Month: May 2023

Authored by Mohamed El-Erian, op-ed via Bloomberg,

Lots will be written on the rise and fall of First Republic Bank. Its customer service was legendary in the banking system, as was its list of rich clients with ample deposits and a healthy appetite for issuing jumbo mortgages to highly creditworthy borrowers. Yet it went from being admired to being seized by regulators and sold to another bank.

Another California bank failure for Mary Daly’s @sffed which is more concerned about DEI, colorful flags, virtue signaling and climate change than, you know, actually supervising insolvent banks

— zerohedge (@zerohedge) May 1, 2023

What emerged on Monday morning was far from perfect, despite weeks of discussions and posturing. What we have are US government institutions caught up in the policy implications of a “second best” world  — that is, the repeated inability to come up with an optimal solution. What’s emerged will come with collateral damage and unintended consequences.

First Republic found itself in a similar situation to Silicon Valley Bank, which was shut down by regulators in March. Its failure to manage an interest rate mismatch on its balance sheet ultimately crippled it as deposits flew out the door in response to the earlier bank failures. Its vulnerability was amplified by the Federal Reserve’s initial mischaracterization of inflation as transitory, the failure to take timely measures, and the inevitably highly concentrated set of hikes that followed.

The inevitable assessments of First Republic’s failure are also likely to point to significant lapses in bank supervision and regulation — the type of failures that were detailed last Friday in a  report by the Fed that, refreshingly and encouragingly, saw the central bank finally take ownership of a mistake and seek to learn from it. Unlike other major central banks, it had repeatedly failed to do so when it comes to monetary policy.

First Republic became increasingly fragile as the contraction in deposits worsened funding costs, deepened a capital hole, and plummeted its stock price by around 95%. That was the bad news. The good news was that, at least on paper, there was a constructive alignment of incentives among the main actors in the bank resolution process.

Having already lost three institutions, the banking system as a whole desperately needed an orderly resolution for First Republic that minimized the risk of further disruptions.

This was not just the case for regional and community banks where the risks of flighty deposits and duration mismatches were under a bright spotlight. It was also the case for the 11  larger banks as they had injected tens of billions of deposits into First Republic in an earlier attempt to stabilize the situation.

It was also the case for regulators, especially the Federal Deposit Insurance Corp. and the Fed. The  FDIC wanted to avoid being on the hook for financial losses and having to dispose of yet another bank’s assets and liabilities; and the Fed did not want to trigger yet again the “systemic risk” clause to allow for an extension of deposit insurance to theoretically uninsured deposits. The Fed was also keen to keep the door open for the policy “separation principle” that has interest rate policy aimed at inflation reduction and other tools used for financial stability.

Despite this alignment, it took weeks for a solution to emerge. And when it did, it involved unfavorable spillovers, as well as having one of the nation’s biggest and most dominant bank – JPMorgan – becoming even more so. With this comes the further evolution of  the largest financial institutions from major sources of systemic risk to stabilizers of the system itself. Moreover, and also departing from the previous conventional wisdom, the bigger and more diversified banks are now being considered “safer” than the narrow banks which have either no or a very limited range of capital market activities that have traditionally been viewed as a source of financial stability risk.

The solution that emerged early Monday morning  deals with the immediate threat of a disorderly failure of First Republic and, therefore, does not fuel the already uncomfortable risk of possible additional disruptions to other regional and community banks.

Yet the potential collateral damage and the unintended consequences are far from immaterial.

Four stand out in particular.

• First, the US now has a more concentrated banking system, with what was once viewed not so long ago as  “too big to fail”/”too big to manage” banks becoming larger.

• Second, there is even greater doubt about the nature of the de facto deposit insurance system in place.

• Third, the compositional risk within the banking system of less credit extending into the economy will continue, potentially aggravating the headwinds to high and inclusive growth.

• Finally, the total cost of First Republic’s resolution remains to be assessed, including how the burden be shared among the public and private sectors and, with that, the extent of the “bailout” for the 11 banks that had large deposits with First Republic.

