The Unfolding Banking Crisis: What Happens When the Bailout Ends

In 2008, the financial world was shaken by the collapse of mortgage-backed securities. Today, in 2024, another crisis looms as the United States treasuries take the spotlight. The banking system’s bailout, which has been growing steadily, is set to come to an end in March of this year. This raises a crucial question: What happens to banks, treasuries, the bond market, and the broader financial landscape once this bailout reaches its conclusion? To understand the implications, we need to take a step back to when the era of rampant money printing began in 2020. In this essay, we will delve into the intricacies of this impending crisis, examining how banks, the bond market, and the US treasuries are all intertwined in a complex financial web.

The Prelude: Loose Money and the Banking System

A Walk Down Memory Lane

It’s astounding how swiftly time has flown by; it has been nearly four years since the printing presses started running in 2020. When central banks flood the financial system with liquidity, and interest rates plummet, it triggers a frenzy of economic activity. People rush to spend and invest, creating an environment ripe for speculation, fraud, and the formation of bubbles. Banks are not immune to this fervor; they, too, seek extraordinary returns in this environment.

The Banking Dilemma

In 2020 and 2021, banks found themselves sitting on a mountain of cash, pondering how to best deploy their newfound wealth. The Federal Reserve, led by Chairman Jerome Powell, reassured the markets that interest rates would remain low and that their primary objective was to stabilize the economy and prevent a crash. With such a backdrop, banks made a seemingly rational decision: they loaded up on US Treasuries. After all, if interest rates were expected to stay low, investing in the safest possible asset, US Treasuries, made perfect sense. This allowed them to enjoy a risk-free return.

The Problem with Banks and Treasuries

The Bond Price-Yield Relationship

To comprehend why banks’ heavy investments in US Treasuries are problematic, one must understand the inverse relationship between bond prices and yields. Consider a simple example: if you lend me $100 at a 5% interest rate, I will owe you $105 in a couple of months. However, if interest rates rise to 10% during the same period, and you need to exit the arrangement before I repay you, selling this debt to someone else for $100 would be futile. The buyer would only receive a 5% return, whereas they could earn 10% elsewhere. To entice a buyer, you would have to reduce the price, perhaps to $95, so that the buyer earns a 10% return.

Banks’ Overindulgence in Treasuries

During 2020 and 2021, interest rates remained at historically low levels, with the 10-year Treasury yield barely surpassing 1.5% in 2021. As long as banks held these Treasuries until maturity, they faced no immediate issue. They would recoup the principal along with the interest. However, an unexpected and prolonged bout of inflation sent shockwaves through the financial system. The Federal Reserve responded with a rapid and aggressive series of interest rate hikes, causing the 10-year Treasury yield to soar from 0.5% in August 2020 to a peak of 5% in October 2023. This tenfold increase in interest rates translated into catastrophic losses for banks holding existing bondsUnited States Treasury securities are debt instruments issued by the United States government to finance its spending. Treasury securities come in a variety of forms, including bil... More issued at much lower rates.

The Banking Crisis Unfolds

The March 2023 Eruption

The crisis erupted in March of 2023, initially triggered by the collapse of Silicon Valley Bank. Banks had not anticipated a bank run, as such events were rare. However, the rarity of bank runs stems from the fact that they are often not possible. If individuals believe they can withdraw their funds from a bank at any time, they don’t rush to do so. Bank runs typically occur when people suspect that banks lack the funds to meet withdrawal requests. In such cases, a single withdrawal sparks a chain reaction as others rush to withdraw their funds.

A System-Wide Predicament

The unique challenge in 2023 was that every bank in America found itself in a similar predicament – underwater on their portfolio of assets. This meant that if a bank run occurred anywhere, it would have a domino effect, potentially causing all banks to fold. To avert a catastrophic collapse of the banking system, the Federal Reserve stepped in and established a bailout facility called the Bank Term Funding Program (BTFP).

The Bank Term Funding Program: A Lifeline for Banks

The BTFP was designed to provide additional funding to eligible depository institutions, ostensibly to support American businesses and households. It offered loans of up to one year in length, with banks pledging collateral such as US Treasuries, mortgage-backed securities, or other forms of debt. However, the key feature of the BTFP was that these assets would be valued at par, which meant that banks could sell assets with unrealized losses to the Fed at full price. The only condition was that they had to repurchase these assets from the Fed within a year.

The Indirect Bailout of the Treasury and Bond Markets

The BTFP’s Impact on Treasuries

The BTFP’s significance goes beyond its immediate impact on banks. It indirectly functions as a bailout for the entire Treasury market. To grasp this, consider the scenario of someone selling their house at a loss in 2009, but the government offers to buy it back at the original purchase price, sparing the homeowner from selling at a loss on the open market. The catch is that they must repurchase it in a year.

The Safe-Haven Effect

The United States Treasury is the bedrock of the financial system, considered the risk-free asset. Lenders demand higher yields when extending credit to other entities, as they carry higher risk. If the US government offers a 5% yield, other borrowers must provide even higher returns. An extreme example illustrates this: if the US government paid 20% on its debt, virtually no money would be invested in riskier assets like stocks.

The Ripple Effect on the Bond Market

When banks are forced to sell assets, prices decline, and interest rates rise. If banks had to sell their treasuries at significant losses, it would lead to a fire sale, causing a rapid surge in interest rates. This ripple effect would also impact the broader bond market, exacerbating the situation. In essence, the BTFP acts as a shield, preventing treasuries from being sold on the open market and thus stabilizing prices.

The Future: What Happens When the Bailout Ends?

A Dual Expiration in Sight

As we approach March 2024, two significant facilities are set to conclude their operations: the Bank Term Funding Program (BTFP) and the reverse repurchase facility at the Federal Reserve. While many anticipate an extension of the BTFP, the dynamics suggest otherwise. Banks no longer face the imminent threat of deposit flight, which was the primary catalystA stock catalyst is an engine that will drive your stock either up or down. A catalyst could be news of a new contract, SEC filings, earnings and revenue beats, merger and acquisit... More for the BTFP’s creation.

The Reverse Repo Connection

The reverse repurchase facility, which peaked in April 2023, is also likely to cease its operations around the same time as the BTFP. Money market funds, flush with cash from depositors fleeing banks, had poured funds into the reverse repo facility. However, with rising interest rates and the allure of T-bills paying over 5%, this money is now being redirected to the US government.

The Resolution of Deposit Flight

Money that flows into the US government through T-bills eventually finds its way into bank accounts, reversing the deposit flight that had initially plagued banks. This reversal alleviates the pressure on banks to sell treasuries at reduced prices.

A Changing Landscape

As the BTFP concludes, banks will no longer need to rely on it as a safety net against deposit flight. The banking system will likely see a stabilization of deposits, reducing the urgency for the Fed to extend the BTFP. Similarly, the depletion of the reverse repo facility indicates a normalization of financial conditions, further diminishing the need for extraordinary measures.

In conclusion, the impending conclusion of the Bank Term Funding Program marks a turning point in the financial landscape. What began as a response to a brewing banking crisis evolved into a safeguard for the Treasury and bond markets. As we approach March 2024, the two facilities, the BTFP and the reverse repo facility, are on the verge of concluding their operations. The changing dynamics suggest that the need for extensions is diminishing, as the root causes of deposit flight and funding pressures appear to be resolving themselves. The financial system may be on the path to stability, but vigilance remains crucial as we navigate the intricacies of the post-bailout era.