The Fed’s Ticking Time Bomb Is About To Explode | Joseph Wang & Chris Whalen
What this covers
Use code JACK250 to get $250 off tickets to Blockworks Digital Asset Summit https://blockworks.co/events/digital-asset-summit-2022-new-york/ Use code “guidance” to get 50% off Blockworks Research: https://blockworks.co/get-research/ -- In September, the Federal Reserve is set to remove even more liquidity from markets by taking its Quantitative Tightening (QT) program to the next level. Joseph Wang, former senior trader for the Federal Reserve, and veteran banker Chris Whalen, join Jack to explain how this additional wave of monetary tightening will send shockwaves through markets, particularly the two assets that comprise the Fed’s balance sheet: U.S. Treasuries and agency Mortgage-Backed Securities (MBS). Joseph argues that the U.S. Treasury will likely enact a “buyback” program of its longer-duration securities in order to dampen QT’s volatility, and Whalen contends that if the Federal Reserve sells Mortgage-Backed Securities (as opposed to merely letting them mature), armageddon will ensue.
Filmed on August 17, 2022. -- Read Joseph Wang’s latest piece, “The Marginal Buyer”: https://fedguy.com/the-marginal-buyer/ Follow Chris Whalen on Twitter https://twitter.com/rcwhalen Follow Joseph Wang on Twitter https://twitter.com/FedGuy12 Follow Jack Farley on Twitter https://twitter.com/JackFarley96
Follow Forward Guidance on Twitter https://twitter.com/ForwardGuidance Follow Blockworks on Twitter https://twitter.com/Blockworks_ -- Get top market insights and the latest in crypto news. Subscribe to Blockworks Daily Newsletter: https://blockworks.co/newsletter/ -- Joseph Wang’s work can be found here: https://fedguy.com/ Chris Whalen’s work can be found here: rcwhalen.com --
Timestamps
00:00 Introduction 01:32 The Effect of Quantitative Tightening (QT) On Commercial Banks 21:00 Vulnerabilities in The Treasury Market 25:15 The Conundrum in Mortgage-Backed Securities (MBS) 32:30 The Fed's Banking "Stress Test" 43:43 Swelling Reverse Repo Facility 48:22 The Fed's Giant Mortgage Problem 59:53 How Far Will The Fed Go In Hiking Rates? 1:02:03 Why Is The Fed's Balance Sheet Not Going Down During QT? --
Disclaimer: Nothing discussed on Forward Guidance should be considered as investment advice. Please always do your own research & speak to a financial advisor before thinking about, thinking about putting your money into these crazy markets.
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Quantitative easing and Federal Reserve balance sheet management have created structural distortions in financial markets—particularly in treasuries and mortgage-backed securities—that monetary policy alone cannot resolve and require coordination between fiscal and monetary authorities to prevent market accidents.
- QE bloated bank balance sheets without incentivizing credit creation, instead pushing capital into speculative securities markets that subsequently collapsed
- The Fed's tightening creates immediate liquidity problems (reverse repo surge, treasury volatility) that require Treasury buyback programs to stabilize, revealing the limits of unilateral Fed action
- Low-coupon mortgage securities created by QE will remain on Fed balance sheet for 15+ years due to lack of prepayment incentive, forcing either sales that risk market disruption or indefinite holding
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The Federal Reserve historically tracked down and helped the Roosevelt administration force Americans to surrender physical gold in the early 1930s, demonstrating an authoritarian aspect to the Fed that is inherent to the institution.
“people would forget that the fed helped track down individuals that owned physical gold in the early 30s even before the law was passed that's how much of new dealers that they were they were willing to help the roosevelt administration track down americans and force them to give up their gold just so they could inflate the currency”
QE pushed interest rates down dramatically, which disincentivized credit creation by commercial banks in a paradoxical way, causing that credit creation to shift into the non-bank fintech sector, which subsequently collapsed, creating economic instability.
“i think lending because it it had the effect of pushing interest rates down dramatically so if you look at jp morgan city the big guys right they're making barely three percent gross before administrative costs and funding and everything else on a commercial loan why do they want to do that so i think disincentivized credit creation in a strange way and it pushed it off into the world of fintechs who have now collapsed”
The U.S. banking system is highly concentrated, with the top four banks holding approximately 40% or more of total banking sector assets (approximately 10 trillion of roughly 20+ trillion), making the system dependent on how Jamie Dimon (JP Morgan) runs his operations.