The US economy continues to suffer from too many years of easy money, and the subsequent mishandling of the rate hiking cycle and lapses in supervision and regulation. With that comes the ever-present risk of collateral damage and unintended consequences given that first best policy responses are no longer available.

Mounting evidence shows consumers are dialing back their fast-food spending as they grapple with two years of negative real wages, maxed-out credit cards, and depleted personal savings. Last week, McDonald’s CEO noted that customers were starting to resist higher burger prices. Now, Chipotle Mexican Grill and Domino’s Pizza have reported that consumers are ditching delivery services due to high fees, opting instead for carryout to save on costs, as reported by Bloomberg. 

Chipotle said delivery sales declined for the first quarter, while similar trends were reported at Domino’s. Chief Financial Officer Sandeep Reddy of the pizza restaurant chain with thousands of stores nationwide told analysts last week that carryout was “strong,” but “the delivery business remains more pressured.”

Restaurant data provider Black Box Intelligence said delivery sales across all the eateries it tracks only advanced 2.1% in the first quarter from a year ago. This is the fourth consecutive quarter of slowing growth. Consumers are starting to notice higher food costs plus delivery fees, in addition to tips, have made delivery too expensive. As a recession looms, consumers retreat: 

“Many consumers have begun to watch their spending more closely,” Victor Fernandez, Black Box’s vice president of insights, told Bloomberg via email. 

Meanwhile, “Growth cooled as in-person visits to some eateries picked up compared to the first quarter of last year, when the omicron wave of Covid-19 kept people at home,” Bloomberg Intelligence analyst Michael Halen said. Domino’s Reddy said lower-income households are quickly moving away from ordering out to cooking at home. 

Chipotle Chief Financial Officer Jack Hartung noted delivery is a “premium experience that comes at a premium cost.” As consumers come under financial pressure, ordering delivery will be some of the first services to cut. 

Also, McDonald’s recently said consumers resist higher burger prices and are less likely to add extras to their orders. 

All of this is more evidence consumers who frequent fast-food restaurants are pulling back on spending as economic storm clouds gather. 

 

Authored by Daniel Lacalle,

The Federal Reserve’s balance sheet reached its all-time high in May 2022.

Since then, it was supposed to drop at a steady pace and shed three trillion US dollars by 2024.

The normalization of monetary policy was built on the idea of a soft landing for the economy. However, the Fed may be killing the private sector to save the government.

Curbing inflation requires a significant reduction in the money supply and aggregate demand. However, if government deficit spending is left untouched, the entire burden of normalizing monetary policy will fall on families and businesses.

The current situation is the worst possible.

The Fed’s balance sheet is not falling as fast as it should; government spending has not even been scratched, but the money supply is falling at the fastest pace since the 1930s, and rate hikes are hurting the productive economy while the government seems unaware of the need to reduce its bloated budget.

The first-quarter GDP figure is extremely concerning.

Government spending showed yet another big rise at +4.7%, much higher than expected. However, consumption, at +3.7% annualized, was well below estimates and driven by a worrying new record in credit card debt.

Even more concerning, gross private domestic investment fell by a massive 12.5%.

There is robust evidence of a negative trend in the real economy.

Rising federal expenditure, more bureaucracy, higher taxes, and weaker activity in the part of the economy that drives growth and jobs

Rate hikes have two direct negative effects on the economy if the government does not reduce its deficit spending spree. They mean higher taxes and a massive crowding out of available credit. The government deficit is always going to be financed, even if it is at higher rates, but this also means less credit for businesses and families. The crowding-out effect of the public sector over the productive economy means lower productivity growth, weaker investment, and declining real wages as the government keeps inflation above target by spending additional units of newly created currency, but the productive sectors find it harder and more expensive to find credit. Additionally, the government borrows at a much lower cost than even the most efficient and profitable businesses.

It is impossible to achieve a soft landing for the economy when the Federal Reserve ignores the signals of the banking system and the real economy. The first pillar of a true soft landing must be to preserve the real disposable income of workers and the job creation and investment capabilities of businesses.

