The Great Depositor Bailout
What constitutes a bailout?
On Sunday, the U.S. government announced a plan to shut down two troubled banks, Silicon Valley Bank and Signature Bank, and guarantee all of their uninsured deposits, recently totaling $220 billion. Reports the Washington Post:
The announcement Sunday immediately set off a debate over whether these actions amount to a federal “bailout.”
On a call with reporters, a Treasury official emphasized that the federal intervention would not bring SVB or Signature back to life, as the enormously controversial bank bailouts during the 2008 financial crisis had done for banks that were close to failing. Their executives would not retain their jobs. These new safeguards were aimed at protecting people and businesses who had made a reasonable decision to put their money into an accredited and regulated bank — not investors who bought risky securities.
Crucially, the Treasury official also emphasized, the money used to reimburse the depositors would come from a fund paid into by U.S. banks.
This is a big debate now – the New York Times reports that many are expressing suspicion that this is just a bailout by another name. So, is this just a stealth giveaway of government money to wealthy special interests, or is it something else?
Keeping money on deposit at a bank is a necessary evil. You can’t earn any meaningful return: to make real money, you need to tie it up in a riskier investment. On the other hand, money in the bank is convenient, preserves optionality, and represents a safe store of value.
Life as a depositor is not entirely without risk. Deposits of over $250,000 at a bank leave you at least theoretically exposed to losing a small slice of your investment if the bank’s assets go bad, unless you buy insurance separately. In the case of SVB and Signature, some estimates had uninsured depositors losing 10%-20% of their money, even after shareholders and bondholders assumed the first tranche of losses.
The other major risk to depositors is one that threatens (almost) all fixed income investors: the risk of rising inflation, which erodes the value of the dollars you are owed over time. Your bank will give you all the dollars you deposited a year ago, but by now, those dollars might each only have 93 cents of buying power left.
Owners of real assets are somewhat insulated from the effects of inflation, as they can pass along price increases to their customers, and benefit from the falling real value of their debts. For example, imagine the owner of an apartment building who can raise rents at the rate of inflation, but whose liabilities consist of a mortgage denominated in the local currency. The value of the building will maintain its real value, while the mortgage will become cheaper in real terms.
By contrast, bank depositors are fully exposed to inflation. In modern times in the US, we have come to expect 2% annual inflation, so if you keep $10,000 in a checking account, you can expect to lose $200 of purchasing power each year.
Sometimes, inflation comes in a bit hotter than expected. Inflation was about 7% in the US in each of the last two calendar years, meaning depositors lost 14% of the value of their investment during that period. Even excluding expected inflation of 2% per year, that’s a 10% surprise haircut.
There are about $20 trillion of bank deposits in the US, so that means depositors collectively ate a $2 trillion surprise loss over the last two years. Given the circumstances, bank depositors as a group hardly seem like a fair target for our collective ire for requiring a bailout of less than $100 billion.
If depositors lost $2 trillion, who was on the other side of the trade? One might think that it was the banks that took the deposits, but banks simply turn around and invest those deposits in loans and bonds, which similarly suffer when inflation rises. The real value of a bank’s liabilities and assets will decline in unison, and in fact since banks have to keep more assets than liabilities, banks should be net losers from inflation as well.
The ultimate winners in this scenario are the entities who borrow from the bank, who get to pay the bank back in (unexpectedly) devalued dollars.
These days, much of the borrowing that goes on in the economy happens away from bank balance sheets, through bond issuances and securitizations. Still, the Fed tracks total borrowing and lending in the economy, and we can get a sense of who the major borrowers are.
One major group is consumer borrowers: at the end of 2022, households had $12.5 trillion of residential mortgages outstanding, meaning homeowners collectively received a $1.2 trillion windfall from the devaluation of their future payments. (This is just from inflation, and separate from any benefit from taking out new mortgages or refinancing at low interest rates during that time.) Consumer borrowers also have nearly $5 trillion in other debt outstanding, such as credit card debt and auto loans, which benefit similarly.
Households are also indirect borrowers through the businesses they own equity in, as in our apartment building example. Nonfinancial businesses have $7.5 trillion in bonds outstanding, and $6.3 trillion in mortgages.
Most households are both borrowers and lenders; they have bank accounts and credit cards and mortgages and equity in companies that lend (like banks) and borrow (like real estate companies). The extent to which inflation affects any given household depends on their net position. If you had a small bank account and a huge mortgage, you were a big winner, and if you lived on interest income from your bond portfolio, you were a major loser.
There is one special entity that is a major net borrower: the U.S. government. The total national debt held by the public currently stands at over $24 trillion. Some of this is owed to foreign governments who need to hold dollars, but most if it is held by American entities: banks (who got it from depositors) and corporations and even directly by private citizens.
About $2 trillion of the national debt is indexed to inflation, and thus does not benefit from rising prices, but the government still had about $20 trillion of non-indexed debt outstanding over the last two years, and thus ended up with a $2 trillion profit from higher than expected inflation.
Inflation is only part of the story, of course. The government also benefited from falling long-term interest rates during that period, locking in low yields on the borrowing it did to pay for Covid relief. The government effectively put on the inverse of the bad interest rate bet that doomed SVB. In fact, even though SVB invested in mortgage backed securities, its investment activity would have pushed down interest rates on similar securities, like Treasury notes, indirectly benefiting all fixed rate borrowers, including the Federal government.
From Q2 2020 through Q1 2022, when longer-term rates were at all time lows, the Treasury issued an additional $4.5 trillion in fixed-rate notes and bonds, and refinanced everything that rolled over during that time as well.
As the economist David Beckworth has pointed out, we can see the combined impact of rising interest rates and high inflation when we look at the massive decline of the public debt burden. The measure Beckworth picks is the ratio of the market value of public debt to nominal GDP, which is a typical public debt measure (public debt/GDP) adjusted for mark-to-market changes in the value of outstanding public debt.
The extra debt the government took on to pay for Covid relief has almost entirely disappeared, due to the combination of higher inflation and lower rates. By this particular measure, public debt is back where it was at the end of Q1 2020, before the real impact of Covid.
High inflation eroded the real value of outstanding debt (which shows up above through inflated nominal GDP in the denominator), while the period of low rates followed by high rates reduced the mark-to-market value of the government’s longer term fixed rate borrowing (notes and bonds are three-quarters of publicly held debt).
Back-of-the-envelope, the government picked up a $2 trillion profit from the spike in inflation, and another $1 trillion mark-to-market profit by locking in fixed low rates.
Treasury officials think that the rescue package for SVB and its peers (not a bailout!) most likely will end up costing less than the $100 billion in the FDIC fund. The market gyrations that wrong-footed the rescued banks almost certainly ended up making the government a profit several times that. Over the past two years, the Treasury is up over $3 trillion on the backs of its lenders, which include, indirectly, bank depositors.
Maybe the government’s plan really is a bailout – it does, after all, potentially involve taking public money and giving it to specific affected parties, even if the money comes from a tax on banks. Or maybe a bailout is justified because regulators seem to have been asleep at the wheel, or because of the risk of financial contagion. But we should also consider that depositors have been bailing out the Treasury for some time now – maybe the sporting thing to do is to write this little episode off as the cost of doing business and move on.
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