A Systemic Banking Crisis
Once again, and as has always been the case in the past century, major financial crises erupt in the US due to America’s free-wheeling capitalist system, weak supervision and extreme monetary policy experiments.
In several articles in 2022, we highlighted the possibility of a banking crisis in the US, coming from rising intent rates, declining real estate prices and the outsized number of regional and niche banks concentrating their assets in specific segments that were bound to experience significant losses ahead.
This is EXACTLY what happened last week with SILVERGATE and New York-based SIGNATURE BANK, two crypto-related niche banks, and SILICON VALLEY BANK, the technology start-up must-go-to bank and 16th largest US bank who made the mistake of not acting swiftly in the face of rising bond yields to shield its bond portfolio form massive losses.
Since Thursday, shares of US banks have been devastated with the KBW index of big US banks losing 25 % in two trading sessions — the last time this happened was in the aftermath of the Lehman Brothers bankruptcy – and having erased all its gains of the last 25 years, trading now at the same level it was on March 11, 1998.
Today, several regional US banks lost between 60 and 80 % of their value in one single session, causing ripples worldwide in a globally integrated banking system and sending European and Japanese bank shares tanking.
To get a measure of the systemic nature of the risks suffice to look at what happened in the bond and credit markets on March 13th …
- The biggest one-day slump for the 2-year Treasury yield (61 basis points) since 1982; the fall during the Black Monday crash of 1987 was 59 basis points;
- The biggest one-day drop in the 2-year German bund yield (41 basis points) since Bloomberg’s data started in 1990;
- The biggest one-day decline in the 2-year Japanese Government Bond yield (20 basis points at one point) since the Bank of Japan introduced yield curve control in 2016;
- The sharpest steepening in the US 2-year/10-year yield curve (48.2 basis points) in the last 40 years, save only Sept. 11, 2001, when it steepened by 50.6 basis points — we all know why
… And the immediate and drastic actions of the US Government, Treasury and FDIC over the week-end, where contrary to all laws, regulations and organisation of the banking system they extended a global and total backstop blanket to the banking system to avoid a devastating run on deposits.
To better fathom the magnitude of the measures, but also the panic that is setting in at the helm of power, beside the US President making a pubic address to reassure investors before the opening of the markets, suffice to highlight the fact that the FDIC normally insures depositors money up to US$ 250’000.
Extending the blanket to the entirety of the US$ 17.6 Trillion of depositors money with the US banking system is the biggest step that could be taken by any Administration, and backstopping the banking system on their USD 760 Billion of unrealised and unaccounted for losses on their bond portfolios is another major step that goes against all the principles of the US legal and financial system.
Committing that the costs associated with these measures will not be ultimately born by the taxpayers and will ultimately be born by the banking system itself remains to be proved as a viable opposition, and in any case, could potentially cause a major hole into the banking system’s net equity.
Granted, there was not much else the US Government could do to avert a devastating run on bank deposits that could have potentially brought the US economy and financial system to its knees.
But let’s delve deeper into the situation of the US banking system and the potential consequences of the crisis.
In the United States, the banking system as a whole has $22.9 trillion in assets and $20.7 trillion in liabilities.
The problem, of course, is that their assets are riskier and less liquid than their liabilities, and so they face both liquidity risks and solvency risks if risk are not managed well, or if they face external shocks that are larger than they can deal with.
That leaves the banking system with barely 2.2 Trillion of net equity.
The majority of bank liabilities are deposits for individuals and businesses, that currently total $17.6 trillion.
These deposits are used by banks to invest in a broad mix of less-liquid, but higher yielding assets including Treasuries, mortgage loans, credit card loans, business loans, and a small percentage of cash dollars.
Banks have just $3 trillion in cash to back up their $17.6 trillion in deposits. The majority of this cash is just a ledger entry with the U.S. Federal Reserve, and is therefore not immediately available. Some $100 billion of it ($0.1 trillion) is held by banks in the form of actual physical banknotes in vaults and ATMs. So, the $17.6 trillion in deposits are backed up by just $3 trillion in cash, of which $0.1 trillion is physical cash.
