Ep. 462: New Year's Eve Special

The Fed won’t allow the BTFP to expire on March 11th without first re-inflating the bond market. The banking industry had $684 billion of unrealized losses on the books at the end of Q3. Bank of America alone had $132 billion of unrealized losses on held-to-maturity securities, $107 billion of which were mortgage-backed securities at a yield of 2.12%. At such a low yield, those securities will be underwater unless the Fed Funds rate moves close to the zero bound. Banks typically pull back on credit when a significant amount of unrealized losses are carried on their balance sheets. Banks have not pulled back on credit to the extent they would have if the Fed had not created its Bank Term Funding Program (BTFP) back in March. The BTFP is attractive to qualifying banks as it allows them to borrow while valuing their underwater collateral at par. Further, in recent weeks the BTFP’s borrowing rate has been below Fed Funds (4.83% as of 12/28), which creates a short-term arbitrage opportunity for the banks. Without the BTFP crutch, it is likely that banks would tighten credit. Banks would likely tighten credit in the absence of the BTFP given their concern about the unrealized losses they carry combined with a softening macro economic environment. That is, unless the Fed rapidly reduces interest rates close to the zero bound in order to fully reinflate the bond market. How else will Bank of America and other banks that gorged on debt when the Fed Funds rate was at zero percent ever get their heads above water? I say allow the banks to suffer realized losses, but that is not how the Fed operates. Separate from the Banking unrealized loss issue, the U.S. has the problem of $34 Trillion of Treasury debt, approximately one-third of which is financed short term. Treasury needs to bring the cost of servicing its debt down. Today, the Fed Funds rate is pushing the average cost of servicing the Treasury debt higher. Interest expense will account for approximately 20% of Federal tax receipts in fiscal 2024 - a suffocating amount. Therefore, between Treasury’s debt mountain and the Banking industry’s enormous unrealized loss position, the Fed has sufficient motivation to move interest rates significantly lower in 2024.