Scylla and Charybdis; The FDIC and the Federal Reserve

Scylla and Charybdis
The FDIC and the Federal Reserve
David R. Kotok
http://www.cumber.com
April 19, 2011

The Strait of Messina separates the eastern coast of Sicily from the southern tip, or “boot,” of Italy. This passage, three kilometers wide at its narrowest, is known for its strong tidal currents. Here is where Greek mythology recounted the tales of Scylla and Charybdis. These two monsters were believed to reside in the Strait of Messina, threatening ships and their crews as they transited through the strait from the Ionian Sea in the Mediterranean to the Tyrrhenian Sea, which lies off the western coast of Italy.

The Greeks described Charybdis as a monster who manifested herself as a whirlpool, gulping and spitting out huge amounts of water several times a day, creating the treacherous currents. Scylla was a six-headed and twelve-armed monster, who would consume everything that crossed her path. It was by the presence of these two monsters Greek legend explained the shipwrecks and destruction that took place in these perilous waters.

Gazing out at the Strait of Messina from the city of Taormina, I have fulfilled a lifelong dream. I remember, over half a century ago, being struck by the stories of Scylla and Charybdis in the course of studying antiquity and reading Greek mythology. A question within me: What led the Greeks to create these two mythological characters?

The answer was clarified by our tour guide. He described how the tidal rise and fall of the Ionian Sea level was substantial. He then explained that the Greeks were completely unaware of how the tides were created. They did not conceive of the power of the moon to pull on water gravitationally. Because they lacked this knowledge, they created mythological explanations for the geographical phenomenon they witnessed.

At peak velocity, the currents flow in the Strait of Messina at nine knots. This is a fierce current with which to contend, especially in such a narrow body of water. Such a force would easily overwhelm sailing vessels of the types used in ancient times.

It is now understandable how Greek legend brought forth the myths of Scylla and Charybdis. What else could possibly explain the deadly surges ships and their crews had to fight against? Had the sailors known about the tides, would they have operated differently? Would they have timed the tides? How much of history would have changed if the epistemological questions were answered, not with mythological characters but with facts and experience?

In addition to touring in Sicily, the GIC meetings in Italy afforded conversations with economists, financial advisors, investors, and colleagues. They lead me to a difficult and intricate question. Does the Federal Reserve face its own version of Scylla and Charybdis?

The Fed is completing its program of asset purchases, called by many “QE2.” As this program reaches its completion this summer, many participants expect the Fed to call it quits on additional purchases. The current market expectation is that the Fed will then go into a mode of preserving the then-existing size of its balance sheet. As maturities occur or paydowns take place in the mortgage-related portfolio, the Fed will replace those maturities and paydowns with purchases of treasuries. Essentially, the Fed will go into a holding pattern and await “incoming data.”

Meanwhile, the Federal Deposit Insurance Corporation (FDIC) has just introduced a new factor. We have written about it in the past. Since April 1, the FDIC now costs a bank an additional between and ten and forty-five basis points as a fee on its assets. That is a payment the bank must make – any American bank – to the FDIC.

In making monetary policy decisions, the Fed did not have to contend with this cost prior to April 1. Now the FDIC has interfered in a way that adds a cost to the banking system at the very time the Fed is engaged in easing. The mechanics of the FDIC fee act as a form of a tightening. We estimate that the impact is the nearly the same as if the Fed were to have raised interest rates about 15 basis points. By some “guess”timates, the FDIC has taken back all the easing provided by all of QE2.

In the last day or two, we have seen the Federal Funds rate trade under ten basis points. Nine basis points is the price of a transaction between two banks, in which one takes excess or additional reserves and sells it to the other. It is also the price at which the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, take their incoming cash flows and sell them to the banking system. GSEs are not permitted to deposit monies with the Federal Reserve, so they have no choice but to sell into the Federal Funds market and get whatever they can, or otherwise earn nothing. Clearly, the selling pressure from the GSEs is driving the Federal Funds rate down. At the same time, the FDIC fee means that it is costing more for banks that would buy the Fed Funds, so we have a double-edged sword at work. Is this interfering with the Fed’s monetary policy intentions? Is it setting the Fed or the markets up for a shock when the policy changes?

Epistemological questions may be answered with facts, examination, research, and experience. However, the United States has never engaged in monetary policies of the type presently underway. We have no experience to guide us. Has that led us to the error of the Greeks?

