The days ahead:

  • Consumer confidence and PCE inflation

This week:

  • Money is leaving some small banks…
  • …but they have good credit lines and problems should not spread
  • The increase in the Fed’s balance sheet is an illusion
  • Money market funds are very popular again
  • We dig into some money flows
  • Credit Suisse is the first major global bank to run into problems since 2008…
  • …but its bond holders should read the prospectus and not complain
  • The Fed raised rates but they seem nervous

Where Does the Money Go?

We mentioned last week that the Federal Reserve (Fed) started a new credit facility called the Bank Term Funding Program (BTFP) and also opened up the discount window to enable banks to draw down lines of credit.

This was the right thing to do.

The BTFP allows any bank holding Treasuries or mortgage-backed securities (MBS) to sell those securities at par value and borrow at a 100% margin. The term sheet is here but it’s basically the good stuff that has minimal credit risk. This means banks do not have to realize market losses to meet depositor withdrawals. A Treasury note bought at $100 with a market value of $90 will receive a loan of $100. By the mid week, banks had borrowed some $54 billion using the BTFP, and we expect this number to go up. This is all in the H.4.1 report.

The Fed also changed the terms of discount window borrowing. It used to be an emergency facility where banks could borrow from the Fed provided they put up certain types of collateral. For most banks this means loans of almost any type, including consumer loans and securities. The discount window has four levels of credit. The highest is primary credit, followed by secondary, seasonal and emergency credit. Each level costs more and requires more collateral. Basically, the Fed wants banks to meet customer withdrawals but has no interest in propping up non-viable banks.

The secondary credit facility has lent a grand total of $2m in the last year, once in June 2022 and another in January 2023. The highest it ever reached was $985 million back in 2010.

It’s the primary credit one we care about. Last week, the Fed made two changes to the discount window facility.

Change one

It extended the range of securities it would accept as collateral, including ones that are eligible for the BTFP. The Fed does not want banks thinking too hard about whether to offer their bonds through the BTFP program or the discount window so it basically said, “Look, if you’re a bank that needs cash and has securities, send them our way to the BTFP desk if you need money for a year, and to the discount window if you need money for one to 90 days.”

Change two

The Fed removed the haircut it applied to loans from the discount window. This gets a bit complicated, but if a bank turns up at the discount window with an MBS and asks the Fed for a loan they will apply par value and no discount, just like the BTFP. If the bank turns up with a non-BTFP security or loan, the Fed will lend at market value but with no discount.

If you look at the far-right column of the table below, the changes increase the amount banks can borrow.

 Par ValueMarket ValueDiscount AppliedLoan Amount to Bank
Discount Window with BTFP Securities$100$950%$100
Discount Window (old terms)$100$958%$87
Discount Window (new terms)$100$950%$95
Source: Federal Reserve

So, yes, the Fed has made life a whole lot easier for banks to borrow, ensuring they get the liquidity they need and do not have to impair assets. Big win all round.

Anyway, if we add up the $65 billion in BTFP loans, the $110 billion in discount loans and the $179 billion extended by the FDIC to banks last week, we can see the Fed balance sheet shot up by over $400 billion.

That looks like a big reversal from the Fed trying to decrease the balance sheet by $95 billion a month. But it’s not what it seems. This is money moving from banks that don’t traffic in Fed reserves to large banks that do. So, it’s just a swap from banks outside the Federal Reserve system to those inside. It doesn’t change aggregate liquidity. This is what it looks like for the discount window portion, which hit record highs.

Source: FactSet

So the two charts are about banks getting money from the Fed on quick and easy terms in order to meet depositor demands. What happens when depositors get their money?

Well, the short answer is we don’t know yet. The Fed releases its own balance sheet, on a Thursday based on data from the previous day. But they release the commercial banking data on a Friday based on the prior Wednesday. So the latest data we have is from March 8th, which was the day Silicon Valley Bank (SVB) announced its intent to raise capital but two days before it was closed.

We know there are big money moves into the regional Federal Reserve banks and, therefore very likely,  into the Globally Systemically Important Banks or GSIBs. There are 30 such banks of which eight are in the U.S. We saw the San Francisco Fed balances rise $92 billion, which makes sense as depositors were clearly emptying cash at SVB and First Republic and taking it to Wells Fargo, whose home is in the San Francisco Fed district. We also saw $80 billion heading into the Richmond Fed, which is home to Bank of America.