“the us has about like four thousand some commercial banks but it's super concentrated i think the top four g subs have like 40 or more of the entire banking sector's assets so it's it's like jpm and then let's say b of a and citibank wells fargo top four is about 10 trillion yeah so it's about half of it so jamie's three bank america's almost three cities two and wells is under two now”
Treasury bills are special as short-dated securities that money market funds can purchase, so issuing bills in a buyback program would absorb the trillions in reverse repo facility cash that currently has nowhere to deploy.
“bills are special because they're sure dated so they're they're with they mature within a year and they can be purchased by money market funds and right now as we discussed earlier money market funds have a whole bunch of money and know where to put it so they're just depositing it in the rrp so if you issue bills then what will happen is that the money market funds which is buy bills instead of the irp”
As a result of non-prepaying mortgages, the duration of mortgage-backed securities extends significantly beyond original assumptions, leaving the Fed and mortgage investors with perpetually longer-duration exposure than they expected.
“and as a result the duration of the mortgage-backed securities extends oh yeah i mean joe was talking about the federal home loan banks today uh they're actually up in the three and a half percent range yield wise on their paper right now”
When private mortgage market participants held mortgage-backed securities, they would actively hedge their mortgage interest rate exposure by selling Treasuries when rates were rising and buying them when rates were falling, which exacerbated rate volatility, but the Fed's holdings have eliminated this hedging dynamic.
“once upon a time when the private sector held a lot of mortgages they would hedge their mortgage interest rates right there's lots of convexity hedging so what that means usually was you know let's say they would sell a lot of treasuries when uh rates when rates were going higher and then buy treasuries when the rates were going lower so it it exacerbated the volatility of of the rates market”
The Federal Reserve is raising capital requirements (via the counter-cyclical buffer and stress test results) on the largest banks, which is reducing their willingness to lend and causing them to shrink their balance sheets, particularly their risk-weighted assets.
“the fed is essentially forcing jamie diamond to turn down the flow of new assets into the bank that in turn lets the bank shrink okay so what he is forcing down that joe explained very nicely is risk-weighted assets that's the number he focused on in the conference call”
Treasury buyback programs allow the Federal Reserve to maintain a tighter monetary policy without triggering a market accident, by providing a fiscal backstop that prevents liquidity crises from forcing the Fed to cut rates prematurely.
“it allows the fed to be a lot tighter than the market expects because one of the things that might happen if the fed tightens a lot is that you have this accident somewhere in the capital markets... but if you have the treasury there ready to fix this market mechanism market failure uh just by this mechanical failure of not enough liquidity causing some kind of accident then you can keep the fed uh defect and keep tightening maintaining a pretty restrictive monetary policy”
Quantitative easing made commercial banks bigger by giving them short-term reserves at the Federal Reserve, but it did not increase their earnings because banks could not profitably deploy those reserves into long-duration lending like mortgages or commercial loans at the rates available.
“it made them bigger they got a lot of short-term reserves at the fed which is cash but they couldn't do much with it you're not going to go make 30-year mortgages or 10-year commercial loans with it so it made them bigger it pushed down their returns on assets and on equity”
Commercial banks have been asking depositors to withdraw funds from their bank accounts and deposit them into money market funds as a way to shrink their bloated balance sheets caused by QE, which then forces those money market funds to deposit the excess cash into the Federal Reserve's reverse repo facility.
“like jack like you said the fed did all this quantitative easing and it bloated the bank's balance sheet and they didn't like that as chris noted so one of the things they've been doing the commercial banks have been doing the past couple years is actually asking some of their depositors to take money out and deposit it into the money market funds right”
The U.S. bond market is a critical structural advantage for the United States, and if the Federal Reserve interferes with it through QE and monetary experimentation, the country will lose the ability to bounce back quickly from crises like COVID or recessions.
“the u.s bond market is a reason we're different and if we mess with this enough and then we wonder why we don't bounce after a crisis like covet or recession that's why”
The primary beneficiary of quantitative easing was the U.S. Treasury, because the Fed monetized the cost of Treasury issuance by purchasing Treasury bonds and passing the income from the Fed's 2.7 trillion dollar mortgage securities portfolio to the Treasury, effectively subsidizing government spending.
