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Bailouts | SBF to SVB | Yield curves & regulations

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“The job of the Central Bank is to worry”

No doubt some former central bankers will agree with that statement. Apologies in advance for the typos… I'm not sleeping enough to even allow my phone to do a software upgrade. Let's roll…

New House Rule

No doing business with 3/4 name acronyms containing the letters S and B: Sam Bankman-Fried (SBF) and Silicon Valley Bank (SVB).  Lehman Brothers traded out of an entity called Lehman Brother Special Finance (LBSF) in Europe – left penniless in the bankruptcy… a bit like SVB UK.
 
Notice a pattern emerging? Let's predict who to avoid next… Credit Suisse First Boston (CSFB)? Bingo!
 
When under pressure, Credit Suisse (CS) is always a good deflection of attention by other banks – Look at them, they're even worse than us. It's a shame, one of the smartest and nicest financiers we know works at CS – the sort of person everyone knows and likes.
 

Introduction

The purpose of this article is to provide a brief overview of post-GFC banking regulations as it relates to the failure of SVB, but more broadly the industry as a whole. We'll provide a couple of counterfactual examples to argue the case for why we believe what emerged in the aftermath of the Dodd-Frank reforms was the least worst choice available. Especially, when examined beyond present day concerns and criticisms expressed by many.
 
In the end, we'll arrive at the, not so profound, conclusion that inverted yield curves are bad for bank profitability. Inflation must quickly fall back down in line with levels comparable to the historical returns of bank portfolios – allowing yield curves to disinvert. It may lead to  Something along the lines of the topic of discussion between Olivier Blanchard and Larry Summers earlier in the week.
 

More like LTCM then Bear Stearns

By the time this update is published the situation may have changed. It's quite a busy weekend on both coasts as startups seek alternative financial arrangements and opportunistic financiers offer their services. Anecdotally, it's been a case of people reaching out to startups offering emergency liquidity and funding, rather than the other way round. Based on this very small sample, the situation is more akin to an LTCM type of crisis than the collapse of Bear Stearns.
 
While Silicon Valley startups may operate with a global reach, it can be a rather insular (and monolithic) place with a strong preference to do business with locals. As an old school Sand Hill Road VC once said: “The further away from Palo Alto, the worse the deals.” But, this was 15 years ago and things may have since changed.
 

Real contagion risk?

The sort of help those exposed to SVB are after is less concerned with liquidity, but more of the “please help make my investments whole” nature. Are there any unfortunate people at risk of losing money from the fall out of SVB who also do not believe it will lead to broader contagion?
How much of the contagion risk is real versus techie VCs on the path to becoming the new age bailout junkies?
And boy, there are a lot of bailout junkies who are free market capitalists only on the way up. Nonetheless, there are valid arguments for why uninsured depositors should or should not be made whole. However, the rules in place today were decided many years ago after a prolonged period of consultation and public debate. At the time, many were invited to share their 2 cents on the proposals. But they were either disinterested or too distracted on myopic things to even remember. Now they wish to travel back in time to voice their strong opinions based on sentiments grounded on current events. It doesn't work that way.
 
Those who were at the table have since moved onto more interesting and pressing issues. The problem with going back too often is that one risks getting stuck in the past. And quite frankly… the idea of bailing out a bunch of entitled, gluten intolerant, Tesla drivers who make right turns on (hwy) 280 from the middle lane without indicating is a bit difficult for most of us to stomach. A healthy serving of humble pie every now and then cleanses the soul and mind… and keeps capitalism alive.
 

Potential suitors for SVB (post-bankruptcy)

A number of big Wall Street names have been rumored to be looking at a post-bankruptcy acquisition of SVB. Morgan Stanley (MS) seems to be most strategically credible to us as a form of ‘vertical' integration – from early stage venture investments to private wealth services. (They're much better at the tech banking stuff than calling markets.) Incidentally, the MS tech conference, one the the major events of the calendar year for investors held in San Francisco, was just this past week as the SVB story unfolded.
 