This next chart gives us some idea about moves in bank deposits, as opposed to Fed, deposits. When it’s updated next week, oooh boy, expect the green line to drop.

Source: FactSet

The chart shows checking deposits at the large, or top 25, banks (blue line), and at about 975 small banks (green line). These are banks regulated by the Federal Reserve. Just to complicate things, the Fed does not regulate about 4,133 credit unions and state regulated banks. They all show up in different data and reports. But for now, we can stick with the Fed’s numbers as a proxy for the U.S. banking system. This is all in the Fed’s H.8 report.

Peak deposits for both the large and small Fed-regulated banks fell from $16.2 trillion in April of 2022 to $15.2 trillion on March 8th 2023. Interestingly, large banks saw a $230 billion deposit outflow in one month, while smaller banks saw a $60 billion outflow. We’d expect a much faster run down in both types of banks, but especially small banks, in the next few weeks.

We also know that money went out of banks and into money market funds. The chart below shows weekly inflows into Treasury money market funds. At $144 billion, last week saw the biggest inflow in three years and the fourth largest ever.

Source: FactSet

We’d also expect those numbers to rise in coming weeks. Yields on money market funds are considerably more than bank deposits and with the additional worry about banks, investors are likely to keep moving money.

 Apologies if all that left you a bit “What the heck?” but diving into the flow of money and credit, especially during a bank crisis, can be tough to track.

The quick version is this: First, depositors worried about small banks and reduced cash. They then moved cash to large banks and money market funds. But the banks can’t easily handle the demand given many of their loans are illiquid. So, the Fed extended them credit lines to ensure a steady flow of funds and reduce panic. The flows and changes haven’t stopped yet and we’ll see more in the next few weeks.

The Fed’s programs greatly helped liquidity and they’ll remain in place for some time.

Credit Suisse Bond Holders are Upset

As we mentioned last week, Credit Suisse has been in permanent crisis mode for over a decade. It’s run through several CEOs, paid billions in fines and lost 20% of its wealth management business. Last week saw depositors take flight, shareholders dump the stock and bond holders mark up the price of default. It was time to put it out of its misery.

Over the weekend, the Swiss National Bank (SNB) engineered a takeover by UBS, the last remaining big Swiss international bank. UBS bought out the few remaining brave Credit Suisse shareholders for about $3.2 billion or about $0.91 cents per share. A year ago, the shares were $10 and in 2009 they were $77. So, a rout for shareholders. But not a complete rout.

Normally, bank creditors are paid in strict order: depositors first, then salaries, then secured bond holders, unsecured bondholders, preferred shareholders and finally shareholders (that’s a short list, it can get more complicated). After the GFC, bank regulators added a new class of securities called “bail-in” capital, which meant if a bank was in trouble, the value of the bail-in capital went to zero and the proceeds would remain in the bank and convert to equity. It was a shatteringly original name because instead of creditors getting “bailed-out”, which is what happened in 2008, they get “bailed-in.” So, if you buy a “bail-in” bond, don’t expect a bail-out.

The most popular of the “bail-in” capital structures were called Additional Tier 1 (AT1) bonds or “contingent convertible” or CoCos. We’ll stick with AT1 from now on because CoCo sounds just too cute for what’s about to happen to them and Additional Tier is just bank jargon.

The AT1 bonds were issued as permanent capital so, unlike a normal bond, there was no maturity. They would pay a generous coupon but convert into equity if certain things happened or “triggers.”. Those things included a bank failing to meet capital requirements. In the U.S. investors didn’t much like AT1 bonds and stuck with preferred stock instead. Preferreds also pay a nice coupon and they too are permanent capital but they don’t convert into equity. There are other differences but, hey, this is probably running long already.

The triggers can be formulaic. This would be when a regulator says, “We ran the numbers and could not help but notice that your tier 1 capital is at 3%, it’s meant to be 4%. Those AT1 bonds convert to equity…mkay?” And if you had bought an AT1 bond you now have a fistful of equity.