In case of a rush of depositors to withdraw their deposits in cash, the banks are totally unable to to pay back their depositors and would have to shut down blocking their clients assets.
In 2008, banks had around 23 dollars of deposit liabilities for every dollar they had in liquid cash, which is insanely leveraged and illiquid. Due to quantitative easing and a slew of new requirements, their ratios aren’t that high anymore, and so it’s more like a 5x or 6x ratio these days.
The FDIC provides insurance against deposit losses up to $250,000 which mitigates some of the risk. However, at any given time, FDIC only has about 1% of bank deposits’ worth of insurance in their fund. They can protect depositors against individual bank failures, but they don’t have enough to prevent against system-wide banking failures, unless they draw in aid from elsewhere or are backstopped by Congress with a fiscal bailout.
In 2008, banks had a global credit problem. They made risky loans, they had very little safe assets, and some of those risky loans started to default. Given how leveraged they were, it did not take much to render large portions of the U.S. banking system insolvent.
Today, the problem is vastly different and probably wider. With interest rates and bond yields having risen twentyfold in the past 18 months, banks are sitting on massive unrealised losses on their bond holdings, the majority of which is in US treasury bonds.
For now, the cause of the problem is not bad credit, but the depreciation of assets issued by the BEST credit due to the surge in inflation and correlative rise in bond yields. It is therefore a global problem that affects the mots liquid portion of any bank’s portfolio of assets. Loans to business and households being illiquid by nature.
This chart shows banks’ holdings of cash and Treasuries (the safest assets in terms of credit risk) as a percentage of total bank assets:
Today, banks have a much higher ratio of their assets in cash and Treasury/agency securities, which are nominally risk free if held to maturity. Banks also have a much higher cash-to-deposit ratio in 2023 than 2008.
But, when as was the case with SVB, if they are forced to sell their portfolio of bonds before maturity, they insure massive capital losses.
To give a sense of the magnitude of the losses, using the largest US Government Long dated ( 20 years + ) ETF TLT, the losses amount to 45 % since the middle of 2020
A benchmark 10 Year treasury bond acquired in June 2020 at 100 % would be losing 18 % if liquidated today at 82 %
In 2023 the problem is liquidity and duration risk and its is a global and systemic risk. Even the safest securities that banks own do have duration risk.
With The Federal Reserve raising interest rates at the quickest absolute pace in decades (a 4.49% move in one year), and the quickest percentage pace of all time (from 0.08% to 4.57% in one year,) or a 57x increase, to fight an inflation that surged following almost a decade of highly dangerous monetary policies and another layer of extreme fiscal polices during COVID, the global liquidity ratio and solvability of the entire banking system has deteriorated markedly.
This chart shows how exceptional and systemic the problem is :
During 2020 and 2021, with the irrational “Helicopter Money” measures mop,emented by the US Government, sending checks to citizens who did not need them and could not spend them, Savings ratios surged and that money ended up in bank accounts, inflating their deposits. As would be expected, banks used those deposits to buy a lot of bonds, and extended duration as bond yields were extremely low, having been artificially tweaked by quantitative easing and the massive increase of the FED balance sheet.
That was the worst possible timing as the previous excesses of monetary and fiscal policies coupled with the war in Ukraine and the supply chain disruptions due to COVID created an inflation spiral forcing interest rates higher and loading bank balance sheets with an estimated USD 800 Billion of unrealised losses.
Normally, banks can hold these securities to maturity and get their principal back and they are classified into the “hold to maturity” segment.
However, if depositors pull their money out of a bank above and beyond the amount of cash that the bank has on hand, as was the case with SVB, then that bank will have to sell securities at a loss, rather than hold onto securities until maturity as planned.
