Fed Bail Out Creates Enormous Moral Hazard

Fed Bail Out Creates Enormous Moral Hazard

If it was not clear in our recent piece Bail Out, I am not a fan of bail outs. Sunday’s Fed action was a bail out, plain and simple. So much for Capitalism. Since 2009 the Fed has done as much to damage Capitalism as FDR’s New Deal, Nixon’s taking the U.S. off of the Gold Standard and the fiscal “stimulus” of 2020 and 2021 – with many of those programs extending through today.

The amount of moral hazard created by this most recent Fed bail out will be enormous. The most recent Fed bail out has a name – the Bank Term Funding Program – in which the Fed will make banks whole as it relates to the assets that banks will pledge as collateral when they apply for loans under this bail out program.

  • For example, assume that Bank ABC has $10 Billion (par value) of corporate bonds that it holds on its books. Normally, if a bank needed to raise capital to meet depositor demand it would sell a portion of those bond holdings to generate sufficient cash to meet depositor demand. Corporate bond prices have been hammered over the past year given that interest rates have climbed rapidly since the Fed began to raise rates in early 2022. Thus, when Bank ABC sells bonds in today’s market to generate cash for depositors, the Bank will take a loss on those bonds assuming the bonds were purchased in a lower interest rate environment. However, under the Bank Term Funding Program, the Fed will value the bonds that Bank ABC pledges as collateral at par value, thereby making Bank ABC whole on those bonds, thus inflating the value of the collateral which allows for a larger loan.

Just what the banking sector and U.S. economy needs – more cheap debt to add to the suffocating debt load.

This debt bomb is only growing in size and severity – both on the corporate issuer side as well as Government issued debt. Given the Bank Term Funding Program combined with the upcoming fiscal 2023 deficit (probably $1.5-2.0 trillion), the Fed will soon be back in the Dollar printing business, which of course immediately devalues the Dollar and implicitly raises prices for goods and services. There is no relief in sight from inflation nor the growing debt bomb. Powell needs to tame inflation now or it will get out of control. We can double dip from the inflation punch bowl as we did in the 1970s.

Corporate Debt (1960 – Q4 2022): https://fred.stlouisfed.org/graph/?g=11dH3
Public Debt (1966 – March 2023): https://fred.stlouisfed.org/graph/?g=11dHC