“it's hard to find somebody out there that benefited more than the u.s treasury from quantitative easing... we monetized the cost of the treasury issuance on every bond that the fed bought and then they took the income from 2.7 trillion dollars for the mortgage securities and they gave that to the treasury”
The Federal Reserve and U.S. Treasury are operating with conflicting policy objectives: the Fed is tightening financial conditions through rate hikes and balance sheet runoff, while the Treasury is proposing buyback programs to stabilize the bond market, effectively 'turning on the humidifier while turning on the dehumidifier at the same time.'
“the fed is doing everything it can to tighten financial conditions uh letting this balance sheet uh roll off uh increasing the duration of the market hiking interest rates uh you know to tighten financial conditions and then it's then that causes liquidity problems that causes problems and then there's all these sort of solutions that everyone else proposes where it's like oh well the treasury will help support uh and make and make an easy qt happen but isn't the whole point that it's difficult... it's like the fed is turning on the humidifier and then the treasury's turning on the dehumidifier at the same time”
The Federal Reserve should avoid selling mortgage-backed securities during quantitative tightening because the market has limited appetite and selling would cause significant price declines, but could opportunistically dribble out small amounts (10 billion per month) if rates fall.
“i don't want them to disturb the market anymore than they have already but you know what joe if rates rallied the desk in new york should have standing instructions to sell take advantage of it little bets fives and tens just dribble it back into the market there's nothing wrong with that”
Federal Reserve officials do not know how much balance sheet reduction (quantitative tightening) corresponds to how much change in the federal funds rate, revealing a fundamental gap in their understanding of their own policy transmission mechanisms.
“it's clear from his comments in the minutes and the press conferences that he doesn't know how much of a balance sheet reduction equals how much fed funds he has no idea”
Banks are seeing growth in credit origination, but this growth is primarily offset by loan prepayments and maturities (15-20% annual runoff), so banks must generate double-digit growth just to maintain balance sheet size.
“on our repo book we're not competitive with the banks the banks are 50 basis points inside us because the market has gone up the bank's funding costs haven't gone up so i mean yes you're seeing growth in new loan originations but remember that book is running off 15 20 a year so in order to keep your balance sheets stable you've got to make up for your runoff”
The Fed created a 'ghetto' of low-coupon Treasury and mortgage-backed securities that no one wants to hold because the cost of hedging these securities is 2-3 times higher than hedging on-the-run securities, forcing either buybacks to remove them from the market or indefinite holding.
“they are admitting grudgingly that they made a terrible mistake with quantitative easing because they created this ghetto of low income low coupon securities both treasuries and mortgage securities that no one wants the cost of hedging these securities is two or three times higher than the on the run stuff”
Federal Reserve officials accumulate power through seniority without being fired or facing elections, creating an unelected bureaucracy with enormous control over the economy, reflecting a 'New Deal socialist institution' model that concentrates power without accountability.
“i noticed that the people who make all the decisions at the fed they basically just get there by getting in early and riding it through seniority and they can never be fired and they eventually over time become more senior accumulate all this power so this is not just at the fed but it's at any agency right... these people you never see them they have you don't stand for elections they never get fired but they hold so much power it's a new deal socialist institution that's what it is”
Banks have been expanding their borrowing from Federal Home Loan Banks by approximately 200 billion dollars over the past three months, suggesting increased demand for home loan advances as banks turn to the Fed's lending facilities.
“the banks they're suddenly there seems to be more loan demand they suddenly expanded their their loan borrowing by like 200 billion the past three months so it seems like there's more demand for home loan advances”
The reverse repo market is approximately 3-4 trillion dollars in size, compared to the federal funds market which is only 80-90 billion dollars, meaning the reverse repo market is now the actual mechanism by which the Federal Reserve controls short-term interest rates rather than the federal funds market.
“the federal funds market well it's been taking up a little bit i think it's around 80 90 billion now the repo market oh my gosh it's like three four trillion dollars”
Treasury issuance has shifted from approximately 500 billion dollars per year before COVID to 1.5 trillion dollars per year after COVID, and is projected to remain at approximately 1 trillion dollars per year indefinitely due to ongoing federal deficits.
