The Federal Reserve is starting to break stuff in its quest to tame inflation.  For example, real estate prices are teetering between stagnation and decline.  Segments of the labor market, particularly big tech, are cutting costs and increasing layoffs.

And perhaps most striking, three large banks failed this month.  Some key statistics show just how unusual the breakage was:

• Silicon Valley Bank (SVB) was the 18th largest bank in the U.S. and the 2nd largest bank failure ever.
• Signature Bank was the 36th largest bank in the U.S. and the 3rd largest failure ever.
• Silvergate Bank had nearly $12 billion in assets, placing it outside the ranks of the top hundred U.S. banks, but it was more than big enough to stoke anxieties.

The causes of these bank failures are all slightly different.  But one common thread seems to be large holdings of anemic-yielding “safe” Treasury bonds and securities that lost billions in value as the Fed raised interest rates and bond prices declined.  For example, long-dated Treasuries represented 55% of SVB’s assets.

Another common thread seems to be heavy concentrations of deposits and lending in the relatively risky areas of the tech sector and crypto companies like the failed FTX.  The money sloshing around in the tech sector for so many years due to historic, rock-bottom interest rates started to dry up with rising interest rates.  This spurred increased withdrawals from cash-strapped tech firms, which ballooned into panic withdrawals as rumors spread about each bank’s health.

Many have been quick to point out that this is not the start of another 2008-style financial crisis for various plausible reasons.  Nonetheless, flocks of regional banks suffered steep stock price declines in one day on March 13 as the fear of contagion spread including:

• First Republic – down 62%
• PacWest Bancorp – down 45%
• Western Alliance Bancorp – down 47%
• Zions Bancorporation – down 26%
• KeyCorp – down 27%.

The SPDR exchange-traded fund (ETF) for a large basket of regional banks (KRE) was down nearly 29% over the last two weeks and has yet to recover as I write this.  I don’t know the stories behind all of these banks, but it seems like the basic math of rising interest rates driving bond losses will continue to “stress test” many regional banks.  And bank borrowing at the Fed’s Discount Window went from $5 billion last Wednesday to $153 billion, the highest level on record.  It seems extremely premature for anyone to sound the all-clear.

Interestingly, higher capital requirements for “mid-sized” banks, like SVB and Signature, from the Dodd-Frank law of 2010 were rolled back in 2018 on a bipartisan basis and signed by Trump in 2018.  Some pro-bank observers claim the specific capital requirements and stress testing levels in question, if they still existed, wouldn’t have stopped the SVB collapse.¹  Many anti-bank observers actually agree.  They point instead to a multi-decade trajectory of increasingly lax and chummy bank regulation by the Fed and Congress.  For example, SVB CEO, Gregory Becker was on the board of the San Francisco Fed up until the day that his bank collapsed.  In this case, the regulator was the bad actor, all in one.

In retrospect, it seems stunningly obvious that rising interest rates would hurt banks with huge bond portfolios.  And yet, I’ve only seen one prediction of this particular breakage, which was in October 2022 by Douglas Diamond, who won the Nobel prize for his work on bank runs.  The recently failed banks clearly made inadequate preparations for the predictable losses, except for selling personal stock holdings and handing out last-minute bonuses.  Similarly, the Fed or Treasury could have evaluated the effect of higher interest rates on the banks they ostensibly regulate, but they failed to do so.

More Pain On The Way

And the Fed seems to have no intention of ending interest rate hikes soon.  The head of the Federal Reserve, Jerome Powell, said less than two weeks ago in Senate hearings that the Fed’s goal is, for all practical purposes, a recession of unknown length and duration.  Specifically, note these two phrases, when put side by side:

“…we understand that our actions affect communities, families, and businesses across the country…the process of getting inflation back down to 2 percent has a long way to go and is likely to be bumpy.“

I’m sure the Fed desires a level of “affect” and “bumpiness” that falls short of an outright recession.  But at the same time, Powell pointed out, “Our monetary policy tools are famously powerful, but blunt.”  Taken altogether, this sure sounds like a recipe for more economic breakage.

The Fed is trying to drive inflation back down to around 2% because high inflation is harmful in many ways.  And although there have been signs of “disinflation”, as the Fed likes to call it, recent decreases in the inflation rate have been gradual and erratic.

A week after Powell’s senate testimony the most recent month of inflation data were reported.  Here’s a graph showing the monthly changes in the Consumer Price Index (CPI) back through 2021.  (I tend to focus on monthly change data for reasons explained in an earlier post.)

And given that the Fed tends to pay more attention to Core CPI, which excludes volatile food and energy prices, here’s the same graph for Core CPI.