When that happens, it turns a liquidity problem into a solvency problem, not because the securities are defaulting like they did in 2008, but because the banks are selling otherwise high-quality securities at a loss, forcing the bank to book large and unexpected losses, eating into their capital base, and even going bankrupt as was the case with SVB.
The cruelty of the situation is that a bank like SVB can literally fail even if they hold 100% nominally risk-free assets that are guaranteed to be paid back in full and was careful not to diversify in lower credit. If the bank used depositor funds to buy Government bonds at low interest rates for lack of anything better to buy at the time, and then those bonds go on to trade at a discount due to higher interest rates by an amount that exceeds the bank’s capital, and then the bank is forced by a depositor run to sell those assets for a realized loss rather than holding them to maturity then the bank is bankrupt.
As one can see, the crisis comes entirely from the actions the central Banks themselves, an issue that we have highlighted many times in the past few years when we faulted the highly dangerous, unorthodox and extreme monetary policies pursued by the FED and other Western Central Banks under the influence of academics like Ben Bernanke.
We warned many times before that by tweaking artificially the price of money – interest rates – through zero interest rates or negative rate policies and forcing bond yields artificially lower, even in negative territory in Europe or Japan, Central Banks were endangering the core of the capitalist system by creating an extremely dangerous situation when normalisation times would come. And it came much faster than they expected, due to the rapid surge in inflation they created themselves through their own excesses.
If one adds to the picture the reckless moves of Donald Trump’s administration to de-regulate the banking sector and reduce the risk parameters of small and medium sized bank with a view to boost economic growth, the stage for the perfect storm was set.
And the problem is definitely not limited to the US. European, Japanese, British, Canadian and Austrian banks are living with the same risks.
It has been one of our core rationale for concentrating assets in China, the only major economy of the world that did NOT resort to those unorthodox methods and prevented the development of these systemic imbalances .
So what the real risks ahead ?
There are actually two ways of looking at the problem :
. The Optimistic View
The demise of the three banks that failed last week were due to specific circumstances. Silicon Valley Bank had 1) a ton of recent new deposits from one concentrated industry, 2) an unusually high number of large depositors (business accounts) that were not covered by FDIC, and 3) an unusually high ratio of securities with unrealized losses relative to its total capital. Therefore, it was uniquely vulnerable to this type of depositor rug-pull that made them sell securities at a big loss following Peter Thiel’s warnings. SIlvergate and Signature bank of New York paid the price of their foray into the crypto world, a bubble that ha dot burns and did burst causing trillions of wealth destruction.
Now that the Government, the Treasury and the FDIC have stepped-in providing all the backstops to both depositors and banks, the crisis should be contained and depositors should feel safe enough not to pull their money out of deposits.
The crisis may reverberate and affect the unusually high number of small banks and financial institutions that characterised the US financial system.
In 1971, according to FDIC, there were 13,612 banks in the US with 23,336 branches. Fifty years later, in 2021, there were only 4,237 banks with 72,405 branches. Although the population increased and the number of branches increased (not to mention all of the online banking ), the number of separate banks dropped dramatically and consolidated into fewer, larger ones. In addition, in 2022 the top ten banks alone had approximately half of all bank assets, with the other 4,200+ banks combined holding the other half.
So a reasonably optimistic assumption is that panic will recede, but that a certain number of smaller banks will either run out of business or be absorbed by larger ones, further concentrating the industry.
Moreover, its is highly likely that the current crisis will force the FED to end its quantitative tightening program, reducing the supply of bonds in a bid to keep long term rates lower, particularly at a time where, on Sunday night, the Treasury and the Federal Reserve coordinated to make a new facility called the Bank Term Funding Program “BTFP” which lets banks use various securities at face value for loan collateral, rather than having to sell them.
All this gives banks a lot more liquidity against bank runs for now, and contains their potential unrealised losses on their bond portfolios.
But this just papers over the underlying problem by kicking the can further down the road, leaving the FED with a bloated and bleeding balance sheet for years down the road.
