DNY59
October 9th marks the 43rd anniversary of Paul Volcker’s 1979 keynote address to the American Bankers Association (ABA) Annual Convention in New Orleans in which he announced the Federal Reserve’s war on inflation. I was in the audience and listened attentively, because I spoke after him at the convention.
His speech received a standing ovation. I was shocked, since I knew that most of the banks at the convention were community banks ill-equipped to deal with the volatile, higher rates Volcker promised. In my opinion banker reaction was masochistic, since I knew their banks were not immunized.
Asset/Liability Management
Banking had published a series of articles by me in the summer of 1978 that presented a theory of bank management that I titled Asset/Liability Management “ALM.” It showed banks how they could define, measure, and manage interest rate risk which I suggested was about to dwarf credit risk. Requests for reprints and speeches led to the publication of my pioneering book titled Asset/Liability Management by the ABA.
In my speech at the convention, I told the attendees that community bank earnings were about to be crushed, because the interest paid on deposits was going to rise far faster than interest earned on assets. Most community banks in 1979 were still making fixed rate loans.
I actually developed the theory of Asset/Liability Management to help me manage my bank’s investment portfolio. I believed that interest rates could not be accurately predicted and that banks needed a system to profitably manage assets and liabilities in a volatile, rising interest rate environment.
Some financial institutions, particularly Savings and Loans, were unable to cope with the increased rates. The interest they were forced to pay for deposits fell far short of the interest received on fixed rate mortgages that dominated their balance sheets.
Asset/Liability Management tools and techniques have advanced far beyond my initial articles and the Model Asset/Liability Policy I published. Most banks and other financial institutions now have systems in place to monitor their interest rate exposure and immunize the impact on earnings. The increase in rates being imposed by the Federal Reserve is unlikely to negatively impact earnings at banks and other financial institutions that have embraced ALM as long as loan losses remain reasonable.
Furthermore, non-financial companies have also implemented techniques to reduce their interest rate exposure. Many publicly traded companies took advantage of the recent low-rate environment by issuing longer dated bonds with fixed rates.
Today’s Systemic Problem
Today’s systemic problem is worldwide and was caused by central bank quantitative easing policies that drove interest rates to zero and encouraged fixed income portfolio managers to reach for yield by extending maturities. The recent significant increase in interest rates has created historic depreciation in the bond-heavy investment portfolios of banks, insurance companies, pension funds, bond funds, and other financial institutions. Among financial institutions, banks have traditionally invested in shorter duration investments; therefore, portfolio depreciation is less of a threat to banks than to those institutions favoring investments with longer durations.
Bond Prices Plummet
The decline in bond prices in the last two years is already larger than the decline observed in the two years following Volcker’s speech. For example, in October 1979 the U.S. Treasury 10 and 30-year maturities were trading at yields-to-maturity (YTM) of 10.7% and 10.2%, respectively. When yields peaked in September/October 1981, the 10 year was trading at a YTM of 15.8% and the 30 year at 15.2%. The rise in yields caused current coupon 10-year securities bought in 1979 to fall by 23% and 30-year securities to fall by 32%.
Unrealized losses in fixed income portfolios are much greater today than at the interest rate peak in 1981. The 10-year U.S. Treasury sold at a low YTM of 0.625% in April 2020 and the 30-year at 1.25%. At the end of September 2022, that 10-year was trading at a YTM of 3.83% and its price had fallen by 26%; the 30-year was trading at 3.78% and its price had fallen by 44%.
Federal Reserve
Any explanation of what led to today’s historic unrealized losses in bond portfolios must begin with the Federal Reserve’s massive purchases of securities as it engaged in quantitative easing “QE.” The Fed owned less than $1T in securities prior to May 14, 2009. Ten years later on May 15, 2019, it owned $3.7T. After that date, the Fed put QE on steroids, and in the next 40 months, it added an additional $5.1T in securities to its balance sheet.
The explosive growth in the Fed’s securities portfolio led to concurrent growth in bank deposits and all financial assets. Fed purchases briefly drove interest rates negative and lowered them to artificially low levels.
On December 31, 2021, the Fed owned $5.9T U.S. Treasuries and $2.7T mortgage-backed securities. Unrealized appreciation on U.S. Treasuries amounted to $135B or 2.3% of book value, while mortgage-backs had unrealized APPRECIATION of $7B or 0.3% of book value. The Fed’s investment portfolio at the end of 2021, therefore, had total unrealized appreciation of $128B or 1.5% of its $8.6T securities portfolio.
Six months later, on June 30th the Fed’s portfolio had unrealized losses of $720B or 8.2% of book value. U.S. Treasuries had depreciation of $430B on $6T (7.2%); and, mortgage backs $293B on $2.8T (10.5%). The Fed’s unrealized losses today probably total about $1T or ~11% of its total portfolio book value, because interest rates have increased significantly since mid-year.
The Fed has a much higher percentage of longer maturity securities than commercial banks, so unrealized losses at commercial banks would amount to a much smaller percentage of latter investment portfolios. On the other hand, pension funds, insurance companies, and bond funds buy longer maturity securities and their unrealized losses as percentages of their portfolios would be larger than the Fed or commercial banks.
Conclusion
The percentage decline in fixed income prices has already surpassed the percentage decline observed in the 1979-1981 period. Large unrealized losses are not fatal as long as they do not have to be recognized. Unfortunately, QT and continued issuance of debt by the U.S. Treasury threaten to raise bond rates, which will increase the amount of depreciation. The depreciation could either lead to margin calls like what levered English pension funds experienced or actual runs caused by rumors and/or a loss of confidence that would force liquidation.
A dearth of bond buyers is already causing liquidity issues in the fixed income market that are likely to worsen. Spreads between U.S. Treasury and lesser quality debt are widening, while some sellers of low-quality bonds are unable to get bids.
Declining liquidity and rising depreciation due to higher rates are creating a perfect storm. The damage already done is hidden from view because bond investment portfolios at financial institutions are among the best kept financial secrets. It is likely that pressure from the Administration, influential financial interests, and bond market participants will force the Federal Reserve to abandon or significantly reduce its planned quantitative tightening in the near future.
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