Core inflation in particular seems to be receding only slowly.

My typical post would focus on how the Fed’s actions and the economy’s reactions could erode the returns of various asset classes.  For example, higher interest rates make borrowing more expensive for companies, which can cut into earnings, which in turn can cause stock prices and dividend payments to stagnate or drop.  And lower consumption during recessions also tends to hurt stock values.  Similarly, more interest rate increases will continue to cause bond prices to slump, at least in the near term.

So, individual investors like us are likely to feel some more pain in the form of short-term losses or reduced long-term returns.  But assuming you follow the tenants of mindful investing, particularly the idea of buying and holding for the long-term, history suggests that you have little to fear from economic gyrations when it comes to meeting long-term investing goals like retirement.  For example, buying an S&P 500 fund in 2008 right before the Great Financial Crisis, and holding it until today would have garnered an 8.8% annualized return, which is just a bit lower than the historical long-term average return for U.S. stocks.

Folks Are Feeling The Pain

But instead, I find myself focused on who will experience the worst of the Fed’s purposeful pain.  And by extension, what kind of economy is encouraged by these entirely logical-sounding and conventional actions to combat inflation?

For example, in the recent Senate hearings, a few senators expressed concern that more interest rate hikes and a coming recession will spur layoffs among their constituents.  But so far, the job market has stayed amazingly resilient to both inflation and the Fed’s actions, although things could still sour pretty quickly.

I’m more interested in the quality of jobs as opposed to incremental changes in job numbers.  When I started this blog more than five years ago, I noted in a post about “optimism” that the only troubling metric of the U.S. economy was the slow pace of inflation-adjusted wage increases.  Here’s a more recent graph of inflation-adjusted (real) median household income from the U.S. Census Bureau.

Real income declined from 2000 through 2014 and didn’t regain its 2000 high until 2015.  For 16 years, most of us have seen a decline in our ability to buy goods and services.  Real wages made headway again from 2016 to 2020.  But then COVID struck causing a new downward tick in 2020 that persisted into 2021.  And looking forward, real median income tends to fall during recessions, whether they’re caused by the Fed or not.

They don’t like to say it this way, but the Fed wants real wages to stagnate because rising wages are often passed on to the consumer as higher prices (inflation).  But why should workers get pay increases above the rate of inflation?  Mainly because, in general, workers have become more productive over time.  Per capita, they are contributing more to Gross Domestic Product (GDP), so it makes sense, at least to me, they should get more compensation for that productivity.  Here’s a graph of real per capita GDP.

You’ll notice that, unlike real income, real per capita GDP has increased steadily between 2000 and 2020.

We can home in on this issue more closely with this graph from the Economic Policy Institute that compares productivity growth to hourly compensation growth.

I’m no economist, and I don’t even play one on TV, but it seems like the Fed’s continued interest rate hikes will further erode quality-of-life for most Americans.

One key to a good quality of life is the availability and affordability of housing.  And the single largest item in most household budgets is rent or mortgage payments.  Here’s a graph comparing nominal income and rent increases since 1985 from The Real Estate Witch.

Put another way, the median annual rent represented only 9% of the median annual income in 1985, but in 2020, rent is now 17% of income.  Collectively, we’re spending nearly twice as much of our pay on housing than we used to, which leaves less for every other expense.

And if you try to buy a house instead of rent, you’ll find that rising interest rates have caused previously expensive mortgage payments to become prohibitive.  Here’s a graph of average mortgage payments from the Fed.

Who Is Sharing The Pain?

Jerome Powell clearly stated that “communities and families” would feel some pain.  So, it shouldn’t be surprising that everyday folks will experience poor investment returns (if they can afford to invest), stagnating wages, and expensive housing.  But who else is sharing the pain?

Corporations – How about those “businesses” that Powell also talked about?  Their profits have been booming since 2020 as this FRED data graph shows.

And analysts are expecting this trend to continue as this graph of corporate earnings from Sam Ro at Tker shows.

And corporation executives seem to be avoiding the pain too, as this graph of the CEO-to-worker pay ratio from the Economic Policy Institute shows.  “Realized” compensation includes those hidden perks like stock awards and stock options.

This graph ends in 2021, but SHRM notes that for 2022 as well as projections for 2023, executive salary increases are “above historical levels”.

So, it’s easy to claim that rising interest rates will hurt companies because borrowing for operations and expansion is more expensive.  But there’s little evidence so far of serious damage to corporate America’s bottom line.

Bankers – The one type of corporation that typically benefits from higher interest rates is the banking sector.  So, they’re probably not going to feel much pain either.