. The Pessimistic View
Systemic crisis always erupt in one particular corner of the markets that act as a revealer of the much deeper problem as they were only the tip of the iceberg. From LTCM to Enron to Lehman Bros, all the major crisis started somewhere that initially seemed to be manageable but ultimately morphed into a major systemic issue.
SVB is no different.
As analysed above, SVB is only the tip of an industry-wide and, actually, world-wide, problem with the banking system.
The Inflationary dilemma
This industry-wide problem can only be resolved through Confidence being restored on one hand – that was the easy, even if costly part, over the week end AND through inflation coming down sharply and quickly on the other hand – and that is the truly tricky part .
What if inflation continues to rise ahead, as seems to be the case in Europe for instance, and interest rates and bond yields have to climb to 6, 7 or even 10 % as was the case in the 1980s, a period that has tremendous similarities with the current period.
The unrealised losses on the banking systems bond portfolios would surge into trillions of US dollars, potentially wiping out entirely their capital base.
This would happen at a time where the balance sheet of Central Banks are already into trillions of Dollars of loss making bonds and where budget deficits and public debt are surging. The financial ability of Governments and Central Banks to contain the potential damage of a continuation of inflation is way more impaired than it was at any time over the past 50 years if not since the great depression.
To tame inflation, Central Banks have no choice but to keep rates rising until monetary policy becomes restrictive. And with a CPI at 6 % in February and FED funds still at 4.57 %, monetary policy is STILL accommodative in the US and the FED will have a hard task at its policy-setting meeting next week.
it faces the unhappy choice of ending its monetary tightening campaign, to ease the tension in the financial markets, and risk a resurgence of inflation later on with the above consequences, or pursuing its inflation-fighting campaign now that is has ensured financial stability through the exceptional measures enacted this weekend.
Moreover, an early ending of tightening could send bond markets reeling again if bond investors dislike the lack of inflation fighting resolve of the FED.
The situation is even worse in Europe where the gap between inflation at 8 % + and ticking up and the Central Bank rate is extremely wide and mechanically feeding inflation. Christine LAGARDE and her colleagues will have a tough choice tomorrow on their policies.
Another shoe to drop for the banking system : the looming Real Estate Crisis
For now, we have not seen the impact of the real estate crisis that we foresee on the banking system. Real estate prices peaked over the summer and are only starting to decline. Its unfolding will gather momentum in the second half off the year, further impacting the liquidity and profitability of the banking system.
The Financial Issue
As with other crises of the past, SVB has just opened the eyes of the public with the dangers of the banking system and keeping too much cash at banks that may experience a systemic issue. Monday
saw a massive shift of deposits into Treasury bills on one hand, and a major shift of deposits from smaller banks to larger banks.
But over time, with T-bills paying 4 % while banks are still paying paltry interest rates on deposits, any sensible economic agent, household or corporations, will be tempted to reduce its bank deposits and shit into US Government short-term paper paying better returns for less risks.
This shift could easily represent 40 % to 60 % of the USD 17.6 Trillion of deposit and would amount ti exactly the same thing as withdrawals when it comes to the liquidity of the banking system on one hand, and its ability to extend loans ti the economy on the other.
The only way to prevent such a shift would be for banks to pay higher interest rates on deposits than Government T-Bills to entice depositors to keep they deposits at the banks. That in turn, would kill their margins and Net interest Income, sending the whole industry into contraction, and by the same way, forcing the economy down into a deep recession by lack of available credit.
The other way to entice depositors to keep their money at bank would be for the U.S. Treasury to issue a ton of T-bills to lower their rates towards 1 or 2 %. Besides the fact it would run against their need to tame inflation through higher rates, thus option is impossible due to the debt ceiling impasse, they cannot.
The only ultimate alternative would be for the Government to enact a ban on withdrawals and freeze deposits, not a happy perspective.
The Psychological Consequences
When consumers and corporations are jolted by events such as last week’s demise of one of the US largest bank and by the drastic countermeasures enacted by the Government, their global level of confidence is severely shaken. No one enjoys the sudden perspective of seeing their money blocked or disappearing with failed banks.
