Fed ratchets interest rates 0.25% higher

and a talk about CoCo

Yesterday the Federal Reserve increased the Fed Funds rate by 25 basis points and raised the target range for the rate to 4-3/4 to 5 percent. This was largely in-line with market expectations. The FOMC’s statement reflected the recent turmoil in the regional banking sector.

“The U.S. banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain.”

This was a point of emphasis during the post-decision press conference. Powell addressed this first before anything else and the first questions were about the stability of the banking sector. It appears Powell and Co are not deterred by the collapse of Silvergate, Signature, or SVB. A question that was specific to SVB was asked and Powell was blunt that SVB failed due to poor management practices. A review of the banking system is under way and Powell was loathe to share his opinion on the matter until that review is finished.

The regional banking sector still looks very concerning. While Powell was trying to reassure depositors, Treasury Secretary Yellen was doing her best to rock the boat. Reuters article is found here.

U.S. Treasury Secretary Janet Yellen told lawmakers on Wednesday that she has not considered or discussed "blanket insurance" to U.S. banking deposits without approval by Congress as a way to stem turmoil caused by two major bank failures this month.

But when asked whether insuring all U.S. deposits required congressional approval, Yellen said she was not considering such a move and was reviewing banking risks on a case-by-case basis.

"I have not considered or discussed anything having to do with blanket insurance or guarantees of deposits," she said.

When a bank failure "is deemed to create systemic risk, which I think of as the risk of a contagious bank run...we are likely to invoke the systemic risk exception, which permits the FDIC to protect all depositors, and that would be a case-by-case determination."

I would not be surprised to see more banks go under in this environment. Depositors of all sizes are concerned about the security of their funds. When depositors pull their money out, these banks are hung out to dry. They can’t continue to operate without a strong deposit base to lend from. The Bank Term Funding Program (BTFP) is essentially a backstop for these banks but only for their treasury, MBS, and agency security assets.

The BTFP offers loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions pledging any collateral eligible for purchase by the Federal Reserve Banks in open market operations (see 12 CFR 201.108(b)), such as U.S. Treasuries, U.S. agency securities, and U.S. agency mortgage-backed securities. These assets will be valued at par. The BTFP will be an additional source of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress.

Depositors need to feel safe. If they continue to pull out their money and cause more banks to collapse, the large diversified banks will be buying up their assets for a discount. Something to keep in mind, bank failures are not a recent development. Brent Donnelly shared the following graph on twitter.

So far we’ve lost two banks heavily involved in stable-coin crypto and one bank that loaned money to unprofitable, VC-backed, silicon valley businesses. The more concerning bank failure was Credit Suisse.

Credit Suisse (CS) is a large diversified bank in Switzerland. It would be similar to a JPMorgan or Citibank. Something to keep in mind is that Switzerland never adopted the Euro, which means their banking system never merged with the European banking system. Their central bank (the Swiss National Bank or SNB) continues to have independence from the European Central Bank (ECB). This is important because it means they don’t have to follow the same set of rules that the rest of the European banking sector follows. It also means that the Swiss banks can act as a conduit for European money to buy US equities. In fact, it is well known that the SNB holds over $139B in US equities. Their portfolio is tracked by WhaleWisdom.

When a public company goes bankrupt, there is a formula for how the assets are divided up. Secured creditors are paid first. These would often be banks but could be anyone who has loaned money to the company against the company’s assets. These would be collateral secured loans. The next people to get paid would be the unsecured creditors. These would be the accounts payable suppliers, banks who provide an unsecured line of credit, and bondholders. Finally, the last to be paid would be the stockholders.

When CS went under, there was a certain segment of bondholders who were purposely skipped over in the bankruptcy process and got nothing. These were the contingent-convertible bonds, also known as CoCo bonds or AT1 bonds. These bonds are special. They pay a regular interest payments and are convertible into stock in the company if certain criteria are met. The tricky thing about these CoCo bonds is that they end up becoming perpetual bonds. There is a certain “investor” who has been pushing these kinds of debt instruments in Europe for some time but these bonds have now been exposed as a kind of poison pill instrument.

When UBS bought CS, CS had $17B worth of CoCo bonds on their books. UBS bought CS for $3.2B. This means those CoCo bonds should have converted to stock and those new shareholders could then force the terms of a bailout from the SNB as UBS would not want to purchase CS. If those AT1 bonds were to have converted, this new shareholder group would have been the largest ownership group in UBS as UBS has a market cap of $56.5B. They would have essentially owned 30% of UBS post-merger. No bank is going to merge with another and hand over its ownership in the process. So in steps the Swiss National Bank. From Zerohedge:

We finally have a deal, and what was at first a CHF 1BN acquisition price of Credit Suisse by UBS, which then rose to CHF 2BN, has now cranked up one final time to CHF 3BN (US$3.25 billion), or 0.76 per share, specifically shareholders of Credit Suisse will receive 1 share in UBS for 22.48 shares in Credit Suisse. As part of the deal, the Swiss National Bank is offering a 100 billion-franc liquidity assistance to UBS while the government is granting a 9 billion-franc guarantee for potential losses from assets UBS is taking over, i.e., this is a taxpayer-backed bailout.

More importantly, however, the bank's entire AT1 tranche - some CHF16BN of Additional Tier 1 (AT1) bonds, a $275BN market - will be bailed in and written down to zero, to wit: "FINMA has determined that Credit Suisse’s Additional Tier 1 Capital (deriving from the issuance of Tier 1 Capital Notes) in the aggregate nominal amount of approximately CHF 16 billion will be written off to zero."

If these bonds would have been allowed to convert, UBS would not have purchased Credit Suisse. The SNB would then have been forced to sell much of it’s US equity holdings to raise capital to bailout CS. Instead, the SNB wrote those AT1 bonds down to zero.

This chain of events had an extremely chilling effect on AT1 bonds across Europe and Tom Luongo has picked up on this and laid out what I believe to be the ultimate conclusion.

These AT1 bonds, all $275 billion of them across Europe (okay $258 billion now), were the financial time bombs meant to go off and wipe out the current owners of these banks and transfer them to those who would consolidate power in Europe.

On two major fronts, limited insurance for bank deposits and terminally impaired capital structures for European banks, the Fed just positioned the US to be the recipient of major capital inflows as all of the interest rate and credit risk is transferred back to Europe.

The EU doesn’t have an FDIC to bail out depositors. If wealthy Europeans understand what is happening, that money is going to flee Europe. It will likely come to the US searching for safety.