ISMS 11: US Banking Crisis and Fed Rate Cut

Did the Fed finally break something with its aggressive rate rises? I’ve been repeating in my investment strategy that the Fed will eventually break something, and yes, they did. They did.

• Was the collapse of the Silicon Valley Bank the beginning of the 2023 US banking crisis?
• Has quantitative tightening ended?
• Are we in quantitative easing?
• Could this spread throughout the US?
• Or the global banking system?
• Was this caused by the government or the bad behavior of banks?
• Is the dollar going up or down due to what’s happening?
• Could this trigger a much-anticipated recession in America?
• And how does this impact Feds tightening and inflation the Fed is meeting this week?
• Did the Fed finally break something with its aggressive rate rises?

Was the collapse of the Silicon Valley Bank the beginning of the 2023 US banking crisis?

First, we start with the situation of Silicon Valley Bank, which is going bust. In Silicon Valley Bank’s case, first of all, there was a huge influx of deposits into Silicon Valley Bank over the last couple of years, as well as the whole banking sector in the US.

Where did these deposits come from? In the US, those deposits came from the US government pumping money into the hands of individuals and companies through the various and massive stimulus programs during the covid shutdown. Those stimulus packages passed by Congress went into the banks as deposits from individuals and companies.

Consider the fact that most countries around the world couldn’t do this. Thailand where I am right now, there’s no way the government could print all that money because the currency would have collapsed. And therefore, most governments did not have the privilege of having a reserve currency asset and the ability to print as much money as needed. So America is quite unique in this, and that’s one of the reasons why what’s happening in the US is may not spread to such an extent globally.

What did Silicon Valley Bank do when they got all these deposits?

Well, they didn’t have enough loans available to lend this money out. A bank does basically three things with the deposits that it receives: 1) it can hold it as cash, 2) it can buy some security or investment, like a security that could be traded, or 3) the traditional business of a bank, is they lend out money.

Now if they had a lot of opportunities to lend that money out, they would have locked that money up in loans. Now imagine that a bank had 5% cash, 5% securities, and 90% loans. If people wanted to pull their deposits out of the bank, the bank would have 5% of the money available of their total, and then another 5%, they could sell those securities and repay deposits.

Now they could also go to the government to the Fed and borrow some money to repay deposits to prevent a bank run. But it’s not so easy to get out of loans, right? If you’ve lent money to a company and need that money back, you can’t get that. So the loans are very illiquid, but securities are very liquid.

After the 2008 crisis, new regulations tried to force the banks to hold more cash

Now, let’s add that after the 2008 crisis, basically, the US government came up with new regulations that tried to force the banks to hold more cash and more securities, with the idea being that the combination of cash and securities would be highly liquid assets. And basically, the banks would then be able to pay back if any depositors came, they would be able to pay back.

In fact, at the peak liquidity of the banks, you had almost 20% of the US banking sector’s assets in cash and almost 20% in securities. That means almost 40% of the bank’s balance sheet was in highly liquid assets.

Now also what the US government did is they said, look, if you buy US Treasuries, we’ll count them as purely risk-free, meaning that you don’t have to put aside any capital for that. And remember, the US government was borrowing tons of money. So they needed the banks to own these treasuries. So they provide an incentive for the banks to own government securities, knowing that 1) those are risk-free assets, and 2) knowing that the federal government was borrowing a ton of money, and they needed the banks, not just the Fed, to buy those to buy the bonds that the Treasury was issuing.

I thought that US Treasury bonds were risk-free

And now we have all this risk that we’re talking about? Well, where US Treasuries are risk-free is they are credit risk-free. In other words, it’s almost impossible to imagine that the US government wouldn’t print the money needed to pay back the debts that they owe.

Now, when they print money to pay back debts that they owe, of course, they’re devaluing the US dollar, but still, you’re gonna get paid. So when we talk about risk-free, we’re talking about credit risk-free, but that doesn’t mean that they’re not interest rate risk-free. In other words, what does that mean?

Remember that the Treasury rate for a 10-year bond, going back a few years, was about 1%. Imagine a bank buying a huge portfolio of these 1% government bonds. And then, all of a sudden, the Fed starts to raise interest rates.

Let’s say that you own three-year government bonds. And then the Fed starts raising interest rates, and suddenly, someone out in the market could buy a three-year government bond at a, let’s say, 4-5% interest rate. And now you’re holding one that only pays 1%, holy crap; yours is not worth that much compared to others. To get other people to buy the bond you may want to sell, you’ll have to reduce the price. And it’s going to be a price reduction somewhere between 10% and 30, or 40%, depending on the maturity. In this case, we said three-year maturity. And so that means probably a 10 to 20% loss on that bond.

Did the Fed cause this problem?

Well? Yeah, I think so. Basically, what the Fed did is the Fed aggressively raised interest rates, knowing that all the banks were sitting on a large amount of US Treasury bonds. Now, in the case of US Treasury bonds, whenever you own a bond, you’re exposed to interest rate risk. So what is the risk management of a bank?