Many have made a big deal of how the banking executives at SVB and Signature have “lost their jobs” and “ruined their reputations and careers”.  But that seems implausible to me.

Just yesterday, I was watching CNBC and they had a current finance industry guest who somewhat proudly declared himself a “Lehman alum”, which presumably gave him insight into the current crisis.  (Lehman Brothers went bankrupt in 2008, pretty much starting the Great Financial Crisis.)  I do not doubt that most of the Lehman alums were able to find new jobs in the finance industry.  For example, the former Lehman CEO, Dick Fuld now runs Matrix Private Capital, which offers investment advice to “high-net-worth” clients.  He ran Lehman for 14 years before the bank collapsed and was paid about half a billion dollars over the last eight years of that period.  Besides his nifty new job, I’m sure he still has a few pennies lying around from the old days.

And today, the CEO of SVB, Gregory Becker, seems to be doing just fine hiding out at his $3.1M beachfront home in Hawaii.  Along with his “normal” compensation of $10M in 2022 alone, he sold $30M in stock over the last two years and another $3.5M just two weeks before the collapse.  There’s been some noise about the government trying to “claw back” those recent stock gains, but I’ll be surprised if that ever actually happens.

Depositors and Savers – One bright spot for average folks is that higher interest rates mean higher yield on short-term money like cash and certificates of deposit.  But you have to go find those deals, because the average yield on a savings account is still only 0.23%, despite 2-Year Treasury Bonds currently yielding 3.9%.  (That’s one way that banks make more money from higher interest rates.)

This brings me to depositors at banks like SVB and Signature.  It would be wrong to assume that most depositors at these banks were average folks.  On the contrary, more than 90% of the deposits at SVB were so-called “hot money”, meaning the account deposits exceeded the $250,000 maximum that is insured by the FDIC.  These depositors weren’t people, they were mostly tech-related and venture capital firms with deposits on the order of $100M, $200M, or even $500M.  Similarly, Signature Bank had a lot of hot money from crypto-related firms, although I couldn’t find an estimate of how much.

The original FDIC plan for protecting these big depositors was to provide 50% of their cash almost immediately, and the rest soon after, with a small possibility of partial losses.  But Jerome Powell and Janet Yellen (a former Fed Chair) forced a complete and immediate bailout of all depositors.

Several European bankers publically expressed their dismay with the U.S. government’s response, calling it “a joke”, “total and utter incompetence”, and more specifically:

• At the end of the day, this is a bailout paid by the ordinary people, and it’s a bailout of the rich venture capitalists, which is really wrong.” 

Biden has claimed that the bailout was not paid by taxpayers, because the money will come from the Deposit Insurance Fund, which the banks pay into.  But this is like saying the water coming out of your faucet didn’t originally come from rain.  The banks get their money from and pass on their operating expenses to people and businesses, some of whom are indeed ordinary taxpayers.

Conclusions

I generally try to avoid political overtones in this blog.  So, this post may seem out of character.  I will confess to being “political” here, but in my defense, I don’t think I’m being particularly partisan.  It’s troubling to see the almost complete bipartisan nature of the now defacto economic standard, where ordinary folks feel the pain and big corporations reap the benefits.  Republicans and Democrats alike seem to mostly defend and support the Fed’s inflation-fighting methods, while supporting continued deregulation and lax oversight.

I guess you could say that this puts me in the “extreme” camp of left-wing wackos and socialists.  But as a former small business owner and investor, I consider myself pretty capitalist.  Whatever happened to the idea of a free market with a level and fair playing field enforced by the government?

John Kennedy, a highly conservative member of the Senate banking committee, recently gave a speech with some interesting points about the SVB fiasco including:

• When I ran for this office in 2016, I observed at that time that . . . we had too many undeserving people at the top in America getting bailouts, and we had too many undeserving people at the bottom getting handouts. And the rest of America—most of America in the middle—was getting the bill, and I didn’t think that was fair.
• This was a bailout. [He cites some of the same reasons I have for why this was a bailout.]
• This whole debacle could have been avoided if the regulators had just done their job and stepped in.
• Where were the regulators?

If this is the conservative position, then I’m on board.²  But instead of asking where are the regulators, I would ask:

• Where is the bipartisan support for policies that help the middle of America that Senator Kennedy is so concerned about?
• Where is the bipartisan support for a reasonable level of financial regulation and competent oversight?

As hard as I look, I can’t find either one.

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1 – However, it’s hard to see how those regulations would have made things worse.

2 – I’m only using Senator Kennedy as an example.  I think there are plenty of folks on both sides of the aisle that say these sorts of things, but they collectively can’t seem to pass any legislation that improves the situation.