The financial world was in turmoil for the last 10 days as one bank after another fell off the chair in a domino effect. First, it was Silvergate, then Silicon Valley Bank (SVB) and First Republic Bank, followed by Signature Bank and then Credit Suisse.
Naysayers were predicting the Great Finance Crisis (GFC) of 2008 all over again while another camp insisted that things are much better this time around. Both were equally right in certain aspects we will dissect and explore them today.
The banking world has changed a lot in the last 15 years, fuelled by cheap borrowing costs and addiction to leverage to reap maximum profits in the fastest possible way. Predictions of an end to the party were persistently wrong as buying on any dips became the winning strategy.
The end finally came in 2022 as we emerged from a pandemic where even more money printing was required to support economies. The Ukraine war woke up the inflation monster and central banks finally had to act to hike interest rates aggressively within a matter of 12-15 months.
Into 2023, we are now seeing the aftermath of what the rate hikes have done to burst asset bubbles last year and uncover the ugly truths of leverage indigestion within the portfolios of financial institutions.
Technically, we are not as highly leveraged as in 2008 with the CDO derivatives voodoo black magic where even strippers can own 5 properties with no money down then. Watch “The Big Short” movie for quick enlightenment. This time around, it is more of traditional banking practices gone horribly wrong.
A normal bank usually attracts mom-and-pop depositors who are relatively sticky by offering CASA (Current Account and Savings Account) facilities. These funds are not volatile as clients normally bank with only one or two banks for all their needs, be it for loans, investment or credit card requirements.
The banks in turn set aside some of that as reserve requirements (around 10%) and tries to place out the rest to earn a higher yield. They pay the depositors a low-interest rate and pocket the rest as revenue. To be on the safe side, a big chunk of the 90% may be placed in longer-dated instruments that pay back the principal at par upon maturity. These include Treasury bills and bonds which are of the highest AAA rating.
This all went haywire when the Fed raised rates quickly in 2022. Bond prices have an inverse relationship with interest rates. If rates rise, bond prices will fall. There is a push for money to switch and reinvest in the newer bonds at higher rates of return and to get rid of the older lower-yielding ones. So if any bank were holding onto bonds purchased before 2022, their values will see a drop versus the current market values where they can sell them.
So SVB was stuck with a gapping problem. Its internet-savvy fintech depositors were not sticky as earlier thought and smelled danger last week (thanks to Peter Thiel’s rally call). They pulled out so fast that SVB had to sell its bonds portfolio at a mark-to-market loss. Otherwise, it could have held the bonds to maturity and gotten their funds back at par value without any principal loss.
The other stunning revelation was that SVB was operating without a CRO (Chief Risk Officer) for most of 2022!! The old one quit in Apr and hung around till Oct doing nothing while the new CRO joined in Dec. All banks normally have an ALCO (Asset and Liability committee) to monitor risks like interest rate exposures. So it seems that no one was red-flagging SVB’s interest rate risk during the greatest rate hike year of the century.
Most banks are in fact having the same gapping issue as SVB throughout 2022 with the rapid Fed rate hikes. Banks normally lend long-term and borrow short-term to “ride” the positive yield curve. But the curve has been inverted for some time and this tried and tested formula now results in a negative return. Worse still, the bonds in the portfolio are now trading below par. A report suggested that all banks probably now hold unrealized bond losses of at least $650 billion as a result. SVB had to crystalize about a $2 billion loss last week to pay depositors who were pulling out their funds as a bank run was formed.
The other irony occurred in Signature bank. One of its directors was Frank Barney, the architect of the Dodd-Frank Act. The Act was created after the 2008 GFC to strengthen the banking infrastructure with stress test scenarios which would have failed SVB for its interest rate exposures. This act was removed in 2018 by Trump as it was deemed that banks had reformed after 10 years LOL. Elizabeth Warren had strongly criticized the revoking of the Act in 2018 with no avail as the GOP was leaning towards less government intervention.
Funnily, for First Republic bank, it was the other big American banks that eventually came to its rescue. The too-big-to-fail banks decided late this week to cough up $30 billion to deposit into First Republic for at least 120 days to shore up the bank. Ironically, depositors were pulling out their funds to place in these bigger banks in a flight to safety! Yellen and Dimon managed to convince everyone that it is in their interest to re-deposit funds back to reduce the contagion bank run effect on the whole industry.
Credit Suisse was the next in line to get a backstop emergency loan from the Swiss National Bank (SNB). Its numerous losses and scandals have finally caught up to it. Even with a recent CHF 4 billion of new equity injection in Dec at a CHF 10 billion market capitalization, its market cap still fell below CHF 7 billion this week.
This week’s bank fiasco is not like 2008. Taxpayers’ monies were not used to bail out troubled banks. But thanks to technology, things now move at lightning speed. A bank run can happen in 24 hours via electronic transfers in real-time. The Fed is likely to only hike 25 bps next week instead of the expected 50 which Powell hinted about a week earlier.
The contagion effect should be minimized into next week assuming that there are no more new shocks. The regulators had surprisingly been extremely proactive in arresting the panic within days without bringing in the big cannons yet. The people will be braying for bankers’ blood to hang for their oversights this time as no one went to jail the last time during the 2008 GFC. Don’t hold your breath though 😉 …
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