With that said, the more SVB client business that's snapped up, the less attractive the acquisition. Goldman Sachs is another potential suitor mentioned. However, in light of the recent issues the bank has had with its retail arm – Marcus – and commitments to deliver on a new business strategy, it seems a tough sell. Both internally and externally. In any case, without any real evidence, it's all pure speculation.
 
In hindsight, Goldman Marcus' woes were the canary in the coal mine. It's always the ones with the least risk that shout first and loudest.
Shhh… keep quiet! Some people are trying to manage real risks.
The collapse of SVB stokes fears of unknown unknowns. As well as the usual non-bank tourist traders perturbed about: i) large ratios of liabilities to equity of banks relative to other sectors; and ii) the impact of rising interest rates and inverted yield curves on bank profitability. It's especially surprising that these concerns are expressed by seasoned professionals who lived through the collapse of Lehman Brothers and the Eurozone Crisis.
 

Key points to address:

– Banks have large balance sheets compared to the size of (common) equity. To state the obvious, a banking license grants the right to (legally) accept customer deposits and issue loans (credit). The maturity mismatch between assets (loans) and liabilities (deposits) means banks are highly vulnerable to deposit runs. To help mitigate the (material) risk of bank runs, governmental agencies, such as the Federal Deposit Insurance Corporation (FDIC), provide retail customers deposit insurance – up to an amount of the order of many times the average person's annual salary.
 

Banking would be very risky business with regulations and deposit guarantees 

Mark-to-market accounting on banks' entire balance sheet has never been a useful approach to equity valuation. It introduces too much market price volatility and exaggerates value in both directions. Most assets held by a bank are subject to stringent accrual accounting rules and regulations. Otherwise, when markets crash and interest rates fall, bank stocks should go up a lot – they don't. Countless sums of money were lost during the Eurozone Crisis of 2010-2012 by credit investors hedging portfolios with short bank equity positions based on this incorrect view. Certain mistakes should not be repeated.
 
– If you're still unconvinced by the previous two points, try running a standard credit-equity firm value model (KMV) on any bank with publicly listed securities. The model imputes the credit spread for a corporate borrower based on the stock price, leverage ratio (debt-per-share), and (options) volatility – as used in some capital structure arbitrage strategies. It is almost impossible to get a 5-year bank credit spread below 500 basis points (5%), well above the average high yield (junk bond) issuer. Unless the stock price volatility is in the low single digits. (For reference, the average single stock price volatility is about 20% per annum.)
 
The conclusion is that banking is much riskier business than a standard corporation without deposit guarantees and strict regulations and accounting rules.
 

Regulatory ratios

– In the aftermath of the GFC, laws were passed to ensure banks held sufficient high quality liquid securities to cover client withdrawals. And to encourage more holding of safe haven assets (Treasuries and mortgage back securities) and less in risky investments, such as equities. It's tempting to blame the regulatory rules, such as the supplementary leverage ratio (SLR) and liquidity coverage ratios (LCR), as the cause of SVB's problems. Unfortunately, reports suggest that SVB did a poor job of hedging its interest rate exposure relative to industry peers.
 

Counterfactual points

Consider the counterfactual examples: What if in March 2020, when the pandemic struck, banks were not holding the safest assets that jumped in value? The windfall profits made by banks allowed credit to continue flowing through the economy, unlike during the GFC. Moreover, what if the largest US banks deemed as systemically financial institutions (SIFIs) were left unconstrained by regulatory metrics? No doubt a couple of banks would have held more US Treasuries and mortgage securities than was necessary.
 
While the status quo plumbing is far from perfect, it's an issue the architects of the post-GFC financial system have been aware of (at least) since March 2020. The temporary relaxation, and then reinstatement, of the SLR suggests their visions of the future may differ from the present. (Just follow their most recent publications.)
 
More specifically on the SLR, Darrell Duffie at Stanford had an alternative proposal to consider the total equity in the banking system as a proportion of the size of the economy. A more pragmatic and holistic approach by someone renowned for his analytical skills.
 