“from then on it's probably going to be around a trillion forever... Just for context just a couple years ago just uh pre-covet we were issuing about 500 billion a year”
Mortgage origination supply has dropped from trillions of dollars per quarter a year ago to only approximately 500 billion dollars per quarter currently, reducing the supply of new mortgage-backed securities entering the market.
“because we have housing prices declining there's not a new purchase origination and because mortgage rates are still high there's not a lot of refinancing so there's basically it'll be 80 purchase this year not a lot of new supply mortgage supplies so that means the existing stock... a couple years ago we were doing trillions a year this year we'll be lucky to do two okay we were doing trillions of dollars a quarter a year ago so you know there's a lack of collateral out there”
Federal Home Loan Banks are currently offering 3.5% yields on their paper but making no money due to their low-coupon assets and operational costs, and without regulatory intervention to allow them to borrow more from the Fed's home loan advance facility, some will go out of business.
“joe was talking about the federal home loan banks today uh they're actually up in the three and a half percent range yield wise on their paper right now so they're paying three and a half but they're not making any money they're underutilized”
The only entities currently lending in the federal funds market are Federal Home Loan Banks, which are quasi-government entities that do not receive interest on reserves from the Fed, and they lend money to foreign banks who then deposit those reserves at the Fed to earn the interest-on-reserves spread.
“the only people who are actually lending in the fed funds market these days are are the home loan banks and they're they're not commercial banks they're basically this special kind of gse um that actually doesn't receive interest on reserves so they get zero in their fed account and they're desperately trying to earn a little bit of money so they're lending”
Homebuyers and real estate agents are rediscovering the concept of mortgage assumability, which allows new buyers to assume existing mortgages at original low rates, making refinancing unnecessary and preventing prepayment of low-coupon mortgage-backed securities.
“realtors are starting to rediscover the concept of assumability which is they sell a house for somebody that has a you know a three percent loan from the fha and the new buyer of the house can assume the old mortgage that's good so those mortgages may never pre-pay”
The U.S. Treasury market and U.S. mortgage-backed security market are under considerable structural distress and together represent almost the entire Federal Reserve balance sheet (roughly two-thirds treasuries, one-third mortgage-backed securities).
“there are two markets that are under considerable distress and it's very concerning because those markets are some of the biggest markets in the world i'm talking about the us treasury market and the u.s mortgage-backed security market and those two asset classes represent almost the entire federal reserve balance sheet two-thirds roughly as treasuries one-third roughly is mortgage-backed securities”
Basel II regulations in the early 2000s were extraordinarily lenient on complicated collateralized debt obligations, allowing banks to hold much less capital against CDOs rated triple-A, which contributed to the financial crisis.
“basel ii in the early 2000s was extraordinarily lenient on uh complicated collateralized debt obligation structures that you know as long as they were rated triple a they were rated triple a so banks could hold a lot more against them”
Current members of Congress lack the financial expertise and institutional knowledge to effectively question Federal Reserve policy, unlike Congress members from a century ago or past Fed chairs like Paul Volcker and Alan Greenspan who could credibly challenge fiscal policy through technical expertise.
“it's hard to find somebody out there [in Congress] that benefited more than the u.s treasury from quantitative easing and yet we don't have a member of congress who can ask chairman powell about this yes they are a real disappointment i must say the current crop of congressmen think about who we had in congress a hundred years ago who actually understood finance it could barbecue chairman powell but there's nobody to ask him questions now”
The concept of a 'neutral rate' used by the Federal Reserve to justify policy is a made-up economic concept that the Fed is unsure about, and policymakers should use real-world inflationary/deflationary terminology instead of invented economic concepts.
“we shouldn't let them make up their own terminology joseph they should have to use real world terminology and say this is either inflationary or deflationary but don't come up with new ideas with little stars next to them and then tell me you're not sure what it is these are the imaginings of economists”
Federal Reserve forecasting has been systematically terrible, but this doesn't stop the Fed from continuing to make forecasts, and the Fed faces no accountability for poor predictions because Fed officials cannot be fired or removed.
“we know that the fed is terrible at forecasting it doesn't stop us for some reason... all the people who made terrible decisions they're still there contributing their bad judgment so we are probably going to screw up again because the same people are there making the same mistakes”
The Federal Reserve's stress test for large banks modeled a 40% real estate decline and higher high-yield spreads, but these surrogates are outsized because today's mortgage market is 99% government-guaranteed, making private label losses negligible compared to the 2008-2012 period.