The triggers can also be at “supervisors’ discretion”. The SNB put that language in especially for Swiss banks. That means a regulator says “I don’t have a good feeling about this bank. I will convert the AT1 into equity.” It’s all there in the prospectuses but the key clause is that if a regulator declares that Credit Suisse is not viable, the bonds convert. And they can say it’s not viable if:

[Converting] is an essential requirement to prevent Credit Suisse Group (CGS) from becoming insolvent or… CSG has received an irrevocable commitment of extraordinary support from the Public Sector…”

It’s standard language. Here’s an almost identical clause from a Julius Baer Bank AT1 bond. Julius Baer is also Swiss.

I dunno. It seems that if the SNB said they’d support Credit Suisse on March 15th, offered a $54 billion borrowing facility the next day and then coordinated a takeover with a government loan of $108 billion and another $108 billion of backstop, two days later, the SNB had a pretty good case that the bank was both insolvent and in need of “extraordinary support.” And if so, bang go the AT1 bonds. They converted into equity which was almost worthless.

Here’s a chart of some of Credit Suisse AT1 bonds:

Source: FactSet

They were all happily trading at around $100 up until March 10th. They now trade at around $3 to $5 if you can find someone to take them off your hands. But as the chart shows, the prices just disappear into the depths of Mordor, never to be seen again. So, there will be no-one to take them off your hands. How many of the AT1 bonds did Credit Suisse issue? About $16 billion.

Some people are very unhappy. Many felt that the AT1 bonds were, well, bonds and so should rank above equity shareholders. Fair enough. But it was all disclosed in the prospectus. Many of the Credit Suisse bonds carried a very nice 7.5% coupon, which sure looked good when government bond yields were yielding about 2.5%. But if you bought bonds and didn’t read the prospectus, it’s hard to feel a lot of sympathy. It just seems that it’s another example of “if it seems too good to be true, it probably is.”

If you were a shareholder in the Invesco AT1 Capital Bond ETF, which invests only in AT1 bonds, you may be upset too. Thankfully, it’s only available in Europe.

Source: FactSet

The total market for AT1 bonds is about $260 billion and they represent about 13% of European banks’ common equity capital. So, it’s an important market that regulators and investors have come to rely on.

The good news is that not all AT1 bonds are structured like the Swiss versions. And there’s also good news that most U.S. fund managers stayed away from these securities. But to us it’s a simple reminder of two lessons. One, that strange and unpleasant things can happen whenever banks are in trouble and, two, understand what you buy.

Ok. That’s a lot on banks and perhaps it should have come with a trigger warning for any GFC vets.

Banks can look all fortressy and too big to fail but they’re fragile creatures. The minimum equity requirement for U.S. banks is 4.5%, which means it’s leveraged 22 times. A small hiccup on the loan or deposit side and the bank is in trouble. We think the regulators have stepped in quickly this time and we expect they will continue to build confidence and backstops when needed. But we’ll also keep a close eye on developments and keep you informed.

Banks and Nasdaq

We took the performance of the Nasdaq index, which is about 55% tech and with no financials, and compared it to the KBW index of 24 leading banks. It’s a crude measure but captures what investors think about the large, money-center banks and the mostly tech companies.

Source: FactSet

When the line goes down, Nasdaq is outperforming the KBW index. It had climbed slowly in 2022 when tech was correcting and the interest outlook was good for banks. But it shifted abruptly in the last few days. It’s close to it’s all-time lows.

The rationale is easy enough to understand. Duress in the banking system is bad for banks, deflationary and is the catalyst for a drop in rates. Lower rates tend to favor tech stocks given their growth and the discount rate one should apply to future earnings. The last two times a sudden drop has coincided with recessions. We’d caution that the data only goes back to 2006 so we’re not pinning any forecast on the move. Still, it shows how quickly sentiment can move from out of favor, to popular and out of favor again.

What Did the Fed Say?

Rates are up 0.25% and the “U.S. banking system is sound and resilient”.

The Fed was in a bit of a dilemma going into their latest meeting. Would they:

  • Hike as normal and down play the financial stress


  • Hold, and thereby suggest that they didn’t really believe what they were saying about the strength of the financial system

They went with the first and re-emphasized that inflation is not where they want it. Chair Powell acknowledged that bank stresses cause “tighter credit conditions for households and businesses” and that “would weigh on economic activity, hiring and inflation” but that the extent of those problems is “uncertain.”

Talk about throwing the kitchen sink in there. He basically listed all the things that could go wrong and left it at that.