Well, the risk management of a bank basically looks at all these different risks and says, how do we hedge this particular risk? So technically, the bank’s not really in the business of trying to make a lot of money on this; they’re in the business of raising deposits and lending those out.

So what they want to do is protect the risk on their portfolio so that the value of the bond doesn’t collapse, and then all of a sudden, the bank is wiped out? Well, basically, what happened is that many of them, the larger ones, in particular, did do some hedging to try to cover this risk. Now, in the bank’s financial statements, you can see analysis, the type of analysis that they do, which is looking at interest rate risk, and they basically say if the interest rates go up by 100, or 200, or 300 bps, it would cause this amount of potential interest rate risk.

Now, if you’re holding a bond to maturity, it’s a little bit different, right? Let’s just say that you as an individual bought a US government bond, that’s a 10-year bond, and you’re gonna hold it for 10 years, and it’s earning 1%. Now, if US Treasury bonds, 10-year treasury bonds now are trading at 5%. If you wanted to sell that bond into the market, yes, you’re going to experience a loss because that bond is no longer attractive because it’s only paying 1%. So you got to reduce the price to equalize the return of that bond between this from 1% to 5%.

However, if you say, well, I don’t really care, I bought this bond for 10 years, I’m gonna hold it for 10 years to maturity, then you are not going to experience this risk, or this lower price, in fact, you’re going to get all of your money back. And so when you get all your money back at the end of the 10 years, you have gotten a pure 1% return.

And that’s part of what Silicon Valley Bank had done is that they had put there, the excess liquidity that they had, they had put into held-to-maturity bonds. When you hold to maturity under US accounting rules, you don’t need to account for this interest rate risk, because you’re going to be holding to maturity.

And there’s a lot of debate about if you were to put that security up for sale; that’s called available-for-sale securities. And for that one, you are going to have to mark it to market and say, well, there’s a big loss on this. But if you hold it to maturity, then you don’t have to. Well, also, what you’re doing is you’re not marking it to market through the P&L. You’re marking it to market through the balance sheet and the equity section of the balance sheet.

Silicon Valley Bank received a lot of deposits, they have a lot of customers, and they’re happy with their deposits there. And then something went wrong. And when that one thing went wrong, all of these friends who are all tech startups and tech companies, all of a sudden told each other, hey, take your money out; there’s a risk at Silicon Valley Bank.

And all of a sudden, Silicon Valley Bank had a run on the bank, meaning that its deposits were withdrawn superfast. So they sold their available-for-sale securities first because they’d already marked down the value of those. So they didn’t have any major loss from those.

But then they had to sell their held-to-maturity assets. It is just like if you owned a 10-year bond, you’re not going to sell it, you’re going to hold it for 10 years, but then you have an emergency in your family, and you are forced to sell it.

What is a liquidity event? How does it happen?

This is kind of a liquidity event where you need the liquidity. And what happened is that Silicon Valley Bank had to start taking losses on their held-to-maturity securities. It’s a debate because I know that in the EU and other places, banks are basically required to show the potential losses on their held-to-maturity. Also, there’s other issues about how you hedge that and how you report the hedging on it.

These are remarks by FDIC Chairman Mark Martin Greenberg at the Institute of international bankers. And he gave this presentation on March 6, so before Silicon Valley Bank collapse happened, and what did he say? I think the most important thing that he said is the following.

“The current interest rate environment has had dramatic effects on the profitability and risk profile of banks’ funding and investment strategies. First, as a result of the higher interest rates, longer term maturity assets acquired by banks when interest rates were lower are now worth less than their face values. The result is that most banks have some amount of unrealized losses on securities. The total of these unrealized losses, including securities that are available for sale or held to maturity, was about $620 billion at yearend 2022. Unrealized losses on securities have meaningfully reduced the reported equity capital of the banking industry.”

Then on March 12, there was a joint statement by the Treasury of Federal Reserve and FDIC, which means Janet Yellen and Jerome Powell and FDIC Chairman Martin Greenberg. So just six days later, they said to take decisive action. I’m quoting from the the announcement,

“Today we are taking decisive actions to protect the US economy by strengthening public confidence in our banking system. This step will ensure that the US banking system continues to perform its vital roles of protecting deposits and providing access to credit to households and businesses in a manner that promotes strong and sustainable economic growth.

After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer.

We are also announcing a similar systemic risk exception for Signature Bank, New York, New York, which was closed today by its state chartering authority. All depositors of this institution will be made whole. As with the resolution of Silicon Valley Bank, no losses will be borne by the taxpayer.

Shareholders and certain unsecured debtholders will not be protected. Senior management has also been removed. Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law.”

Everything that the federal government does is supported by taxpayers

Of course, everything that the federal government does is supported by taxpayers. And the result of this is that if they say that this money is coming out of a fund, the banks have contributed to the other banks, belt, also, that comes from the back of the taxpayers. So what we have here is the Fed coming in, and the Treasury and the FDIC, and basically saying, everybody’s gonna get their money back.

