The Fed, Investment Firms, And Rising Interest Rates

(Photo Credit: TheMortgageNote.org)

This originally appeared on TheMortgageNote.org

There are some simple life lessons in business: It is hard to be liked by all people and it is hard to be liked all the time

Leaders at central banks and investment firms know this very well… today’s economic crisis will likely end with a simple reminder.

The Federal Reserve: Essential to Society or The Source of the Problem?

There are few, if any, central bankers who are not taking some public criticism today for raising rates.

For Jerome Powell, chairman of the Federal Reserve, and the other Fed members, their position cannot be enviable: stop inflation and maintain financial stability.

It is always a tough assignment to raise interest rates (the usual dose of medicine for inflation) without any market disorder… the degree of complexity being a direct correlation to how low the existing interest rate is and how long that current interest rate has existed.

Between January 2009 and November 2015, the Fed rate did not exceed 0.2%. It climbed to 2.4% in 2019, then dropped to near zero through 2021 in response to the Covid-19 pandemic. These low rates are a stark contrast to the 20% implemented in 1980 to combat double-digit inflation. Thus, when the Fed began raising rates in March 2022, it was “disrupting” 13 years of low rates.

The Fed rate is now targeting 5% to 5.25% with politicians and consumers alike fearing a weakened economy will soon fall into a recession. Much of the pain inflicted on consumers in 2022 was in the pocketbook with inflation hitting prices at the grocery store and the gas pump among other things.

In 2023, the pain inflicted is hitting consumer wealth – property prices are cooling for house owners yet buying a house is more expensive with mortgage rates up, banks are failing and putting deposits at risk, and the stock market is more volatile with the uncertainty of rates in the near term.

Blaming inflation was the trend in 2022. What’s the trend in 2023?

The truth is inflation will take longer to come down (compared to the general public’s expectations). The Fed must also contend with differing strategies on the size and pace of rate increases across the globe alongside the usual dynamics of engaging a global economy.

Asia Pacific central banks may already be holding rates steady for now, including U.S. trade partners South Korea and India. China’s inflation has already cooled to its lowest rate since February 2021. The UK raised rates again earlier this month. Germany is now in a recession.

The Fed rate is simply one of a few levers (not some secret sauce) that the Fed can utilize to achieve its stated goals of “maximum employment, stable prices, and moderate long-term interest rates.” The Fed can also consider reserve requirements, which has increased for 2023 compared to 2022, and open market operations, which is the tool the Fed has most frequently used to manage monetary policy.

That said, it is a proven reality that raising interest rates combats inflation. Thus, how can we blame central bankers for pursuing this strategy (for as long as required)?

To be fair to the Fed, inflation is not the result of one thing. Blaming OPEC+ was once the ‘cool’ thing with high oil prices. Covid-19 impacted global supply chains while the Russian invasion of Ukraine, coupled with U.S.-European sanctions, certainly did not help the situation. And, ultimately, many central banks, including the U.S., were slow to raise rates. How to allocate the percentage among these causes is not a precise exercise.

If inflation is the original sin, then consumers view central bankers, like the Fed governors, as a bunch of Judas-types with interest rate hikes… forgetting that Judas was part of the overall resurrection story.

Nonetheless, critics will ask if Judas was necessary to achieve the greater story.

Shadow Banks: Resolving Financial Problems Or Exacerbating Them?

Rising interest rates and a few bank failures have created a crisis for the Fed and an opportunity for investment firms.

When banks pull back on lending, investment firms have long stepped in to fill the gaps. Investment firms and related financial institutions (also described as unregulated banks or shadow banks) have increased their share of the leveraged loan market from 54% in 2000 to 75% in 2022.

It is this “shadow bank” industry that significantly expanded in the aftermath of the 2008 global financial crisis when new financial regulations and rules were introduced by Congress. The Fed rate may have dropped to zero in 2009, but traditional banks tightened lending back then with reduced risk appetite and higher reserve requirements, with business accordingly migrating away from traditional banks.

Major CEO banks (and regulators) are keenly aware of the changing dynamics in lending markets. Jamie Dimon, CEO of JPMorgan Chase & Co, highlights, in his annual letter, “the decreasing role and size of U.S. banks relative to the global economy alongside the increasing role and size of shadow banks” and adds that “many of the new ‘shadow bank’ market makers are fair-weather friends — they do not step in to help clients in tough times.”

Investment firms, like Apollo and Blackstone, will tell a different story. Many regulated banks are currently shackled by loans written before interest rates began to rise and face constraints on new lending. The outcome is many large and small businesses in the market searching for credit.

Shadow banks are both infusing liquidity into this tightening market with new loans as well as purchasing and extending existing loans. And, if regulators adopt new rules under consideration for small and medium-sized lenders, including new capital requirements, then even more business will migrate to the shadow bank market.

Still, some politicians are already adopting the narrative of sharks at the gate, or uncontrolled bad actors in the market. It is true that the shadow bank market is less regulated – the word “shadow” naturally suggests this reality. But it is these investment firms and related financial institutions that help banks offload risks that they are unable or unwilling to hold. This relationship effectively helps banks manage their liquidity.

Is there contagion risk? Potentially.

Regulated banks and non-regulated banks can share exposure to the same clients with significant financial losses having a spillover effect across the balance sheets of multiple financial institutions.

Yet, the current market chaos is better described by fallout at regulated banks, which should not inherently suggest that the shadow bank market is at risk of catastrophe – again, let’s not forget that investment firms stepped in to help jumpstart the revival of the U.S. economy following 2008.

Critics will argue that the shadow bank market has grown too big to not be regulated – in other words, its opacity and size should raise concern. It is true that these shadow banks are lending to firms that traditional banks will not extend credit to – this is not a secret. There are two perspectives, however, on this situation. Shadow banks are lending to companies that the market fundamentally should be avoiding. Or shadow banks are crafting and creating lending options for small and medium-sized companies that have no credit rating but require capital and help fuel growth in the U.S. economy.

Sounding the alarm today feels like a stretch. But, similar to the central bankers, investment firms can do a lot of good work for the economy, especially when traditional banks are weakened and cannot provide liquidity, and still become the villain when something goes wrong.


Author: Kurt L. Davis Jr.