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SVB Goes Under - Here We Go Again
It's going to be an interesting week.
UPDATE 3/13/2023: What a joke (emphases are mine):
The Fed and Treasury also announced the Bank Term Funding Program (BTFP), which would provide advances of up to one year to any federally insured bank that is eligible for discount window access, in return for eligible collateral (generally Treasuries and agency securities). A key aspect of the facility is that the Fed would value collateral at par without the standard haircut the Fed applies in other programs. This will allow banks to fund potential deposit outflows without crystalizing losses on depreciated securities.
Or, as I show below, the Fed will buy your used car for what you paid for it as new.
UPDATE: Fox News quotes Bill Achman on Twitter as saying (emphases are mine) “By allowing [SVB] to fail without protecting all depositors, the world has woken up to what an uninsured deposit is – an unsecured illiquid claim on a failed bank,”
As I say below… No shit, Sherlock! Damn! the Red Pill for the finance world!
Bank deposits - even a single dollar which is otherwise insured by the FDIC - are still an unsecured claim. And if it is a claim on the books of a failed bank, it is an illiquid claim. (Read: You might not get your money back.)
The FDIC is required to maintain all of $0.0135 in reserves for each insured dollar on deposit! In the whole, if you have money in Federal Reserve System banks you are insured for 1.35 cents on each dollar! THAT IS IT! 1.35 cents on your dollar! You are both unsecured and uninsured for $0.9865 of EVERY dollar in your bank accounts!
GET OUT! There is only one way to deal with this: The Digital Liberties Amendment.
With Silicon Valley Bank (SVB) notching the second largest bank failure since Washington Mutual went under in 2008, we are going to start hearing a deluge of what I call “specialty language.” If you’re younger and have never watched The Wizard of Oz please take the time. Some say it is a parody/allegory about banking. The old dotard behind the curtain is the Central Banker. But what really matters is the curtain itself - the specialty language of Wall Street. So I am going to try to pull that back. And as I am wont, I will use the English language however I damn well please. Note to the lettered economics faculty: I am not in your class and this is not a paper for your grade. In other words: I don’t give a shit what you think about it.
Here is what is happening - AGAIN!
Imagine you drive a brand new car off the lot. You paid $40K for it. You did not have $40K sitting around, so you got financing from the dealer. You go home and update your accounts. You have a new asset (the car) and a new liability (the loan). They zero each other out, right?
Sure, you can claim the car is worth $40K as an asset. After all, that’s what you just paid for it, right? But try to sell it tomorrow for $40K and see what happens. No, your new car is not worth $40K as an asset because you are not going to get $40K for a what is now a “used car.” But you still have that $40K loan to pay. If you value the car by what you can sell it for instead of what you paid for it, you are doing what the specialty language of Wall Streets calls “mark to market.”
Watch - you’re going to hear that term a lot in the coming weeks.
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Now let’s look at these things called bonds. Basically these are like interest-only mortgages, but with interest payments made quarterly. Before computers, a bond was a printed document that looked and felt a lot like a larger version of paper currency. And it had perforated strips which the person who owned the bond would detach and redeem for the agreed-upon interest payment. These strips were called coupons. This is why the specialty language of Wall Street calls interest payments “coupon payments.” The ability to redeem these coupons for a fixed amount over a fixed time is also why bonds are considered “fixed income” investments.
Now let’s compare buying and selling a car with buying and selling a bond. If a bond is sold in $1,000 denominations and has a 10 year term, when you hand over your $1,000 for the bond, you get forty coupons (four quarterly payments a year times 10 years). If the interest rate is 10% per year (to simplify the math) the coupons are worth $25 each (10% of $1,000 is $100, divided by four quarters in a year).
Buying a $1,000 bond at 10% “yield” (i.e. annual interest) buys you the right to collect 40 coupon payments of $25 each - or $1,000. After ten years, you then return the original bond (the perforated coupons all having been redeemed) and get back your original $1,000. (The specialty language for this is “redeeming at par.”)