The alternative to relying on legend would be to see if anything can illuminate our present circumstances. Then we can build models for guidance. Our assertions may be right or wrong. That remains to be seen, but what we do now know is that we have a construction in which the Federal Reserve pays banks 25 basis points for its excess reserves, which are deposited at the Fed. At the same time, the pricing of overnight reserves traded between banks is now down to nine basis points and has been falling erratically. Simultaneously, there is a fee structure that costs banks 10 to 45 basis points, depending on the size and characteristics of the bank, and therefore that pricing is acting as a “wedge” and altering the composition of monetary policy.

Think of it in the following way: a basis point on one million dollars is one hundred dollars. As stated before, the overnight interest rate on Federal Funds is nine basis points. Nine basis points are 900 dollars per year on one million dollars of reserves traded between two banks. If you divide 900 dollars by 365 days, you can see that for a smaller bank to do an overnight, million-dollar transaction in Federal Funds is to gain that bank about two and a half dollars. It is simply too much trouble for the bank to go through for such little result.

Add three zeros and think in terms of one billion instead of one million. You can see that for a large bank it is still not substantial, and so the intention of Federal Reserve policy making is being altered by this present combination of pricing. We are already seeing banks reorganize themselves to qualify for the lower FDIC fee schedule.

What does the pricing indicate? Does it tell us that the value of excess reserves has reached zero? There are indications that affirm this. When you look at the repo market and the pricing of the collateral used in the repo market, you have an indication of how repo is priced. It is currently near zero. One has to ask oneself why this is so. Is there such weak demand as to price the value of overnight liquidity at zero? The alternative question is: has the FDIC effect driven that overnight liquidity pricing to zero? In fact, is there so much excess liquidity that we now face the true confrontation of the “zero bound” in monetary policy?

The epistemological question is as classic as Greek mythology: how do we know, and how can we arrive at an answer? The second derivative of that question is what happens when the Fed finally changes this policy. Furthermore, is this FDIC-altered policy the policy that the Fed wants? The home-mortgage interest rate is higher than when the Fed started QE2. The housing market continues to be in doubt and prices in many regions are falling. The economy got an initial burst after the financial crash of Lehman and AIG, but subsequently, economic growth rates are falling. We see revisions of growth rates ratcheting downward. The policy has clearly weakened the US dollar, as allocations of dollars are going elsewhere. What is not clear is whether that reallocation is taking place because of choices made by holders of dollars, like state sovereign oil funds, or being made by investors, or both.

Epistemological questions face the Federal Reserve, investors, the US economy, and the world. The true origins of tidal forces were not apparent to the Greeks as they transited the Strait of Messina. They thought they understood; they held strongly to their belief system. The Greeks described their theories through mythological figures, and even deified them. 2500 years later, we understand how some epistemology failings misled the Greeks. As for the US and its policy at the Federal Reserve, we are operating on legend and uncertainty.

As investors, we confront the likelihood that the short-term interest rate will remain near zero for the rest of this year. The gulping and spitting of excess reserves is coming from the modern Charybdis. The FDIC fee is the modern-day Scylla.

Investors will face the “zero bound” in interest rates for a while longer. They can sit on their cash and earn nothing. They can fret and wring their hands about a ramp-up in inflation, but the evidence so far does not support it. They can stay in the US dollar, in which case they can watch their dollars weaken relative to the rest of the world. Travelling in Sicily or Rome validates how strong the euro is relative to the dollar. All you have to do is buy a dinner or hotel room.

We are back in our office. It has been an enlightening trip. We have been able to examine some history while discussing monetary policy and financial affairs. This writer, finally, and after nearly 60 years, was able to witness Scylla, Charybdis, and the Strait of Messina.

Lastly, we return during the Christian Holy Week and during the Jewish Passover festival. We celebrate faith and freedom. We do not actually burn a sacrificial animal. We invoke it as a symbol of the past.

This year we do so after being reminded that those ruins of temples and amphitheaters, those paths and stone quarries, are evidence of slavery. The Trojan, Carthaginian, Greek, Roman, Arab, Norman, Spanish and other conquerors of Sicily all used slaves.

To a human being, legend and deification can be a dangerous thing. Freedom is as fragile as a weakened monetary and political system will make it. Modern mythology resides in the temples in Washington, not in the Messina.

David R. Kotok, Chairman and Chief Investment Officer