Fed Update, Documentary, AI, Reserve Banking Rant

Fed Updates

In all likelihood, the Fed will raise interest rates from 5% to 5.25% next week for their May meeting. The next CPI inflation report is on May 10th. The hope is that inflation continues to tick down again, widening the gap between the Fed Funds and inflation and setting the stage for the Fed to cut rates eventually. Unfortunately, CPI is a low-precision number due to how it is calculated. Truflation shows inflation below 4%, but that’s not what the Fed uses for official reports. The prudent thing to do is to expect that the headline CPI number will disappoint due to statistical noise.

College tuition is declining for the first time in decades (or ever?). Private tuition is now down -7% from the 2019 peak due to Covid, remote learning, dramatic changes in the future of work and now ChatGPT. Expect this to fall further. Separately, the dollar has continued its declined since its October peak, which will help earnings.

The New Americans: Gaming a Revolution – New Documentary

In 2021 I was interviewed for a documentary about meme stocks and the impact that gamified retail trading had on markets, finance and culture. The film, The New Americans, debuted at SXSW two weeks ago. I have not seen it yet, but I was told that I have many appearances throughout along with legendary hedge fund manager Lee Cooperman, Harvard economist Kenneth Rogoff and many other financial pros. You can read the review here. Variety called it an, “Eye-opening portrait of a new generation… Fascinating and essential.” You can read the review here. Shepard Fairey made the movie poster.

The producer Ondi Timoner won the Grand Jury Prize at Sundance twice for films about the conflict and friendship of once-promising rock bands The Brian Jonestown Massacre and The Dandy Warhols (Dig! 2004) and the loss of intimacy and privacy with the advent of the internet (We Live In Public 2009).

The New Americans was acquired by Paramount last week and should be available on the Peacock streaming service shortly.

Quick AI:

• The Supreme Court rejected a case attempting to name AI as an inventor on a patent. It’s another tool like a hammer or a calculator, albeit an extremely advanced one. Some people are oddly desperate to anthropomorphize AI.
• HuggingFace is a leading open-source AI lab. They just released their ChatGPT competitor named HuggingChat.

Fractional Reserve Banking Rant (Long Read) – Empty Vault, Empty Promise

Unfortunately, First Republic Bank (FRB) is in trouble now, which should not surprise anyone. We are an FRB customer, as is my wife’s company, as are many of our readers. They have a passionate client base because they employ great people, but their business is in a spiral they are unlikely to recover from. FRB deposits are FDIC insured, just like other banks, but FRB got caught up in a similar mess as Silicon Valley Bank.

Our deposits in FRB are not held 1 to 1. Your deposits are not held 1:1 at your bank either. Banks like FRB can lend out 90% of our money to borrowers. We consider this “normal” because it’s the system we’ve always known, but it’s like a valet giving your car to Uber instead of parking it. It’s out of sight, out of mind, and not hurting anyone until something goes wrong.

This system has created a broken social contract between banks and customers that the government is forced to backstop with FDIC insurance. Fractional reserve banking will always lead to more banking crises and bailouts.

Banks provide customers access to money transfer systems, a place to store their cash, and lending products like mortgages and business loans.

By creating fully digital custodial accounts, PayPal was among the first to separate money transfer systems from the banks. PayPal users can store and transfer cash without any risk of a bank run because their cash is stored 1:1 in accounts that PayPal cannot touch. Most banking customers want a bank only for the money transfer system. They want to send wires, pay their mortgage, receive a paycheck, run payroll and pay off their monthly credit card statements. Most customers only want what PayPal offers, a place to store and transfer cash safely.

Banks don’t pay enough interest. Fidelity and many other brokerage firms offer money transfer systems attached to their accounts. I pay my monthly credit card bill directly from my Fidelity account’s money market balance (not financial advice). The cash I hold earns a money market return north of 4%. In this example, Fidelity automatically invests my cash in Treasury assets for a fair fee (typically .35%), and I get the rest. My FRB and Chase checking accounts pay almost nothing, which is why people won’t keep their deposits there, and why I’ve never kept more than the minimum.

Banks take unnecessary risks with customer deposits. Banks have nearly $670 billion in losses on investment securities it bought with customer deposits. Banks will get all of those losses back when the bonds they bought mature, but not if you all withdraw your cash before then, like with SVB and now FRB.

Why work with a small bank? Friction and momentum keep small banks going, but the number of small banks has been shrinking consistently for many decades. Today the top 10 banks hold half of all assets, while 4,200 others share the other half. This makes large banks like JPM more attractive as they gain market share during periods of stress because customers want their deposits safe above all else. This again raises the question: why keep your deposits at any bank when they are being lent out? Yes, the FDIC guarantees your deposits, but those bank deposits don’t earn interest, and fair alternatives like the money market example above exist.

Why do we allow fractional reserve banking at all? Lending against your deposits allows for more leverage to be created in the system so that we can grow faster and accomplish more with capital-intensive projects. It also helps keep loan rates lower because the cost of capital for these loans is low – ie, the interest they pay you. So fractional reserve banking allows for lower interest rates which can help with growth and profitability. However, I think this was taken too far because First Republic issued 2% mortgages. Artificially low mortgage rates may make houses more affordable, which inflates housing prices to unattainable levels. Rates do not need to be artificially low or subsidized with customer deposits backed by government guarantees.

Direct lending was labeled the scary term “shadow banking” because banks don’t want to lose market share to competitors. Direct lenders are healthier for the economy than fractional reserve driven debt originators. A direct lender takes in investment capital and lends it to a business just like a bank would. What’s different here is the capital provided for that loan is risk capital managed by a portfolio manager with a fiduciary obligation to make intelligent decisions on behalf of the investor. In this case, the investor chooses to loan out their capital for a return by paying a manager to source and manage the loans. This is much better than consumers and businesses unknowingly risking operational cash to support lending activity.

In the end, here are my predictions. We will continue to see the number of banks shrink and the larger banks will continue to capture market share. The banking industry will shrink on a relative basis, or the growth rate will continue to shrink. Technology solutions can create custodial accounts for people to store and transfer cash while investing in treasuries without risking their deposits on loans or exposure to bad risk management. This exists now, but it’s not marketed for this purpose. Higher money market returns driven by higher interest rates will continue to pull deposits from all banks. Direct lending will continue to eat into the lending market share of banks, allowing investors to earn a risk-adjusted return and a better match of expectations and returns. There are no technologies that need to be invented to make all of this happen. The only thing slowing this transition down is lack of awareness and there are many catalysts waiting to accelerate this transition.

The purpose of this section is to highlight what happened with SVB and FRB and how it will accelerate change within our financial system.