Is the Fed Secretly Bailing Out a Major Bank?

The promise of something for nothing is always an enticing proposition.  Who doesn’t want roses without thorns, rainbows without rain, and salvation without repentance?  So, too, who doesn’t want a few extra basis points of yield above the 10-year Treasury note at no added risk?

Thus, smart fellows get after it; pursuing financial innovation with unyielding devotion.  The underlying philosophy, as we understand it, is that if risk is spread thin enough it magically disappears.  In other words, the solution to pollution is dilution.

With this objective, new financial products are fabricated into existence.  The risk free reward of several extra basis points are then packaged up into debt instruments and sold off to pension funds and institutional investors.  The search for yield demands it.

Yet as an economic expansion progresses, especially one that has been extended and distorted with the Fed’s cheap credit, these derived financial securities are polluted with more and more toxic waste.  Spreading the risk ultimately pollutes the entire pool of liquidity.

At this moment in the business cycle, after a lengthy bull market in stocks and bonds, countless manifestations of the greater fool theory have bubbled up to the surface.  Bonds with negative yields epitomize this.  Buyers accept a guaranteed coupon loss with the hopes of scoring capital appreciation as yields fall.  But when yields rise, it’s game over.

Of course, the greater fool theory extends much deeper and wider than negative yielding debt.  It also extends to the polluted world of corporate debt…

Wreckage from the Past

The progression of a credit crisis often starts with an initial shock, which is then followed by a much deeper revelation.  This initial shock also serves as a turning point for banks and financial institutions and their attitudes towards risk.  The promise of something for nothing turns to toxic waste.

Financial innovation always works great until the precise moment it doesn’t.  And, unfortunately, financial innovation has taken its wreckage from the past and applied it to the present.  Here we turn to the Bank for International Settlements (BIS), September 2019 Quarterly Review, for edification:

“Collateralised debt obligations (CDOs) that invested in subprime mortgage-backed securities (MBS) were at the centre of the Great Financial Crisis (GFC).  The issuance of subprime CDOs ceased after the GFC, but other forms of securitisation have grown substantially – in particular, collateralised loan obligations (CLOs).  CLOs invest mainly in leveraged loans, i.e. bank loans to firms that are highly indebted, have high debt service costs relative to earnings and are typically rated below investment grade.

“The leveraged loan market has surged in recent years to roughly $1.4 trillion outstanding, of which about $200 billion is denominated in euros and the rest in US dollars.  This rapid expansion has been accompanied by the securitisation of leveraged loans into CLOs.  As of June 2019, over 50 percent of outstanding leveraged loans in US dollars and about 60 percent of those in euros had been securitised through CLOs.

“The rapid growth of leveraged finance and CLOs has parallels with developments in the US subprime mortgage market and CDOs during the run-up to the GFC […] including some that could give rise to financial distress.  These include the deteriorating credit quality of CLOs’ underlying assets; the opacity of indirect exposures; the high concentration of banks’ direct holdings; and the uncertain resilience of senior tranches, which depend crucially on the correlation of losses among underlying loans.”

What to make of it?

Is the Fed Secretly Bailing Out a Major Bank?

By now you’re well aware of the trouble in the overnight funding market.  We’ve touched on it several times.  In short, sometime between Monday night and Tuesday morning September 16/17 the overnight repurchase agreement (repo) rate hit 10 percent.  Short-term liquidity markets essentially broke.

After several technical glitches, the Fed executed its first repo operation in a decade – $53 billion – to keep the interbank funding market flowing.  Since then, overnight repo operations have become a near daily occurrence.  However, these daily operations have ballooned to the order of over $120 billion and are being maintained indefinitely.

Despite the Fed’s efforts, and the efforts of professional economists to sweep concerns under the rug, something is clearly broken.  Why else would $120 billion in repetitive overnight repo operations be needed to control interest rates?

Could it be, just maybe, the Fed is secretly bailing out a major U.S. or foreign bank, or some other financial institution?  Maybe.  Maybe not.  But this week the New York Fed stated it would not disclose which banks are receiving repo cash for at least two years.  If this was disclosed now, an old fashioned bank run would ensue.

In the meantime, with a little imagination, today’s problems in the repo market could be a warning that CLOs are turning to toxic waste, and, as a result, are developing into the next financial crisis.  While it is still unclear, it is very possible that a bank or financial institution did not have sufficient high quality collateral and were frozen out of private repo markets.  Hence, the dramatic rate spike followed by Fed supplied liquidity.

The takeaway from all this: Don’t be surprised if a large bank goes belly-up with little advanced notice.

On an unrelated note, Deutsche Bank flushed a net loss of 832 million euros – that’s $924 million – down the toilet during the third quarter of 2019.


MN Gordon
for Economic Prism

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4 Responses to Is the Fed Secretly Bailing Out a Major Bank?

  1. John Blake says:

    The Central Banking system is the bank of last resort, one bank may have initiated demand in the REPO market, to which the FED responded positively. Once this door was opened banks need little incentive to follow suit. The FED is now the interbank money market, thereby reducing all bank overnight risk. The FED holding the overnight debt has transferred debt default risk from the market to the FED. An effective risk transfer to bank depositors and taxpayers.

  2. Pingback: Is the Fed Secretly Bailing Out a Major Bank? - Free World Economic Report

  3. Hans says:

    In my view this is just another QE. But why after an economy
    which has experienced a decade of growth?

    A broker analyst recently stated dat the bank sector is in great shape.
    If so, why is the FBR injecting monies into the system again?

    No one knows the mechanics behind this new action by the FBR and
    their explanation [if even offered] remains befuddling.

    One thing for certain, is that anytime the central bank adds liquidity
    to the system, there is an ongoing issue.

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