Blanchard, Summers & Tucker

– The problems of rising short-term borrowing costs and yield curve inversion have been ongoing concerns amongst experts for a while. In October 2022, we covered Paul Tucker‘s IFS paper highlighting the pandemic policy missteps by central banks purchasing low yield assets in high demand by the private sector. Governments rolling debt maturity profiles toward the short-end. The chickens have come home to roost. Central banks pay banks higher rates of interest on overnight deposits which are not being passed onto savers. This is similar to the GFC where low rates and liquidity provided by central banks could not reach the broader economy.
 
The Fed currently pays banks an estimated total rate of interest of about ~$140bn per annum, and rising. Meanwhile, the major banks pass on a small fraction of the interest earned to retail depositors. It allows them to stay profitable by paying less in funding costs than is earned on legacy assets – at least for now.
 
As a side note, earlier in the week (Tuesday, March 7th), Larry Summers interrupted the concluding remarks of his debate with Olivier Blanchard to emphasize Paul Tucker‘s point that the prolonged nature of quantitative easing (QE) in response to the pandemic was a major policy misstep by the Fed. It was a bit cheeky of Summers, but we highlight the point because it was emphatically made 24-48 hours before SVB became a household name.
That is to say, the serious people are not as aloof as the mainstream narrative likes to portray. But, in fact, several steps ahead. It also suggests the contents of the discussion has more profound consequences than the average screen joey may appreciate. Remember, nothing is put in front of us without a reason, or purpose. We just need to learn to listen carefully to what's said.
 
Circle closed.
 
– Many are trying to figure out contagion risks and who's next to fall. Contagion risks typically delve into the realm of unknown unknowns which have a poor hit ratio, but are high impact events. It's situations where giving advice is inappropriate since it comes down to individual circumstances, outlooks on life, and risk appetites.

Autonomous Research

For those who truly wish to understand the facts, rather than being led by emotions and hearsay, we would highly recommend following Autonomous Research. The good stuff isn't free, but it is of high value.
Autonomous research
 
Would Bank of America be in better or worse shape today were it not for a stricter regulatory regime? Circle closed.
 
To conclude, most of the views expressed on the most appropriate course of action on SVB pay little-to-no consideration for current rules and regulations. To some techies, it may seem more like a beta launch of a new product or service, but some have seen this movie several times before. The anecdotal evidence suggests there's capital willing and ready to invest in opportunities from the fall out of SVB. Unforeseen setbacks are an unfortunate part of free market capitalism.
 

Yield curves must disinvert 

Looking beyond SVB, it becomes patently clear why inverted yield curves are bad for banks' profitability. A theory for inverted yield curve signals a recession has to do with reduced incentives to lend when interest margins are non-favorable. Similarly, the converse is true when yield curves are steep – banks are keener to lend. Fortunately, US bank lending has (so far) remained strong despite a highly inverted yield curve.
 

Inflation must quickly come down

For the US yield curves to disinvert, inflation must be convincingly brought back down under control to levels nearer the Fed's inflation target of 2%. Which brings us back to where we stood a week ago, high and faster Fed rate hikes may be necessary to avoid systemic contagion of the banking system.  It includes higher and more uniform interest rates on retail deposits – it's less about the solvency of banks, but improving monetary transmission to help bring inflation down. Savers are more likely to save when earning higher rates of interest on deposits. In turn, this leads us back to the topic of the Blanchard-Summers debate last week. Circle closed.
 

Milton Friedman on enemies of free market capitalism

 
Milton Friedman may have been right when he said the greatest enemies of free market capitalism are his academic colleagues and business people – for totally opposite reasons.

The man was an intellectual giant… and probably a lot of fun to chat to over a few beers.

Good luck, and remember… It's only livelihoods (not lives) at risk.

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Bailouts | SBF to SVB | Yield curves & regulations

Why it’s so important to quickly bring inflation back down under control closer to the Fed’s target