Now, this is a big problem. Why is this a problem? Because only a small number of depositors at Silicon Valley Bank were actually guaranteed by the FDIC. And yet here we have a blanket guarantee. And this is a particularly big moral hazard. Now, some people would say, well, you have to do that; otherwise, money’s going to come out of every bank. They’re going to move money, either home and put it under their mattress, or they’re going to go and put their money into a bigger bank that they trust more.

The Fed knows that other banks are sitting on unrealized losses related to their bond portfolio of US Treasury bonds because they’re holding 1% yielding bonds, and the Fed has increased interest rates up to almost 5%. And the result of that is that they have massive unrealized losses.

We’ve seen the chairman of the FDIC say those losses amounted to about $620 billion in his estimate at the end of 2022. Just imagine that there’s probably more that come out, you know, from under the woodwork.

Also on March 12, the Federal Reserve Board announced it will make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors. Okay, so this is where the government comes in and says we’re going to protect the whole system.

How are we going to do that?

The Bank Term Funding Program (BTFP)

“The Fed set up a new borrowing facility, the Bank Term Funding Program (BTFP) offering loans of up to one year in length to banks, savings associations, credit unions and other eligible depository institutions, pledging US Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. The Fund has $125 billion (bn) and it can borrow another $100 bn from Treasury.

The assets will be valued at par, so that banks won’t have to sell US treasuries at a loss in order to redeem deposits as was the case for SVB.”

So the fund can borrow 100-125 billion and another 100 billion from the Treasury. But the kicker is, remember, all of these unrealized losses are because the value of those bonds that were yielding 1% has collapsed. And those bonds now are maybe 20-30% down in price. They say the assets will be valued at par so that banks won’t have to sell US Treasuries at a loss to redeemed deposit. As was the case with Silicon Valley Bank.

Okay, so let’s talk about this for a second. What did they do? First, they gave kind of an implicit guarantee of all deposits at Silicon Valley Bank. And then the next thing they did is they said, if any other bank is facing this problem, and you’ve got massive losses, good news, we’ll help you hide those losses. We’ll hold those losses for year off your balance sheet. This is a very sneaky way of basically trying to prevent losses from hitting the balance sheets of the banks and collapsing the whole system.

Fed will hold the losses for banks at risk

Now what’s happening is all of these small and midsize and regional banks, remember, America has almost 5,000 banks, all of these guys are facing deposit outflows. The result of those deposit outflows are that they have to sell government securities. And suppose they have to sell those government securities at a loss. In that case, it’s going to crush their capital, and all of a sudden, you’re gonna have hundreds, if not thousands of banks, that could be in a difficult situation as far as capital is concerned.

So instead of that, what they’re basically saying is all you guys can come to the Fed. And you can pledge that security at 100%. We’ll hold those losses for a year, and at the end of the year, we’ll figure out what we’re going to do.

Is this quantitative easing (QE)?

Well, there are some people that say that this is not quantitative easing because it’s a swap so that it’s just one asset on the balance sheet of that now has been swapped out as cash. So technically, you could say that when you’re swapping assets with the central bank, it’s not really QE.

However, a second reason why people say that it may not be QE is because it’s also a short-term situation where in one year, those assets are going to go right back, and the losses are going to go on to the bank’s balance sheets.

Well, come on, you think that the Fed, if things go bad, a year from now, they’re going to force all the banks handle the losses?

One of the best ways to understand this, is just look at the assets of the balance sheet. Remember, that for the past year or so the central bank of the US, the Fed has been telling us that they’re doing quantitative tightening, and quantitative tightening means they’re reducing the size of their balance sheet. And also quantitative tightening has to do with, you know, increasing interest rates.

From my experience and what I’ve seen in the banking system, as well as with the Fed, my prediction is quantitative tightening won’t last for long; eventually, quantitative easing will come back. Why?

Because now, the US is in such a situation where it just can’t bear pain. Politicians can’t bear pain. Individuals can’t bear pain. And if you’re bringing pain upon the system, you’re gonna get voted out of office. Why let them bear pain when you can solve this problem?

And that’s one of the reasons why looking at the repeated times that the Fed tried to get off quantitative tightening and to quantitative easing. They wanted to do quantitative tightening but every time they did it, they barely did it. And then eventually, they had to reverse it. And they had to go back to quantitative easing.

So to answer the question that I asked at the beginning, is this the end of quantitative tightening and the beginning of QE? Yes, it is. How do I know? Because the assets of the balance sheet or the assets of the Fed just increased after roughly a year of small decreases? It increased by nearly $300 billion as a result of them providing funding and buying the assets from the bank. So the answer to that question is yes, we are now in QE5; how long it will last?

11 banks announce $30 million in deposits into First Republic Bank

“Washington, DC -- The following statement was released by Secretary of the Treasury Janet L. Yellen, Federal Reserve Board Chair Jerome H. Powell, FDIC Chairman Martin J. Gruenberg, and Acting Comptroller of the Currency Michael J. Hsu:

Today, 11 banks announced $30...