When the government continues to increase spending, there is no signal of the mildest budgetary control, and the entire “landing” comes from the private sector, what we get is upside-down economics.

The Federal Reserve has stopped paying attention to monetary aggregates just as the money supply is contracting at an almost historic pace. Even worse, the money supply is contracting but federal deficit spending is untouched, and the debt ceiling was raised again.

The money supply is collapsing due to the inevitable credit crunch and the difficulties faced by consumers and businesses.

It is impossible to grow with rising taxes, persistent inflation—a tax in itself—and carrying the entire burden of the normalization of monetary policy.

Fighting inflation without cutting government spending is like reducing weight without eliminating fattening foods.

Heading into the weekend, US regulators were facing a dilemma over the fate of First Republic Bank: either let the insolvent California bank fail and bail-in some (or all) of the $30 billion in uninsured rescue deposits given to the bank by a consortium of banks including JPMorgan, BofA, Goldman and others so as not to appear like the Biden admin is bailing-out big, bad banks again a la 2008, but in the process restarting the bank run panic as an impairment of all bank depositors would reverse Janet Yellen’s vow not to do just that in the aftermath of the SVB collapse, or bail out FRC including all of its depositors, both retail and institutional, insured and uninsured, and spark a fresh political crisis where republicans accuse democrats of rescuing Jamie Dimon and his banker pals.

In the end, early on Monday morning, the US unveiled a hybrid solution – after all other attempts at a private rescue effort failed – one where the FDIC would seize the insolvent First Republic, the 14th largest US bank by assets, making it the second biggest bank failure in US history, and immediately sell the bulk of its assets and all of its deposits to JPMorgan after a sham but “highly competitive bidding process” had taken place over the weekend (one in which virtually nobody wanted to participate as nobody would buy FRC without explicit government backstops, which in the end is precisely what they ended up getting on FRC’s IO and CRE loan portfolio) while keeping FRC’s toxic Interest-only mortgages to Hamptons’ billionaires.

According to the FDIC announcement, JPMorgan would assume all of First Republic’s $92 billion in deposits — insured and uninsured, including the $5 billion in deposits gived by JPM to First Republic on March 16. It is also buying most of the bank’s assets, including about $173 billion in loans and $30 billion in securities.

As part of the agreement, the Federal Deposit Insurance Corp. will share losses with JPMorgan on First Republic’s loans. The agency estimated that its insurance fund would take a hit of $13 billion in the deal, which is precisely the hole that prevented a private sector solution from being reached. JPMorgan also said it would receive $50 billion in financing from the FDIC to consummate the deal.

More importantly, the FDIC and JPMorgan also entered into a “loss-share transaction on single family, residential and commercial loans it purchased of the former First Republic Bank.”  As part of this transaction, the FDIC as receiver and JPMorgan will share in the losses and potential recoveries on the loans covered by the loss-share agreement. 

The loss-share transaction, the FDIC said, is projected to maximize recoveries on the assets by keeping them in the private sector, and “is also expected to minimize disruptions for loan customers.  In addition, JPMorgan Chase Bank, National Association, will assume all Qualified Financial Contracts.”

The second largest US bank failure in history become a fact after the San Francisco-based First Republic lost $100 billion in deposits in a March run following the collapse of fellow Bay Area lender Silicon Valley Bank, a testament to the catastrophic supervision of the Mary Daly-led San Fran Fed, which was more worried about rainbow flags and DEI than making sure banks in its regions were, you know, solvent. It limped along for weeks after a group of America’s biggest banks came to its rescue with a $30 billion deposit. Those deposits will be repaid after the deal closes, JPMorgan said.

And with the collapse of FRC, three of the four largest-ever U.S. bank failures have occurred in the past two months. First Republic, with some $233 billion in assets at the end of the first quarter, ranks just behind the 2008 collapse of Washington Mutual. Rounding out the top four are Silicon Valley Bank and Signature Bank, a New York-based lender that also failed in March.

