Other people’s money to solve shoddy bank collapses - some thoughts on Silicon Valley Bank and Signature Bank failures

Here’s my fast take on the collapse of Silicon Valley Bank and Signature Bank of New York.

The “regulatory capital” of banks – that capital with zero risk of default held by banks – may have suffered “mark to market” losses of as much as 25% from increases of 3-4% in LEVELS of interest rates. However, banks mostly make money from MARGINS on floating rates of interest for loans, not LEVELS.

This “regulatory capital” is probably around 10-15% of the value of bank balance sheets – meaning banks have incurred losses of around 0.3% to 0.5% - banks would have made profits of the same order (“banks” includes the Federal Reserve Bank) over the last few decades of financial repression.

Silicon Valley Bank and Signature Bank would have been subject to “stress tests” that did not cover the 3-4% rise in levels of rates, hence this represents regulatory failure. Bank regulators impose rules, banks abide by them and still make losses that exceed their reserves intended to cover “shock” losses.

Look for more regulation to expand the list of “significantly important financial institutions”, the amount of regulatory requirements and control that will only serve to increase the risk from holding regulatory capture.

Banks should have been allowed to fail, rather than get bailed out, in the GFC and the same applies now. Caveat emptor. Depositors – insured or not – and shareholders should not be compensated if their investments and deposits fail in any bank. Full stop.

A comment on “contagion” and the impact on financial markets.

Volumes and prices of derivatives are key. The need for Treasuries and high quality collateral to secure p/l on the positions of banks and other players has increased as the levels of rates has increased. This results in perturbation and shake-out of those that cannot buy/secure/provide collateral of this sort.

Other thoughts.

Derivatives markets dwarf “physical” markets like Government debt markets i- Treqsury bonds. There are probably more than one or two quadrillion in dollar notional value of derivatives globally, with a net p/l value of around 2-3 trillion dollars. The p/l is predominantly secured/collateralized by Treasury bonds and bonds rated single A or better. As these bonds drop in value, more of them are required to meet collateral requirements. Calls for collateral to secure derivatives p/l have increased. Putting a strain on derivatives markets that has not been seen in decades.

In properly functioning markets, without the heavy hand of regulations and central banks, bond yield curves would be far more steeply inverse – short term rates would be level with headline inflation and ten year bond yields would be close to nominal GDP growth – 6-8% for Fed Funds and around 5% for ten year Treasury yields (reflecting a sharp fall in expectations over ten years from the current 9% nominal GDP to  around 3-4% in one year’s time in nominal GDP thereafter.

Government debt in all Western countries and Japan is unsustainably large – governments have no ability to repay debt run up after decades of spending like drunken sailors on pork barrel and unrealistic spending policies based on politically determined and impossible to satisfy, demand for “entitlements”.

The headlines are symptomatic of the socialist mantra from the GFC – “socialize losses and privatize profits” combined with, “whenever a policy or political ideology fails, double down”.

From here:

Government Steps In With Plan to Protect All Deposits at Silicon Valley Bank (theepochtimes.com)

“Banking regulators announced an emergency measure on Sunday to fully protect deposits at Silicon Valley Bank, a critical move in averting a panic over the bank’s collapse.

U.S. Treasury Department, the Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC) have revealed the plan in a joint statement.

“Today we are taking decisive actions to protect the U.S. economy by strengthening public confidence in our banking system,” the statement read.

Treasury Secretary Janet Yellen, after consulting with the president and regulators, has authorized the plan that “fully protects all depositors.”

Okay, that’s the guts of my view, FWIW – here are some ramblings.

This is becoming a well-trodden path, reminiscent of the 2007-2009 GFC where Treasury Secretary Paulson and Fed Chair Bernanke introduced their ‘this is the only way” solution to “socialize losses and privatize profits”.

The bank has been shuttered – as has the other bank in New York.

“Regulators also announced a similar measure for New York-based Signature Bank, which was closed on Sunday by the state chartering authority.”

It is clear that regulators, once again, failed to impose regulations and safeguards that ensured proper banking practises and solvency.

The issue?

“The primary reason for the bank’s failure, according to industry analysts, was that it heavily invested customer deposits in Treasury bonds, which are highly sensitive to interest rates.”

Basically, borrow money from depositors with short maturity dates and lend to the US government for longer maturity dates, “borrow short and lend long”. In a rising interest rate environment, the effect is that your short term borrowings cost more and your holdings of Treasuries lose money. For example, taking a Treasury bond with a starting yield of around 0.5% and a duration of nine years, an immediate 1% rise in the yield results in a 9% drop in value. Duration is the weighted average time to receive all the coupons and final maturity proceeds from a bond.

Here is a chart of ten-year Treasury yields over the last five years.

Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis (DGS10) | FRED | St. Louis Fed (stlouisfed.org)

Yields “bottomed” at the end of July 2020 at just 0.5% as investors took the view that the economy would remain in recession for the next decade. As the potential for the C19 pandemic disappeared and Federal government measures were shown to be risible and impactful on inflation for years to come, Treasury ten-year bond yields have shot up to 4%.

