.  In other words, puts, both actual and metaphorical, insure their holders against declines in the price of the asset.  Some have dubbed Quantitative Easing after the 2008 Financial Crisis as the “Bernanke Put” and its continuation the “Yellen Put.” 

Expansion of the Fed Put has been the go-to move for the Fed under Jay Powell.  The Fed reversed course on interest rates in 2019 when the President started to complain on Twitter.  Also in 2019, the Fed established an overnight repo facility when market rates on short-term repos, a type of short-term lending, spiked.  In response to market disruption following the COVID-19 pandemic, the Fed lowered short-term rates, resumed QE with a vengeance and established nine different emergency lending programs.

There has been some hair-splitting over whether the decision to cover uninsured depositors represented a bailout.  Defenders of the action emphasized that the actions did not protect the failed bank’s shareholders or management.  BTFP sure looks like a bailout.  Let’s look at why.

The current rate on the BTFP is 4.69% and is available for up to a year.  That’s just below the rate for borrowing from the Fed’s discount window (4.75%), a bit above the one-year Treasury rate (4.35%) and below the four-month Treasury rate.  Borrowers can prepay with no penalty.  That provides a heads you win, tails you also win proposition for the borrowing banks.  If market interest rates go up over the next year, they can lock in the 4.75% rate.  If rates go down, they can prepay.

The biggest part of the sweetheart deal relates to the collateral the Fed will accept.  Normally, the value of the collateral needs to be worth at least as much as the amount of the loan, plus a little extra (called a haircut) to account for fluctuations in the value of the collateral.  Under the BTFP, the Federal Reserve Banks will lend based on the par value of the collateral with no haircut.

The regional Federal Reserve Banks (FRBs) are quasi-public entities.  Member banks purchase shares in their local FRBs, receive a 6% annual dividend, and may serve on FRB boards.  Conversely, members cannot sell these shares in the market as you might be able to do if you owned shares in Amazon or Apple.  The U.S. Treasury will provide $25 billion in credit protection to the FRBs in connection with the BTFP.

There is good reason to suspect that par value will be a lot higher than market value for many banks.  As noted in my earlier post, Silicon Valley Bank’s HTM portfolio was roughly $15 billion underwater.  SVB wasn’t the only one.  As of September 30, 2022, the HTM portfolios of the ten largest bank holding companies were in aggregate $262 billion underwater, or about 12 percent of their book value.  While not all these securities would be eligible for BTFP, the HTM portfolios consist mainly of Treasuries and agency MBS, which would be eligible.  It’s like getting a home mortgage (or better yet, a cash out refi) without an appraisal.  But in this case, the lender would already have good reason to suspect the collateral value is down significantly.

Will we know the recipients of this government largesse?  Not immediately.  The Fed will publicly disclose information concerning the facility one year after the BTFP ends (currently scheduled for March 11, 2024).  The disclosure will provide the names of the recipients and the terms of the borrowings.  The timing will likely ensure that this information will be buried on Page D-17 of the newspaper, if reported at all.

Steven Kelly, a senior research associate at Yale’s Program on Financial Stability has described recent government actions as writing “insurance on interest rate risk for the whole banking system.”  I certainly hope that is not the case, but I have my concerns.  The BTFP is certainly protecting banks from the consequences of some poor investment decisions.  Designating securities as held-to-maturity rather than available-for-sale is a case of accounting form trumping economic substance.  Just because you don’t need to recognize the decline in the value of HTM securities on your financial statements doesn’t mean a decline hasn’t occurred.

An HTM designation gives banks much less flexibility in responding to increases in interest rates.  AFS securities give more flexibility in rebalancing portfolios, but mean more capital volatility, at least for the very largest banks. 

Why load up on long term securities at all?  A common response is that the investments hedge the interest rate risk of the bank’s deposits.  This claim doesn’t stand up well to scrutiny.  The theoretical argument goes along the following lines.  Fixed rate liabilities, like CDs, are less attractive when rates go down since the bank is stuck paying an above market rate.  Investment securities tend to go up in value when rates fall.  However, most deposits at large banks don’t have defined maturities.  Most are savings or checking accounts, which are payable on demand.  More significantly, banks loaded up on the HTM investments in 2020 and 2021, when rates were close to zero.  There just wasn’t a lot of room for rates to go down.

The assumption that the BTFP will “ensure the ongoing provision of money and credit to the economy” may be a triumph of hope over experience.  Justifications for various forms of emergency assistance and other accommodations over the past 15 years rest of their ostensible benefit to the overall economy.  Who’s to say they won’t instead go on a stock buyback tear once the storm passes.  There is some precedent there.

Financial policymakers sometimes need to take unappealing actions in an emergency.  The extent of the emergency remains unclear.  We experienced in 2022 the worst inflation in 40 years and levels remain elevated.  However, overall economic indicators hardly look dire.  Consider the Misery Index, which is simply the inflation rate plus the unemployment rate.  It currently stands at 9.6%.  It stood at 11.4% in November 1984, when it was supposedly morning in America.  Financial markets can blow up well before key economic indicators deteriorate and that may drive the reaction.  However, the BTFP rolled out just two days after the SVB closure, so it may be a case of bail out first, ask questions later.