Meanwhile, just as we said a month ago when we joked that the regional bank crisis is meant to make JPM even bigger and more systematically important than ever, as it pays just 0.01% on its deposits as it remains the only truly “safe” bank for US depositors, in effect collecting a $90 billion annual subsidy courtesy of its TBTF status…

JPM’s “Too Biggest To Never Fail” subsidy: if it paid 4% on its $2.3 trillion in deposits, it would pay out $90BN per year. Instead it pays nothing to fund its assets thanks to 0.01% deposit rates pic.twitter.com/w7D4oCZ2HN

— zerohedge (@zerohedge) April 25, 2023

… both First Republic and Washington Mutual are now substantially owned by JPMorgan. The nation’s largest bank, it has been known to step in during banking crises. Chief Executive Officer Jamie Dimon was pivotal in earlier efforts to rescue First Republic.

“Our government invited us and others to step up, and we did,” Dimon said Monday.

Following the transaction, First Republic’s 84 branches will reopen as part of JPMorgan Monday during normal business hours, and customers will have full access to their deposits, the FDIC said.

As the WSJ notes, First Republic’s failure seems unlikely to spur another crisis of confidence in the Main Street lenders that serve a large chunk of America’s businesses and consumers. Regional lenders uniformly lost deposits during the first quarter, but the declines were modest compared with First Republic’s $100 billion outflow.

“This is the last stages of that initial panic. First Republic’s problems started as a result of SVB and Signature,” said Steven Kelly, a senior researcher at the Yale Program on Financial Stability. “This isn’t the story of 2008, where one bank went down and investors focused on the next biggest bank, which would wobble.”

Actually, it is, because only now does the solvency crisis courtesy of trillions in commercial real estate on bank books start to manifest itself, as we also warned it will. But it will take a while for that to trickle down to the rest of the population.

As for the immediate cause of First Republic’s collapse, just like in the case of Silicon Valley Bank, was a smartphone-enabled exodus of panicked depositors with big uninsured balances, but the bank’s problems were rooted in a wrong-way bet on interest rates. A focus on America’s coastal elite helped First Republic become one of the most valuable U.S. banking franchises. Big deposits from customers with lots of cash funded low-rate jumbo mortgages to wealthy home buyers in both California and New York. Ultralow interest rates and a pandemic savings boom supercharged the bank’s growth.

When the Fed began raising interest rates last year to cool inflation, customers began demanding higher yields to keep their money at First Republic. Rising rates also dented the value of loans the bank made when rates were near zero.

The chronic problem turned into an acute one in March, when the collapse of Silicon Valley Bank sparked fears about the overlooked risks lurking in the banking system. Investors and customers were especially worried about banks, such as First Republic, that relied heavily on uninsured deposits and had large unrealized losses in their loan and securities portfolios due to rising rates.

“It was a run on the business model,” Kelly said.

First Republic’s badly damaged balance sheet left it with few good options.  In a dismal quarterly-earnings report last week, the bank disclosed the extent of the deposit run and said it had filled the hole on its balance sheet with expensive loans from the Federal Reserve and Federal Home Loan Bank. An untenable future, in which it earned less on its loans than it paid on liabilities, appeared all but certain. The earnings report sent the bank’s stock down nearly 50% in one day. First Republic shares ended the week at $3.51. They closed at $115 on March 8, the day before SVB’s disastrous run. They traded around $1.9 in the premarket following news of the FDIC seizure which effectively wipes out the equity.

AS the WSJ notes, while some employees started jumping ship after SVB’s collapse, many stayed and watched the bank’s stock crater last week and frantically texted friends about how they feared the bank would go under soon. Some said they wished management had provided clearer communication about where the bank was headed.

Business had grown quieter since the banking turmoil started, current and former employees said. First Republic bankers who previously focused on luring in deposits found there was little they could do to reverse the tide when customers started pulling cash. Pay took a hit too: Bankers were compensated in part by how much in customer deposits they brought to the bank.

In a pair of emails late Friday and Saturday morning, CEO Michael Roffler and Executive Chairman Jim Herbert thanked First Republic employees for staying focused during the turmoil.

“Throughout our history and in these past weeks, we have done what we always do—serve our clients, support our communities, and take care of one another,” Roffler wrote. “When we come in next week, we will continue to do the same.”

