A Run For Your Money?
Updated
March 17, 2023
7
m
TLDR:
When I said more volatility ahead last week, I didn't think we’d get a bank run. If they teach you anything about banking, it’s that banks borrow short term and lend long term in a process called maturity transformation. This is profitable since the yield curve is generally upward sloping.
And as much as people would like a salacious story of an evil conspiracy, the problem this time around is literally because people forgot about banking 101. It’s not any different, but in the digital age, everything is accelerated.
The Fed has hiked rates faster than any other previous time in history. In fact, the last time we hiked remotely this fast, we got the Savings and Loan Crisis. How little did we learn! The setup is slightly different this time around but the gist is the same.
Let me take you on a little history tour of…
There’s never been more regulation towards making banks safer. Yet it doesn’t seem like we are able to stop them from blowing up, or even reducing how often they happen! How did we get here?
Well, following the Great Financial Crisis of 2008, banks were excoriated. Governments had to do massive bailouts due to excessive bank risk taking that was aided and abetted by creative accounting and even more creative financial derivatives. Apparently you can slice and dice a pile of junk bonds into AAA paper. If you ever hear the term copulas, run away!
The fallout was a series of regulations that required banks to massively delever and account for risks of derivatives in a way that would essentially make it not capital efficient for banks. One such rule was the Supplemental Leverage Ratio (SLR), which decreased leverage in the banking system, but ironically made certain safe low margin activities such as tri party repo unprofitable since the rule did not factor into account the riskiness of the activity. This forced banks to either take more risks per dollar of balance sheet or to get out of that business.
This led to the core regulation that precipitated today’s crisis. The Liquidity Coverage Ratio (LCR). In simplistic terms, it means a bank should have enough cash and cash like instruments to be able to meet an extended period of deposit outflows.
What kind of cash-like instruments you ask? Well… in the US case, Treasuries, and government guaranteed mortgage backed securities, AKA High Quality Liquid Assets (HQLA). The creme de la creme of fixed income securities, the very instruments that Silicon Valley Bank held in ample quantities…$100 Billions+ too much?
So you follow the regs, buy a bunch of HQLA instead of making loans, the irony is you actually take zero credit risk and you appear even more high quality than an institution that would actually expend effort to build a giant loan book.
There’s just one slight problem. Securities of that nature are typically marked to market on a bank’s balance sheet. Even during 2008, many hypothesized that such accounting rules might have helped fuel the flames of a financial crisis.
So how do you force banks to take on much more HQLA without causing undue earnings volatility? Enter Held To Maturity (HTM). It really is as obvious as it sounds. The securities in this portfolio, even though they are tradable and have liquid prices in real time, would be marked at the price you bought it at, and it would sit on a shelf and send you coupons until it matured and you got the principal.
This worked uniquely well with HQLA since there was no risk of default, so you’d always get your money back. What could go wrong?
Unfortunately markets don’t care about which bonds have been given what labels. As a result of the unprecedented speed of rate hikes, banks have been saddled with huge losses. Rates go up, price goes down to compensate. And because HTM is not marked to market, banks are incentivized to put riskier (in terms of interest rate exposure) assets in that portfolio and… close their eyes.
Even more hilarious is that once securities are put into this HTM bucket, you are not allowed to hedge them, and moving them in or out of HTM is also frowned upon for obvious reasons. So basically you’d go all in on whatever you put in there… Score 1 for risk management!
What could go wrong?
So SIVB really took this to heart, grew rapidly, and ended up putting over $90B of assets into HTM, all in an effort to generate higher yields. It was also fairly aggressive in that regard as it put assets which reportedly had a duration of 6+ years. The basic bond math of how much the price of a bond changes is simply duration times the rate change. So a 4% upward move in rates would mean a 24% loss on the value of the bond.
However, it is technically true that if no one actually started a bank run, they’d eventually get all the money back + interest. So what’s the problem?
Unfortunately, the coupons for those bonds were created in an era of low rates (6 months ago?). So even if they didn’t experience a bank run but rates stayed elevated, they’d experience a very big drag on their income as they generate much lower yields than the prevailing level of rates. This could be so severe that it would get them eventually to a solvency issue, but it’d be months/years instead of hours and minutes.
However, that’s not what happened. Due to a communication snafu, on Thursday March 9th, they:
Amidst the confusion, and the extremely poor judgment of announcing before a deal is secured, everyone panicked. Peter Thiel sent out an email telling his portfolio companies to get their funds out, thereby kickstarting/contributing to the bank run they were desperately trying to avoid.
The fallout came fast and furious: SIVB was halted for trading on Friday and seized by the FDIC. Government agencies furiously worked on a deal to contain the panic. They were not able to come up with a buyer to their liking, but they more than made up for it with the most generous loan program aptly named BTFP (Buy The Fed Pivot?)…
That’s right, you can borrow at par by giving the Fed your heavily underwater securities as long as they are HQLA. Borrowing more than $1 for each dollar of collateral is a good deal. That pretty much stopped the bank run dead in its tracks.
But wait, there’s more! It’s not sufficient just to provide liquidity to banks, what if they aren’t solvent? What if I don’t know if they are solvent and pull my funds anyway just in case? Well, FDIC says you don’t have to worry about that either.
And that, my friends, is how you stop a bank run. Until…
CS makes SIVB, Signature Bank, and First Republic Bank look like a walk in the park. It is an actually systemically important financial institution (SIFI). Its balance sheet is much bigger than those other 3 banks, and it is a global trading powerhouse with a lot more exposure in derivatives and capital markets.
It also just recently reported a loss of $8B, a big fraction of its market cap. So who will support CS? On Wednesday the 15th, in the wee hours of the night, it announced that it will get ~$50B of support from the Swiss National Bank, effectively ending the bank run.
So clearly regulators have learned from 2008 that swift action is required to stem the crisis. The main question now is: will it stick? CS has a client base that is composed of flighty and very sophisticated hedge funds and financial institutions. It remains to be seen whether they want to gamble on keeping their assets there or simply decamp to safer pastures.
The road towards stability is a tough one, especially when…
Yes, we are only 1 week into a bank run, the Fed is scheduled to meet next week, and markets are pricing in either a single hike, or a low probability of no hikes at all. The ECB is in a tough situation though since the inflation picture looks a lot worse in the Eurozone vs the US.
With CS receiving liquidity just hours before, they decided to go for 50 bps raising rates to 3%. I don’t think it’s contentious to say that the ECB has to raise rates with inflation in the 8% range. However, it is not clear what they will do at the following meeting. If indeed they flinch under the guise of financial stability, that would be the supportive signal that will set equities on fire.
A lot has happened in the past week and a half with many things still developing. The stability measures undertaken by the Fed are equivalent to a de facto unlimited deposit guarantee. It prevents future bank runs, but isn’t exactly a hand out, which means it’ll force banks to bleed slowly as the low yielding assets runoff the balance sheet.
This stops lending in its tracks. If the recession wasn’t so obvious in the last few months, it will become painfully obvious in the next few. The biggest question, however, is what this does to risk assets.
On one hand, we have a looming recession, on the other, we have Fed balance sheet expansion. It doesn’t take too much work to look at this chart and notice that asset prices run up following a balance sheet expansion.
What complicates the picture is a period of high inflation, but in the medium term, since stocks are generally inflation hedged as they can pass on the costs onto consumers, there’s really not much holding back another run up in asset prices.
Is this healthy for the broad economy? No. Does this raise the specter of potentially uncontrollable inflation further down the road? Yes. But at least we know what the playbook is. Risk assets go up. See you next week!
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