“i think they're wrong i think the surrogates they use in their model are outsized you're never going to see those kind of losses in a market which is 99 government guaranteed securities today the the private label market it's a rounding error in today's market”
Banks are forced to raise capital because regulators look back at 2010-2012 (bad years) when banks took losses not just on private mortgage securities but also huge costs in fines and settlements, so they assume a similar crisis could occur despite changed market structure.
“they look back and when they look back they see 2010 2012 which were bad years and banks not only took losses on private securities but they had huge costs fines settlements it was extraordinary so they look at the fed they look at quantitative easing co-vit everything else and they say oh we could have another problem”
Federal Reserve models that use reserve requirements based on a percentage of GDP are overly simplistic and reflect a lack of understanding of financial complexity, but they are used because they are the only concepts the Fed can explain to the public and Congress.
“the thing that bothers me is a lack of sensitivity that they have for what they're doing to the markets they don't seem to mind and then they model things like reserve requirements that you were talking about earlier based on a percentage of gdp this makes no sense at all but that's what they do because it's the only thing they can talk about at the press conference that people would understand”
Operation Twist, executed by the Federal Reserve under Janet Yellen, was a disaster that attempted to manipulate the yield curve by selling short-term treasuries and buying long-term treasuries, and the Treasury is now proposing a similar buyback program using government debt issuance instead of fiscal surplus.
“you're referencing operation twist which correct me if i'm wrong that was the federal reserve's actions not the treasury and then also well they're undoing twist they're making up for their earlier mistake it was a disaster this is janet yellen by the way don't forget she's the author of twist she's the author of twist okay”
In 2008-2009, the primary stress in financial markets was credit risk (defaults on subprime mortgages and complex structured securities), but in the current period, the stress is liquidity risk and interest rate risk, not credit risk.
“in 2008 the real stress was credit risk extremely uncredit worthy borrowers getting capital and then those things being published labyrinthine financial structures this time it's all about not credit risk but liquidity risk and primarily interest rate risk”
Jamie Dimon objected to the Federal Reserve's stress test projections in the second quarter earnings call, arguing that the $40 billion projected loss on mortgages was unrealistic because his bank has 'pristine' jumbo mortgages with negative loss-given-default (meaning the bank cannot lose money even if the loan defaults).
“jamie dimon went off he was very unhappy he i actually wrote a column at national mortgage news just about jamie because he said look you tell me i'm going to lose 40 billion dollars in a stress scenario and most of that was coming from mortgage no jamie has the the most pristine jumbo mortgage book in the industry his loss given default has been negative for years what that means is he can't lose money even if a loan defaults because they're such high quality”
The ideal monetary policy would be for the Federal Reserve to hold interest rates steady at a restrictive level (around 3.5-4%) for an extended period without making changes, allowing the economy to adjust to those rates while letting the balance sheet run off gradually.
“i think powell would like to have a year when they did nothing maybe just let the balance sheet run off next year yeah and don't change fed funds at all that would be wonderful for the interest rate market”
Stocks and bonds have both sold off significantly over the past year, which is unusual, because the main driver is that the Fed's reaction function has changed—when inflation rises the Fed hikes rates, which causes bond prices to fall, and when bonds fall (due to expected rate hikes) stocks also fall because of the tightened financial conditions.
“something really weird has happened in the markets the past year so stocks have sold off and bonds have sold off and a big reason for this is because the fed's reaction function has changed so as uh we had this discussion with alpha a few videos ago and he explained it very well is that when the fed when inflation is rising so the fed is going to be hiking rates uh that means bond prices have to sell off as a bonds price into the price those rate hikes in so that's part of it that's part of the reason why when stocks file now bonds also fall because they know that the fed is going to hike rates because there's inflation”
The TIPS (Treasury Inflation-Protected Securities) portfolio held by the Federal Reserve has grown in face value not because the Fed is buying more TIPS, but because TIPS adjust for inflation monthly, causing the face value to increase automatically with measured inflation.
“if you look at a holdings of fred treasuries you'll notice that after qe it actually gradually grew a little bit now that's not the fed continuing to buy treasuries what that is is tips which are inflation-protected securities appreciating so the fed holds a few hundred billion dollars in tips and tips um every month they are adjusted for inflation so let's say you have a hundred dollars in tips and inflation is 12 then in a month maybe you end up with 101 in face value”
Mortgage-backed securities settlements are delayed up to three months after purchase, so securities purchased during the QE period are still settling on the Fed balance sheet even after QE has ended, creating an accounting illusion that the Fed is still buying.