Hoping that the bank crisis is over now that First Republic has been tucked away, the US Treasury issued a statement on Monday morning after the deal was announced, saying that the US banking system remains sound, resilient, and with the ability “to fulfill its essential function of providing credit to businesses and families.” 

The good news is that we will very soon test just how resilient the banking system is after the full extent of the CRE crisis become evident over the coming year.

By Joanna Marsh of FreightWaves

The California Air Resources Board is poised to take action this week on a proposed regulation that seeks to reduce locomotive emissions in the state by phasing out diesel locomotives and requiring zero-emissions locomotives within a certain time frame.

“In the absence of federal action to address harmful emissions from locomotives, CARB is developing regulatory concepts to reduce criteria pollutants, toxic air contaminants, and greenhouse gas emissions for locomotives in-use,” CARB says on its website. “These concepts are intended to be implemented statewide, and provide an opportunity for the railroads to better address regional pollution and long-standing environmental justice concerns with communities near railyards. The goal of the regulatory concepts is to accelerate immediate adoption of advanced cleaner technologies for all locomotive operations.”

The proposed regulation, which would apply to both passenger and freight rail operations that involve travel to seaports, rail yards and other locations, consists of the following:

• In 2024:

  • Locomotive operators would need to fund a trust account based on how much emissions their locomotives produce and that account would help fund the purchase of cleaner locomotives or the upgrade of existing locomotives.

  • Locomotives with automatic shutoff devices would not be permitted to idle for longer than 30 minutes, except for certain circumstances such as maintaining air brake pressure or providing heat or cooling to the locomotive cab.

  • Locomotives operating in the state would be required to register with CARB and locomotive activity, emission levels and idling data would be reported annually.

• In 2030:

  • Locomotives must be 23 years old or younger in order to be used in California.

  • “All switch, industrial and passenger locomotives with an original engine build date of 2030 or newer would be required to operate in a ZE [zero-emission] configuration — i.e., qualify as either a ZE locomotive or ZE capable locomotive to operate in California.”

• In 2035:

  • “All Class I line haul locomotives with an original engine build date of 2035 and beyond would be required to operate in a ZE configuration — i.e., qualify as either a ZE locomotive or ZE capable locomotive to operate in California.”

CARB estimates that between 2023 and 2050, this regulation statewide would reduce approximately 7,455 tons of particulate matter (PM), 389,630 tons of NOx emissions and 21.9 million metric tons of greenhouse gas emissions. The agency says that would be equivalent to removing all heavy-duty diesel trucks from California’s roads for all of 2030.

CARB projects in 2022, locomotives used in passenger and freight operations emitted more than 640 tons per year of PM2.5 and over 29,800 tons per year of NOx emissions.

Rail industry, environmental advocates differ on rule’s usefulness

This week’s deliberations will be the latest in a debate that has been going on for years on whether to regulate locomotive emissions. This proposed regulation was released in November 2022.

The American Short Line and Regional Railroad Association (ASLRRA) has said the regulation could render a number of short line railroads operating in California to become “financially insolvent.” 

“CARB has dramatically underestimated the cost of the Proposed Rule. While the rule proposes extremely onerous recordkeeping and anti-idling requirements, the spending account provision provides the most severe burden to small businesses,” ASLRRA said in an April 2021 statement to CARB. 

The trade association also said costs for new locomotives that could be compliant range between $5 million and $7 million for each locomotive.

“Combined with necessary infrastructure upgrades needed for things like hydrogen fueling or battery recharging, other regulations from local air districts in some parts of the state mandating additional improvements such as exhaust scrubbers in shop facilities, and new indirect emission source rules, these new regulations would significantly destabilize the state’s short line railroad industry, which already operates on relatively small profit margins,” ASLRRA said. “The result of such a destabilization would be California shippers cut off from rail service, impacting their cost structure and ability to compete effectively in the U.S. and world economies.”

ASLRRA also questioned the legality of the regulation since locomotives — including the ones that travel to California from out of state — participate in interstate commerce. 