The natural reaction of households is then to retrench and play it safe. They start worrying for their jobs, their savings, their investments, their retirement fund and naturally cut down on un-necessary expenses, postpone the acquisitor of a new car, of holidays, travels and luxury items.
At the corporate level, CEOs and CIO’s are probably already extremely busy examining their finances, cash holdings, existing investments, bond portfolio and, most probably, future investment and hiring plans.
One of the most likely consequence of the crisis is to mark the beginning and accelerate the sharp economic contraction that we had been predicting for the second half of this year.
This, in turn, will be a positive for the Fed’s efforts to contain inflation and actually will be the only way to tame it in a lasting way without having to raise rates much higher.
In sum, the SVB demise is a landmark event that reveals the highly dangerous imbalances of the US economy, financial system, supervision and public finances.
Rarely has the environment been as challenging …
Unfortunately the only way out is a deep recession that clears the excesses and reduces the threat posed by inflation.
Are the markets accurately pricing those risks ?
MAXIN GLOBAL FUND – USD
Transaction Update 13 March 2023
At times of extreme uncertainty, volatility and crises, we keep our tack steadily, buying cheap assets and selling expensive ones and sticking to our Marco strategies. Thanks to its large diversification, our portfolio is staying remarkably stable and we are disciplined in taking profits, protecting through stop losses and igniting new positions.
Today, a day of extreme intraday swings following the major liquidity crisis of the American Banking system, we did all three of the above.
The markets moves were incredible with, as we expected, a massive shift of bank deposits into short term bills with 3-months, 6 months and 2 year Treasury yields falling by the most in a single day in history. We took advantage of the move to tale some profits on the Long US treasury bond ETF position TLT we had initiated in the past few weeks.
Likewise, the second flight to “quality” into cryptos, that we analyse as a knee-jerk reaction from crypto aficionados switching from stablecoins into the main tokens gave us the opportunity to re-establish our short exposure in ETHERS
The massive surge in volatility gave us the opportunity to take some profits on our long volatility position, cashing in a 37 % capital gain in only a few weeks and reducing our exposure there.
We were stopped out of our LONG Gold Miners position through a protection stop Loss order and re-instating it immediately higher up as Gold, Silver and Miners shot up during the day.
We also cut some long positions through the execution of protective STOP LOSS orders on ZALANDO, JNJ and our long position in Oil futures.
But we also took advantage of the volatility to add to our position in NIO, the bombed out Chinese Electric vehicle automaker who stands to benefit form two powerful trends, the sharp rebound in Chinese auto sales in February and the sharp decline in Lithium costs as supply is surging and major new deposits have been discovered, but we also added to our short positions in European equities by selling BEIERSDORF and SIEMENS in Germany, SWISSCOM in Switzerland, and luxury good maker BURBERRY in the UK.
It has long been our case that the current valuations of luxury groups vastly underestimated the sharp economic slowdown that is to come in their major market, the US and Europe, and the unfolding of the biggest banking crisis since 2008 will affect their sales brutally in these markets. The whole sector has now turned technically and we are juts adding Burberry to our short portfolio comprising of LVMH, HERMES, CHRISTIAN DIOR, RICHEMONT and FERRARI.
From a strategic standpoint, regardless of the upcoming inflation numbers and the decision of the FED to pause their rate hikes, the Q4 bear market rally has peaked and we have entered the next leg of the secular bear market, hence our strategic SHORT positioning in European and US equities, which now amounts to 137 % of our portfolio,.
Conversely, our long positions (58 %) are mainly concentrated in China (50 % ) where the economy is rebounding sharply, assets are undervalued and the new Government nominated last week comprises of extremely seasoned professionals who were maintained at their posts with a clear mandate : boosting economic growth.
Our other long positions in the US and Europe (8 % ) are special situations that we are managing on their own merits and where the volatility is justified by their upside potential down the road.
New Asset Allocation
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