New bank rules - a look at the Term Funding Program
The Federal Reserve has announced the new Term Loan Program (BTFP) to ensure liquidity for eligible lenders. I have gamed 4 scenarios, in which the first 2 banks are successful, and the last 2 in which the bank suffers losses as a result of declining mortgage-backed security value.
This is just a fictional scenario based one risk, however still plausible.
Scenario 1: Successful Early Repayment Bank A obtains a $1 million Term Funding Program loan with $1 million collateral and successfully repays the loan early. Bank A's worth after the repayment is $1 million, which is positive news for Bank A's owners and shareholders. The outcome for the Fed is positive as they received the full repayment plus interest. The outcome for the bank depositors and the owners of the mortgages whose mortgage-backed securities Bank A holds is neutral.
Scenario 2: Late Repayment Bank A obtains a $1 million Term Funding Program loan with $1 million collateral but is late repaying the loan. Bank A's worth after the late repayment is $900,000 due to the penalty for late payment. The outcome for the Fed is negative, and the outcome for the bank owners and shareholders is negative due to the penalty and the loss of reputation. The outcome for the bank depositors and the owners of the mortgages whose mortgage-backed securities Bank A holds is neutral.
Scenario 3: Bank Default Bank C obtains a $1 million Term Funding Program loan with $1 million collateral, but mortgage-backed securities pledged as collateral decline in value and depositors withdraw funds, leading to a liquidity crunch and eventual default. Bank C's worth after the default is -$1 million due to the outstanding debt. The outcome for the Fed is negative, the outcome for the bank owners and shareholders is negative due to the loss of the entire investment and the damage to their reputation. The outcome for the bank depositors is negative, and the outcome for the owners of the mortgages whose mortgage-backed securities Bank C holds is negative due to the decline in value of the securities, which were used as collateral.
Scenario 4: Partial Repayment with Shortfall (Continued) Bank D has obtained a $1 million Term Funding Program loan with $1 million collateral, but due to the decline in the value of mortgage-backed securities and a shortfall in interest payments, the bank is unable to repay the loan in full. Bank D's worth after the partial repayment is $800,000, which is $200,000 less than the value of the collateral. The outcome for the Fed in this scenario is negative, as they received less interest and did not receive the full repayment. The bank owners and shareholders will also face a negative outcome due to the loss of reputation and the reduced value of the bank. The bank's depositors will not be directly affected by this scenario since their deposits were not used as collateral for the loan. The owners of the mortgages whose mortgage-backed securities Bank D holds will face negative consequences since the value of the securities has declined. This scenario highlights the risk involved in using mortgage-backed securities as collateral, especially in a volatile market where the value of these securities can fluctuate.
Overall, Scenario 1 has positive outcomes for all parties involved, while Scenarios 2 and 3 have negative outcomes for the bank owners and shareholders, the depositors, and the owners of the mortgage-backed securities. Scenario 4 has negative outcomes for the Fed, the bank owners and shareholders, and the owners of the mortgage-backed securities. Bank D may face difficulties in securing further funding in the future since its reputation and value have been negatively impacted. Proper risk management and due diligence are crucial when using mortgage-backed securities as collateral for loans to avoid potential financial losses and reputational damage.
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I suspect that a year from now we may see some of the above scenarios unfolding from at-risk banks. At 4.9% OIS plus 10 basis points, borrowing a million dollars for $25,000 is a great deal, I am sure many banks at risk will use this opportunity to recapitalize. Those who don't may find themselves short and unable to meet depositor's demands for cash. Alternatively, banks that opt in to these programs could be seen by investors or depositors as risky. I already see many friends wanting to close down their accounts at certain banks for having to accept new digital terms.
Sources include https://www.federalreserve.gov/monetarypolicy/bank-term-funding-program.htm https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20230312a1.pdf https://www.federalreserve.gov/publications/files/13-3-report-btfp-20230316.pdf https://finance.yahoo.com/news/factbox-key-elements-feds-us-040445983.html