Environmental advocate Earthjustice said the regulation would clean up the air in communities situated nearby rail yards.

“There are few places where this dirty diesel locomotive pollution is more saturated than in communities located near railyards. Southern California’s Inland Empire and Los Angeles regions are all too familiar with locomotive pollution,” Earthjustice senior associate attorney Yasmine Agelidis said Wednesday on the group’s website. “Not only do these areas suffer from some of the worst air quality in the country, but of the 18 major railyards in California, at least 10 are situated in this region.”

Agelidis also pointed to an environmental analysis by CARB that determined that trucks and not trains would be the cleaner mode to move cargo in 2023. 

This would be due to the shift toward zero-emissions trucks in California, per CARB regulations. CARB is seeking to accelerate a target requiring zero-emission vehicles in California’s trucking sector to 2036 from 2040. 

CARB’s regulation on locomotive emissions would affect Class I railroads Union Pacific and BNSF. Both railroads have been involved in testing alternatively powered locomotives with state officials.

Via Political Calculations blog,

What month will the National Bureau of Economic Research someday get around to saying marked the beginning of the next recession in the U.S.?

The NBER is notoriously slow in identifying when the business cycle in the U.S. either peaks before going into recession or troughs when coming out of one, often lagging behind these events by many months. That’s because they take a number of data series into consideration and will wait until many go through revisions before determining if the national U.S. economy has truly changed direction from growth to contraction or vice versa according to their model of the economy.

Because they’re so slow, analysts have built models to try to predict the timing of when the country’s business cycle has changed when evidence is building that it has, long before the NBER makes its “official” determination. Some of these models are oriented toward recession forecasting. They have been built to use currently available data to try to anticipate the most likely timing of when the NBER will be likely to say the business cycle changed from boom to bust.

In a sense, they’re using models to predict when the NBER’s business cycle model will someday find the U.S. economy went into recession! That brings us to a recession forecasting model whose results we’ve been featuring since October 2022, when a leading recession indicator first flashed a red warning light.

That model was introduced by Jonathan Wright in a 2006 paper while he worked at the Federal Reserve Board. This model uses just three data series to generate the probability the NBER will identify a month sometime between a date of interest and one year into the future. One of those datapoints is the rolling one-quarter average of the Federal Funds Rate. The other two are the rolling one-quarter averages of the yields of two constant maturity U.S. Treasurys, one for the 10-Year UST note, the other for the 3-Month T-bill.

For this data, the red warning light starts flashing when the yield of the 3-Month Treasury drops below the yield of the 10-Year Treasury. This is a clear signal the U.S. Treasury yield curve has inverted, with short term yields paying higher yields than long-term yields. Historically, yield curve inversions have occurred before the U.S. economy entered into recession. Wright’s innovation was to also take the level of the Federal Funds Rate into account, recognizing that how the Federal Reserve sets it in accordance with its monetary policies affects the likelihood of recession.

As of the close of trading on 27 April 2023, Wright’s recession forecasting model anticipates a 67.0% probability the period between now and the end of April 2024 will contain the month the NBER will someday say marked the beginning of a national recession in the U.S.

The latest update to the Recession Probability Track shows how that probability has evolved since our previous update one month ago.

The chart shows the current probability of a recession being officially determined to have begun between 27 April 2023 and 27 April 2024 is 67.0%. Assuming the Fed follows through on hiking the Federal Funds Rate by another 0.25% next week, the probability of an “official” recession will continue rising. Doing some back-of-the-envelope math using our recession odds reckoning tool, with the 10-Year and 3-Month Treasuries as inverted as they are today, the odds of recession will breach the 70% threshold in about two weeks. Even if the Federal Reserve stops hiking the Federal Funds Rate after its Federal Open Market Committee meets to set its rate next week, the odds of recession will breach the 80% threshold in early July 2023.

Analyst’s Notes

Two members of the NBER’s Business Cycle Dating committee have a new working paper in which they indicate Americans should expect a recession in 2023 and 2024. The role Federal Reserve officials in changing from expansionary to contractionary monetary policies looms large in their assessment.