“when the fed buys mortgage-backed securities it can take delivery of them within three months so some of the mortgage-backed securities you're looking at right now were actually purchased three months ago”
The Fed should implement a licensing system for Federal Reserve officials requiring them to make and publish regular predictions about economic outcomes, with scores tracking their forecasting accuracy to create accountability.
“i think we should license them and they should have to put out regular predictions and we should score them how about that”
Ginnie Mae 2 mortgage-backed securities with 2% coupons were issued in April-May 2020 when 10-year Treasury yields were 50 basis points, were heavily traded then, but are now undesirable because mortgage rates have risen to 3.2% on 2-year mortgages, making the older 2% securities economically unattractive and illiquid.
“they have a coupon meaning they yield two percent and those were issued in let's say april or may of 2020 when the 10 year was at 50 basis points so a two-year percent was a really good deal and those securities were flying back and forth all across from la to new york to l.a to new york to you know to europe everyone's trading them all the time but now that the you know 10-year treasury rate is you know the two-year treasury is two is excuse me 3.2 percent no one wants a two percent coupon”
The Treasury market exhibits poor liquidity and extreme volatility, with the 10-year Treasury yield jumping around 'like a meme stock,' suggesting the potential for a market accident if major disruption occurs.
“you have a lot of charging market that has a very poor liquidity you see the 10 year just you know jumping around almost like a mem stock so you know i it almost looks like the fed is trying to stress just the treasury market”
The Federal Reserve has historically changed monetary policy direction (from tightening to cutting) approximately 7-8 months after stopping rate hikes, demonstrating a pattern of policy reversals that undermine credibility.
“the average duration of months after the federal reserve stops hiking to when it starts cutting again is something like seven or eight months”
If the Federal Reserve issues a Central Bank Digital Currency (CBDC), it will have the ability to track and monitor all transactions and control access to accounts, potentially denying individuals access to their money if the Fed disapproves of their activities.
“they want to have a cbdc oh fed now that's going to happen cbdc not necessarily depends on who's in power but you know that means that they're going to be able to track and see what everyone does and maybe if they don't like you maybe you don't get a count”
The Federal Reserve's regulatory concern is not actually credit risk but market risk (interest rate risk) from the 300 basis point rate movements it has generated, and if regulators were truly worried about market risk, they would push the Fed to reduce the volatility it's creating.
“they're worried really though not about credit risk you said this before jack they're worried about market risk that's at the end of the day what they're worried about if they're worried about market risk they should call jay powell and tell them stop tell them to buy more workers”
Loan growth appears strong in aggregate data but this is primarily a rotation from non-bank financing sources (mortgage REITs, fintechs) back to banks as the bond market volatility peaked, not true new credit creation.
“well it was muted for so long now that the bond market's been a little volatile borrowers are going to go back to the banks that's just the basics right now on our repo book we're not competitive with the banks the banks are 50 basis points inside us because the market has gone up the bank's funding costs haven't”
Small companies lack the ability to manage volatility like Jamie Dimon's JPMorgan can, which has internal transfer systems for half its daily transactions, so when regulators restrict large bank lending, it disproportionately harms the broader economy.
“most companies are small you know there's only a very few large financial institutions in this country be surprised how small they get when you go down the list they can't manage volatility the same way jamie dimon can jamie dimon's run in a small country he can stop doing business with people outside of jp morgan and he'd be just fine i mean seriously half of the transfers every day that jp makes are internal”
The Federal Reserve allowed itself to be politically pushed around during the COVID period when it was part of the massive stimulus effort, causing it to now overcorrect on inflation-fighting to regain credibility, but this credibility loss reflects a loss of institutional independence.
“they allowed themselves to be pushed around politically yeah let's be fair and now they're in a position where they have to try and regain their credibility so you know there's no winning in washington”
Even though aggregate credit card lending is spiking, this is a sign of late-cycle distress as consumers turn to higher-cost borrowing to maintain spending, which is normally associated with economic weakening rather than strength.