Roughly speaking (there are other complicating factors to take into account) - duration reduces as yields rise but the general premise holds - the loss in value from holding ten-year Treasuries is 4% - 0.5% = 3.5% times 9 year duration = a loss in excess of 30%, offset a little by the 0.5% starting yield.

Once losses exceed reserves (reserves mandated at minimum levels by the Federal Reserve and the BIS) the bank becomes insolvent. After the GFC, reserve requirements of banks were stipulated to be a minimum of around 10-12%.

Don’t forget all the “stress tests” that banks were required to pass. Silicon Valley Bank and Signature Bank passed these tests, supposedly. The implication is that the “stress tests” are faulty - hence systemic risk to the entire banking system has emerged.

Obviously a rise of 3-4% from record lows was not one of them. Neither was the impact of the financial repression of central banks on the economy as a whole. Financial repression = central bank rates below inflation – where savers lose purchasing power and borrowers gain I – discriminatory policy that encourages borrowing and the discouraging of savings, in the belief that wealth always results from debt, rather than its elimination.

Keep in mind that the yield on Treasury bonds reflects an average expectation over the life of the bond for inflation – that peaked recently over 9% and is sitting at around 8% (more accurately “core” inflation that excludes food and energy prices).

Monetary theory holds that inflation is always and everywhere a monetary phenomenon – the Fed (and other central banks) has printed a lot of money in the last five years – see page 6, Figure 7 here:

Monthly Balance Sheets (yardeni.com)

Why did the Fed (and other central banks) print such vast sums of money, in the full knowledge that it would create inflation? Good question. It is because central banks have become politized and, rather than maintaining a focus on their mandates for maintaining monetary policy settings consistent with full employment, inflation and growth, the Fed bailed out profligate government spending way beyond the tax base – over decades.

By the way, if the Fed’s actions in supporting fiscal profligacy are egregious using a balance sheet that has monetized around a quarter of all US Treasury debt (around a third of US GDP) look at Japan. Its central bank has monetized almost half of Japan Government debt (which in turn is close to 240% of GDP).

Around 5 trillion bucks or around a 20% of US GDP in the last 3 years. Manifesting in inflation that must be absorbed by ordinary folk for the last few years. Central bank purchases of Treasury bonds, to support the profligate and useless spending by Congress and the President during the C19 “manufactured crisis”.

Now factor in that the duration of hundreds of US Treasury bonds ranges from a few months all the way out to 25 years and the “portfolio duration” of Silicon Valley Bank v the close to zero duration of its borrowings springs into stark relief. So do the losses on the Fed’s balance sheet. Do not forget that the Fed has its own portfolio of Treasury and Agency bonds here:

System Open Market Account Holdings of Domestic Securities - FEDERAL RESERVE BANK of NEW YORK (newyorkfed.org)

The odd 8 trillion or so. If the duration of these is, say 5 years (rather than the 9 years used in the example above), the Fed has losses of as much as 400 billion bucks.

Of course, the Fed and other central banks can simply exchange letters with their Treasuries saying “cancel the debt and the losses”, - the Fed has been paying over profits as it pursued policies to try and gin up inflation and economic growth.

The Fed had been worried about deflation resulting from the GFC, rather than inflation – hence ZIRP (Zero Interest Rate Policy) - some countries/regions like Japan and the EU had been pursuing NIRP (Negative Interest Rate Policy).

Most central banks have been buying up bonds as well as setting low or negative interest rates, in a policy called “quantitative easing” – some morons even support simply printing money to pay for free health care, cash benefits, education – all of it – they call this Modern Monetary Theory (MMT) – “do no work, py no taxes, print money”. All left leaning morons of course.

This sort of capital loss has been experienced by all banks – up to the mega banks like JP Morgan, Citi, Wells Fargo, Bank of America and others.

These banks and a few other non-banks are called Systemically Important Financial Institutions. (SIFI’s)

Here is a list of bank SIFI’s from Wikipedia:

List of systemically important banks - Wikipedia

Note that neither Silicon Valley Bank or Signature Bank are on the list. (Wikipedia accuracy, not fact!)

With this latest intervention by the Biden Administration et al, we are seeing an extension of those designated as SIFI’s and socialist policies.

This might explain the losses incurred by the bank that have led to its collapse, but it does not explain its ridiculous “bailing out”, using other people’s money, or the price of insurance contributions to cover banking sector losses (the government and its agencies set the insurance rates) or the failure of bank supervision by the Fed (Yellen is an ex-Fed Chair)

There is a reason why millions are employed in the financial sectors around the world. It is complex and needs to make money to survive.

Much more could and will be written in the coming weeks. Contagion will be prompted by each and every cock up manufactured by those that panic – politicians especially. The need to “do something, anything” dominates, rather than letting the chips fall where they may.

Onwards!

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