Marc Cuniberti The Feds have the trouble of their own making
I often scratch my head when it comes to the movements of the Federal Reserve (FED).
Responsible for raising and lowering interest rates, currently they are raising rates to try and quell inflation. Inflation of their own making I might add.
It’s a well-known fact that printing up copious amounts of money to fund the government, bailout financial institutions and stave off economic pullbacks, if done to excess, will cause inflation.
Such is our current fate.
Increasing all the money in circulation by about 80% in the last half a decade to stem off the economic collapse brought about by the CoVid shutdowns, all that newly created cash has fostered the worst inflation in 40 years. In an attempt to reduce it, the FEDS has implemented a historical series of rate increases.
As often occurs in economic mechanics, however, trying to fix one problem can result in other problems. A great example of this is the current banking crisis.
Banks take in deposits and are only required to keep a fraction of those deposits in cash. The rest they invest in a variety of highly regulated holdings.
A common practice is to loan short term but invest long term.
What this means is they pay customers a small percentage on their deposits, then buy long-term debt instruments that pay a higher percentage than they pay out and pocket the difference.
All is well and good until interest rates start to rise. Locked into longer-term debt whose interest rate is fixed, when rates rise, the face value of that debt falls.
It works like this. Suppose a bank pays you 2% on your savings accounts. To cover that payment, they might buy a five-year bond (which is basically an IOU) paying 4%. Remember, the longer the term of the loan, the higher interest it pays.
When rates rise (forced up by the FED as they are doing now), the bond the banks bought, which pays them 4%, then falls in value. This is because if rates rise, a new five-year bond might now be paying 6%.
The problem arises when customers start withdrawing money in economic downturns to pay bills. In the case of all the recent bank failures, and the cause of most bank failures in general, customers increase their withdrawals as the economy slows. Since the bank is only required to keep a fraction of the deposits on hand and invest the rest, the bank soon runs out of cash, and now has to sell those 5-year bonds (paying 4%) to raise cash to meet withdrawals. But who would buy a bond paying 4% when the new ones, because of rising rates, pay 6%?
No one.
So the bank has to discount the face value of the bond to entice buyers of their bonds that only pay 4% in the current 6% environment.
So if the bank bought a $1,000 bond way back when paying 4%, they have to sell the bond for less than $1,000 to compensate the buyer of that bond for the lower 4% interest rate since new bonds pay 6%.
Bingo, the bank starts taking losses having to sell its bonds for less than what it bought them for.
The more withdrawals that occur, the more bonds have to be sold. The losses mount, until such a point that the losses break the bank. Known as the old fashion “bank run”, the bank runs out of cash and then suffers horrible losses on the sale of its bonds. The bank may eventually close its doors and short-pay its customers or wait for a bailout.
In a nutshell, the increase in rates by the FED dooms the banks to losses if customers start massive withdrawals over and beyond what cash the banks keep on hand.
The FEDs aren’t dummies. They know how this mechanism works. But having to quell the inflation they caused by printing up insane amounts of money during the last few decades, they must now raise rates.
This may cause banks to take massive losses on their bond portfolios as nervous Americans run to withdraw their life savings. And round and round we go.
As I said, one problem begets a solution which in turn can cause another problem.
The real problem, in this analyst’s opinion, is the FED itself. Raising rates to address inflation now opens up a whole new can of worms.
“Watching the markets so you don’t have to”
(As mentioned please use the below disclaimer exactly) THANKS (Regulations)
This article expresses the opinion of Marc Cuniberti and is not meant as investment advice, or a recommendation to buy or sell any securities, nor represents the opinion of any bank, investment firm or RIA, nor this media outlet, its staff, members or underwriters. Mr. Cuniberti holds a B.A. in Economics with honors, 1979, and California Insurance License #0L34249. (530)559-1214. He was voted best financial advisor in the county 2021.