“you kind of expect that late cycle but uh joseph can you just explain the ratios and then chris i want to get your view on how that's impacting banks actual activity yeah so i think the big ratios are the leverage ratio and the capital ratio”
The Fed's initial hypothesis that it could manage QT automatically through an 'autopilot' runoff schedule has proven problematic, requiring continuous adjustment based on market conditions, indicating that managing a 9 trillion dollar balance sheet requires constant active management.
“so we're going to get 60 billion in treasuries and 35 billion in mortgages and as you know chris and we'll talk about it later they probably won't get there uh because of the prepayments and so forth but i think they're going to proceed on their current plan and let it run on autopilot starting in september”
The mortgage industry has excessive capacity (one-third to one-half too much) that will persist until weak competitors are forced out of business through natural attrition, and until then mortgage pricing will remain irrational due to desperation.
“we still have a third to a half too much capacity right now we've got to get these people out of the market because they are under pricing mortgages in an attempt to survive and you know we're sympathetic to survival right but you know until we get supply and demand in that market back in the balance”
Deposit rates are not rising as fast as Treasury rates because the Fed's transmission mechanism to deposits is weak, allowing banks to pay depositors only 50-70 basis points while buying Treasuries yielding 3%, creating an arbitrage opportunity for a new banking startup.
“if i deposit money at my bank now i don't know exactly what i'm getting i'm getting 50 60 70 basis points but a bank could buy a treasury and earned three percent so you know we could form a financial bank we could form a banking company a weyland wang and farley and we just get podcast people who listen to this podcast to give us money at 50 points and then we buy treasuries and then we go home”
Equity managers wanted the Fed to finish rate hiking quickly (in 2 quarters) so they could then justify cutting rates and resuming bull markets, rather than experiencing extended period of flat/negative equity returns from prolonged restrictive policy.
“everybody's in a hurry you know why did we go to 75 it's because the equity uh managers wanted to get done with this in two quarters they're all thinking well the fed can declare success now and then we can drop rates because the last thing the equity crowd wants is to have a year of down quarters”
Markets believe the Fed will hike rates to approximately 3.60% (360 basis points) by December, but both Chris Whelan and Joseph Wang expect the funds rate to go over 4% and then remain elevated.
“how high do you think the fed funds rate is going to be currently in december the market is projecting it gets to let's see about you know 360 basis points do you think it's gets there lower higher and then joseph your view i think we'll get over four and then hopefully stay there for a while joseph i think i think we're going to get over four as well”
Typical large banks like JPMorgan, Citigroup, and Bank of America turn over their balance sheets every 3-4 years with a short weighted average maturity, while Bank of America is different with a 15-year weighted average maturity.
“think of your typical bank like jp morgan you know city some of the others they turn over their balance sheet every three to four years so they have a pretty short weighted average maturity”
The leverage ratio limits the size of a bank relative to its capital (e.g., 5 dollars in capital allows a 100 dollar balance sheet), while the risk-weighted capital ratio is similar but treats different assets differently based on risk (with treasuries having zero risk weight while corporate loans have higher risk weights).
“the leverage ratio which kind of limits the size of a bank relative to its capital so let's say you have five five dollars in capital then maybe you can only have a hundred dollars in your balance sheet size and the other way to look at this is the capital ratio which is similar except that it's a risk-weighted asset ratio”
Charles Schwab is now the seventh largest bank in the United States with three times the core deposits of Goldman Sachs, making it a larger bank than most traditional banking competitors.
“for schwab did you know charles schwab is the seventh largest bank in the united states now i didn't know that chris uh three times the core deposits of goldman sachs”
If the Federal Reserve system were reformed, it should be reorganized to eliminate the Federal Reserve Board in Washington and turn three of the western Federal Reserve branches into full reserve banks, subject all of them to Senate approval, and convert the Federal Reserve building in Washington into a homeless shelter.
“my concept would be let's go back to 1929 get rid of the federal reserve board entirely we've got to turn three of the western branches into full reserve banks and then we subject them all to senate approval get it out in the public and we close down that building in washington by the way we can make it a homeless shelter it's a beautiful area they can play on the lawn”
Federal Reserve Chair Powell used the word 'duration' in press conferences, which went 'right over everybody's head' because journalists and the public at press conferences have insufficient economics education to understand technical terms.
“chair powell's used the word duration a couple times it just went right over everybody's head you know the people at the press conference are basically groupies for economists”