Money, Get Back

There is plenty of “money” around, the Fed makes sure of that. But what kind of money?

We just saw the Fed swoop in when banks had massive unrealized losses on their bond portfolios to ensure depositors don’t care about those losses. SVB had unrealized losses equal to 100% of their “capital”; the average across the U.S. is about 30%.

Basil III requires Tier 1 Capital of 8.5% plus another 2% of Tier 2 capital for a total of 10.5%. Take a company like Schwab: $517 billion in liabilities, total equity of $66 billion but $30 billion in unrealized losses from their bond portfolio. Schwab before those losses had a capital ratio of $66 billion / $517 billion = 12.7% but only $36 billion / $517 billion = 7%. Even though unrealized, these bond losses are deducted from equity and thus affect capital ratios. Depositors were starting to look under the covers and many financial institutions were under their capital requirements, so the Fed just guaranteed the value of their bonds. I suppose from an accounting perspective Schwab and others will now enter an offset and raise their capital ratios above the requirement. Problem solved.

This problem was created as the solution to the crash in 2008. With the massive leverage in banks, a rise in interest rates in 2007 wiped out the capital in the banking system. Every bank was an SVB or close to it. No matter how much stimulus the government threw at the market it kept going down because the banking system was considered insolvent. Then in March of 2009 the stalwart FASB changed the accounting rules and allowed banks to mark all those bonds back to par. Just look at a chart of the SP500 in early March 2009. Checkmark. The market never looked back.

How You Invest Matters

FASB looked the other way even though they knew better. Should an entity that borrows money to buy a bond be allowed to just mark that bond at par no matter what? This question gets into the difference between capital and credit.

Let’s say I borrow money from a bank and buy a $10,000 treasury bond at par with it. Interest rates rise so when I look at my broker account statement it says the bond is now marked at 98 and it is valued only at $9,000. No matter, I say, when the bond matures I will still get my $10,000.

But then the bank calls my loan and want their $10,000 back. When I am forced to sell the bond, I only have $9,000.

The problem is I bought the bond with credit and not capital. Same thing with banks. When their deposits go down (credit) they would have to sell their bonds to generate liquidity to pay their depositors, but they wouldn’t have enough to pay them with their bonds only trading at 98. That’s why the Fed put in the facility to guarantee bond portfolios, so depositors wouldn’t run to the bank and force banks to sell their bonds at losses.

“Money” comes in two forms, credit, and capital. Credit money has claims against it while capital does not. If I buy a bond with capital, nothing can force me to sell it. If I buy a bond with credit, no matter how safe the principal is, I can be forced to sell it and take a loss.

Capital is finite but grows with GDP. But if you look at the charts above you will realize that both the private and public sectors (through the Fed) have levered actual capital more than ever before. When the Fed guarantees banks’ bonds that “money” has claims against it and is inflationary.

The last thing the government wants is deflation, so they always err by avoiding it with inflation. Never mind it is an insidious tax on every citizen in the U.S. At least the rich will be okay, and the stock market won’t crash. But the more they avoid deflation, the more brutal it will be when it does happen.

Risk to the system is high. Corporations and consumers have levered a great deal since 2008 while banks may have moderated a bit.

About the author

John Succo is a finance expert with extensive experience in the derivatives market. He worked at Morgan Stanley and Paine Webber before joining Lehman Brothers in 1996. He then joined Alpha Investments before co-founding Vicis Capital, a hedge fund that became one of the world’s largest in its niche. He now teaches Capital Markets at Indiana University and partners in SS Financial, managing private companies in a variety of industries.

Disclaimer: The information contained in this article is for informational purposes only and should not be considered as investment advice. The information presented in this article should not be interpreted as a recommendation to buy, sell or hold any security or investment. Before making any investment decisions, it is important to do your own research and seek advice from a qualified professional. Investing in securities and other financial instruments carries a high level of risk and may not be suitable for all investors.