(It should not be lost on you that you have doubled your money over those 10 years. I wont go down this mathematical rabbit hole, but if the true rate of inflation is 10%, the same math will tell you will lose one half of the purchasing power of that original $1,000 over ten years. This is why interest rates follow inflation.)
There is another rabbit hole that would be a distraction right now if we do anything other than note bonds are “priced” such that it inverts the “yield” or interest rate. In other words, if the interest rate is low, the price is high. As interest rates rise, bond prices drop.
So now back to “mark to market.”
If you are a bank and you take your customers’ deposits and buy U.S. Treasury Bonds (as most Money Market Funds do) you doing the same thing as we noted above in buying a car. If you buy $1M in U.S. Treasuries you have $1M in assets on your books.
Until you don’t.
If you buy a bond when the yield (interest rate) is low (let’s say the 10-year U.S. Treasury Bond at 1% per year), the value of your “inventory” of bonds starts out at a relatively high price - remember, price is inverse to yield. As “new issues” of those same 10 year treasuries command higher yields as the Fed raises its expected interest rates to cool down inflation the “market price” of the 10 year treasury drops accordingly.
So, is your previously-bought-at-1% $1M inventory of bonds still worth the $1M you paid for them? Is your brand new car still worth the $40K you paid for it? Do you see that these are the same questions?
Parsing the Language of Wall Street
On March 6, FDIC Chairman Martin Gruenberg made the following statement.
The good news about this issue is that banks are generally in a strong financial condition, and have not been forced to realize losses by selling depreciated securities. On the other hand, unrealized losses weaken a bank’s future ability to meet unexpected liquidity needs. That is because the securities will generate less cash when sold than was originally anticipated, and because the sale often causes a reduction of regulatory capital.
Let’s unpack this:
The good news about this issue is that banks are generally in a strong financial condition...
Read: Valuing my new car at its purchase price makes my finances look good.
...and have not been forced to realize losses...
Read: No one has called bullshit on me yet for valuing my car at its purchase price.
...by selling depreciated securities.
Read: By having to “mark to market” their inventory of bonds.
...On the other hand, unrealized losses weaken a bank’s future ability to meet unexpected liquidity needs.
Read: “Unrealized losses” is specialty language for play pretend as interest rates rise. “Meet unexpected liquidity needs” means return depositors’ money. Here, in the case of SVB, we have to understand that it is the main bank for Silicon Valley startups. These companies burn through a tremendous amount of money on R&D. When money was cheap, R&D was easy. As money gets more expensive (i.e. interest rates rise to meet inflation), these startups have to tap into their savings... What’s absolutely egregious is to call this “unexpected” liquidity needs.
...That is because the securities will generate less cash when sold than was originally anticipated...
Read: No shit, Sherlock... Just like if you went to sell that new car.
...and because the sale often causes a reduction of regulatory capital.
Read: You need to have enough money to redeem customer deposits. If you can’t sell your inventory of bonds for what you are pretending they are worth, you’re gonna have some problems.
Just Like Last Time
The Great Financial Crisis was just one huge example of a bunch of banks who had stocked up on this kind of bond called a “mortgage backed security” (MBS). You don’t need to know what those are other than they are bonds. The ability of the banks to be paid back depended entirely on the ability of the mortgage borrower to make their own payments. Once it became apparent that this market was full of “liar loans” to people with no possible way to pay them back, the market price of these bonds dropped like a stone.
The banks who built their businesses around this nonsense pretended for as long as they could that their bonds were worth their face value, which only made the collapse all the more dramatic. Today we are reading that “market participants” were shocked at how fast SVB went under. Only an idiot would be shocked. I suspect these market participants are a younger set with no memory of what an economy with normal interest rates looks like.
Mortgage backed securities broke the economy in 2008. Now it will be corporate bonds... which are just the corporate version of the personal mortgage. The banks who hold these bonds are going to resist “mark to market” until it is way too late - just like last time. And at that point the collapses will be incredibly fast... but will only amaze the young and foolish.