The Fed also updated its December economic forecasts. It expects growth to slow this year and through to 2025, unemployment to rise 1%, which is equivalent to 1.7 million job losses and the number of unemployed to rise to 7.6 million from 5.9 million. Cheery stuff.

They also updated their rate projections which means we have to show their “dot-plots” and the worst-ever-designed graphic. Sorry.

Source: Federal Reserve

The takeaway from that monstrosity is that rates end up at 5.1% (point A), which is unchanged from December and at 4.3% in 2024 (point B), up from 4.1% in December. The 5.1% projection for 2023 implies one more rate increase of 0.25%

The good news is that in December they said that “ongoing increases…will be appropriate” and this time they said “some additional policy firming may be appropriate.” A change from “will” to “may” is a climb down of sorts. It clearly reflects the recent mauling of SVB and others.

Beyond 2024, there is a huge range for rates! At the low end there’s one person who thinks rates will be 2.3% and one who expects 5.6%. In other words, who knows?

There’s a slight hint of Fed nerves. Just a few months ago, there were calls for rates to peak at 6% and on March 6th 2023, Chair Powell told Congress that “ongoing increases… will be appropriate.” The language is a lot tamer now.

We’d expect one more rate hike. The next meeting is in May and by then the Fed will see one more inflation and jobs report, and two more JOLTS (Chair Powell likes JOLTs) and Personal Income reports, from which we get the PCE inflation measure. All those provide a lot of information. Meanwhile, we and the Fed don’t know, if there will be more credit tightening.

So that’s why we’ll keep a close eye on the Fed’s H.8 reports, where we expect some big shifts in coming weeks.

Debt Ceiling Update

Again, this is our list of things we’re watching:

  1. Thursday Bill auctions
  2. 10-Year Treasury
  3. U.S. dollar
  4. Rise of safe haven assets
  5. Treasury short positions
  6. Bonds, Bills, and Notes maturing in June and July
  7. Stock performance of companies with 90% of revenues from the government
  8. Credit Default Swap (CDS) prices

Banking problems pushed the debt ceiling off the front page, again. Bill and bond auctions are going well as indicated by how much the demand for bonds exceeds supply. It’s around 2.5 times for both bonds and bills.

The White House and Freedom Caucus have both released budgets but the House has not. The White House budget includes tax hikes and the Freedom Caucus rescinds things like the Inflation Reduction Act and caps current non-defense spending for 10 years.

The House introduced the “Default Prevention Act” which instructs the Secretary of the Treasury to pay all debts and Social Security, and prioritize Veteran’s Benefits, but stop all pay for the Executive and Legislative branches. It’s basically a “prioritization” plan but Treasury Secretary Janet Yellen pushed back hard saying that the Treasury is not set up to prioritize payments. There’s a pretty dire list of things that would happen if spending were curtailed. I don’t recommend clicking the link.

At some point the debt ceiling problem will reemerge front and center. But for now, it’s simmering in the wings.

The Bottom Line

The theme of continuing to hike rates with banking turmoil continued Thursday when the SNB raised rates by 0.50% to 1.50%. The rate was -0.75% as recently as last June and this was the fourth hike of 0.50%. This was an unmistakable message that inflation containment and financial stability are two separate challenges and monetary policy need not change to solve bank problems. Swiss policy rates were stuck at zero to negative rates from 2008 to 2022 and caused all sorts of problems in the banking sector. We’d take this latest move as an overdue return to normalcy. Swiss bond yields did not change.

The SNB also took a bow when they stated that they “have put a halt to the crisis” with Credit Suisse. From where we sit, they have. Other central banks will take note.

For the next few weeks, the big questions are:

  1. Will we see credit tightening, especially by small and mid-sized banks to small and mid-sized companies
  2. Will the 10 successive rate increases from March 2022 to now, start to show up in other sectors of the economy?

We’ll keep an open mind about the economic and policy outcomes but we’re clearly in a state of flux.  

And markets? Well, they’re holding up well. The 10-Year Treasury has held on to its gains since early March 2023. It was yielding 4.10% then and is now 3.45%. Credit spreads have risen since early March but look steady. The S&P 500 is flat for the week but tech and communication services, which is the sector with Google and Facebook, have risen around 18% this year and are up 8% in the last two weeks.

That’s a good sign.

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Art: Zoey Frank (b. 1987)

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