Despite the extraordinary actions by the Federal Reserve and FDIC last night, the idea that shareholders and bondholders will be wiped out due to this new policy may not have been such a hot idea.
Why?
Regardless of balance sheets, depositor base, and the assets on hand, the very message that the Fed wanted to send is that we do not care about investors in the equities or bonds of said banks. Let’s face some reality as this is not a FDIC imposed program they are just running cover so as to justify using taxpayer funds to cover unlimited deposits for such poor middle class souls like Oprah, Gavin Newsom, or any of the Hollywood crowd.
The problem they created without thinking through this program is that instead of allowing the natural liquidation of these institutions, they have sent a scare through the markets which means that investing in small or regional financial institutions will not have any backstop financially or legally. The entire United States banking system be it from the fractional reserve consumer side or the investor is build on confidence. Break either side of this unwritten confidence agreement and the banks will fail and confidence in the system shall also.
Another side effect of these actions has not been seen yet, but has been hinted at for several weeks now. The potential for a credit event has been created by the Fed which will further impair the profitability of all financial institutions. What do I define as a credit event? Think this through boys and girls, it’s going to hurt.
What happens when the depositor base loses confidence in Bank A down the street? The depositors, including businesses withdraw and move their money to Bank B. Bank B analyzes their balance sheet and starts to sell some of their loan portfolio because they see a similar overlap to Bank A and does not want to get caught being compared with the problem institution. Then that impacts other banks and so on and so on down it goes.
Of course at first that doesn’t sound dangerous, it sounds like the institutions are “trimming the fat” from their portfolios. However if Bank B liquidates those types of loans at 90 cents on the dollar the next bank at 85 cents, the next bank at 70 cents, etc., it ends with those loans being worthless and stuck on someone’s, usually a lot of someone’s books.
That of course is where credit comes into focus. I’ve personally witnessed (not myself) individuals submit applications for car loans with 10% down and a 859 credit score being offered 8.5% interest rates on a four year loan. That’s absurd. But what happens now? What if individuals with sub 750 credit apply? Does anyone want a marginal consumer loan on their books for a deteriorating asset? No, ,so the cost to issue that note will now be far north of 10, 12, or even 15% on four years if not higher. And that’s just automotive.
Think about the funding needs for a startup business that’s averaging a 3% profit this year after inflation but now has a dramatic increase in daily or monthly funding costs from one of the local banks due to this problem.
Credit is going to seize up because it will be too expensive for individual and small companies to obtain if it is even offered by institutions at all, just like 2008.
This will result in small businesses failing, individuals paring back their purchases and moving money out of small banks and into other instruments, and worse, no new businesses starting up as capital will be cost prohibitive for new operations. The other result is that everyone will begin selling any credit instrument or equity for any institution that looks similar to the banks that failed in the last week.
There is no logical reason to take a risk investing in a small or regional bank, a non-bank institution, online brokerage, or any finance company now that the Fed has told every investor that you can or will be used for any bail-ins as needed.
This is the Cyprus solution on steroids and will eventually lead to a massive market crash.
Good job Jay Powell, you save Oprah’s bank account. But you’ve also instituted a program where investors are now going to liquidate their bond and equity portfolios for the very banks which make this nation grow and prosper. The consequences of last night’s actions will reverberate through the economy for the remainder of this year and the leadership in our nation’s government is so incompetent, this will make 2008 look like a walk in the park.
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