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Addressing Some Basic Questions in Light of the Banking Crisis Today
Last week I wrote on the collapse of Silicon Valley Bank, SVB. A lot has developed since then. You can read the latest, ever-evolving news for yourself, but I thought I might address a few questions that are likely on your minds.
Photo by Ehud Neuhaus on Unsplash
Question 1: Are we having a global banking crisis?
Yes. With “just” SVB, we hoped it was a relatively isolated case. It wasn’t. Signature Bank soon followed and the next big name was First Republic. First Republic was in the business of serving an elite, wealthy clientele and investing in lots of real estate.
What do these banks have in common? Well, rich elite clientele for one. That is raising suspicion that there are some political motives behind bailing out depositors. Economically speaking that matters, because it decreases the confidence building aspect of any bailout policy.
The Fed’s intention in guaranteeing SVB’s depositors is to alleviate concerns for depositors in general - i.e., people like you and me - so we don’t run to our banks and cause a general panic that is truly widespread. But if we, the public, think political motives were involved, then rather than easing our minds, the bailouts will tell us we need to move our money to other banks with politically connected individuals.
I’m not saying that deposits flowing out of regional banks and into large banks is solely due to this perception, but it’s a part of it, and it weakens the effectiveness of the Fed’s effort to ease people’s minds.
The Fed and US Treasury really hoped to avoid those flows out of regional banks, but their announcement has suddenly raised the hair on everyone’s neck, and the money is moving. This will put extra pressure on those small banks, and also lead to even more consolidation in the banking industry, something most people wanted to avoid.
The second thing SVB and First Republic have in common is that they concentrated their lending/investing into very interest rate sensitive industries. There were signs all last year that the tech sector was being hit particularly hard by rising interest rates.
For those interested, listen to a July - JULY! - Odd Lots Bloomberg podcast “Jason Calacanis On the Expensive Lesson Coming to Silicon Valley”. They were discussing how rising interest rates are hitting this sector, and how it will have more trouble as financial conditions tighten. I’m an Odd Lots fan, but you can find plenty of other articles in the WSJ, Bloomberg, and other places on this topic going back at least to last spring, and certainly this summer.
The other area, long known to be sensitive to interest rates, is real estate. As mortgage rates rise home values fall. SVB invested in tech, and First Republic in real estate.
This is an oversimplification, but these do seem to be the first-order effects.
The surpise was Credit Suisse. But, I think, that’s only because I’m not in the world of banking. I was listening to Bloomberg the week SVB collapsed, and one industry insider commented that he thought Credit Suisse would be one to watch. I think that was Thursday or Friday, and it struck me as odd. By Monday they were in the headlines, and by the end of this last week, they were bought out.
A high-level banker at a major multinational told me privately last week that he wasn’t surprised at all. Credit Suisse was known to be engaged in poor management practices. He mentioned another bank too, which I won’t repeat.
It’s therefore clear to me that people in the industry knew which banks were problematic. These were slow moving trainwrecks. SVB just shined public spotlight on the trainwrecks so that we all see them now.
The sad conclusion is that we are witnessing a banking crisis play out. It’s not done yet, and it is global.
Question 2: Will it cause a global financial and economic collapse on the order of 2008?
I hope not!
Last week I thought it was unlikely. It’s always possible, but I thought it was very unlikely. I would have given that less than a 10% chance. But that probability seems to rise every day with the revelation of each new bank and banking system problem. Today, maybe I’d say there’s a 20-30% chance it will lead to a serious financial and economic crisis.
I add both words, financial and economic, because it is causing a financial crisis. The question is whether this feeds into an economic collapse like 2008. I still see that as unlikely.
I’ll continue this line of thought with the next question...
Photo by Maarten van den Heuvel on Unsplash
Question 3: What’s different between the banking/financial crises of 2008 and 2023?
Again, I simplify, but before 2008 banks were all buying mortgage backed securities (MBS). These were new financial instruments that securitized mortgages. And “securitization” just means someone took thousands of mortgages, sliced and diced them into little pieces, and mixed them up into a meal that all the banks then ate.
Regulators said banks must hold “safe” assets. Rating agencies rated these securities AAA (i.e., “safe”) so every bank ate its fill, and these made up significant parts of nearly every bank’s asset portfolio.
Then it turned out that the mortgage boom was a house of cards, and many, many of the mortgages were “toxic”. That is, totally worthless. But, no one knew how many toxic components were mixed into the security they held.
The food analogy is apt. Imagine the banks all eating hamburgers made from a giant ground beef supplier sourcing beef from over a thousand suppliers. It’s all ground, mixed together with other ingredients, shipped, made into patties and cooked. After everyone at the party ate their fill, they find out some of the suppliers’ beef is poison, some not. Even visually looking at the remaining burgers won’t help you know good from bad.
And, voila, the fundamental values of nearly every bank’s assets were suddenly unknown and potentially toxic. No one wanted to trade. No one knew their own asset values, and certainly didn’t know the value of other banks’ assets! … Trading screeched to a halt.
That’s part of the story. But, the “solution” for this was that the Fed eventually stepped in and bought the toxic assets from banks so that only “good burgers” were left.
What happened in 2008 was that everyone suddenly realized some of the assets they all held were bad.
What happened thus far in 2023 was that everyone could see that rising Fed interest rates would make real estate markets worse, and erode the value of the long-term bonds that banks bought when interest rates were still low. This is a classic banking problem, known, well-understood, and entirely avoidable.
So we all expected to see poorly managed banks and other businesses have trouble as interest rates rose.
We didn’t think of tech, to be honest, although it was being discussed as I mentioned earlier. But that’s okay. Every recession is a little different. Like the Tolstoy’s famous opening line to Anna Karenina: “All happy families are alike; each unhappy family is unhappy in its own way.”
The same is true with happy economies and unhappy recessionary economies. That’s why recessions are inherently unpredictable. They are always a little different.
What is surprising, however, is how many poorly managed banks there are. Credit Suisse? Really? A Swiss bank! Don’t Swiss bankers wearing Swiss watches run the world with great precision and an abundance of caution? … I guess not.
The issue we are watching, and that could lead to further economic problems is how many more and more banks are poorly managed than anyone knew.
As of today, I think there are some more surprises coming for you and me, but not as much for the industry specialists. Apparently they all knew Credit Suisse was poorly managed. Apparently there were discussions in recent weeks (weeks with an “S”) about problems. The same was true of SVB.
That means they knew. It means SVB didn’t cause Credit Suisse’s collapse. What happened is that they were all skating on ever thin ice, market participants were sitting on the shore watching them all sliding out on the thining ice and saying “wow, that doesn’t seem smart”.
Photo by Denis Agati on Unsplash
SVB and others broke through the ice first, and can be said to have influenced the timing of the crisis, but that’s it. That’s different from the 2008 crisis where everyone ate poisonous MBS burgers that they thought were good. When that came to light, that caused a global crisis. And that crisis caused an economic crisis.
In 2023, the economic slowdown and tightening financial conditions - international central bank policy today - are causing economic trouble across the economy, including in the banking sector. And, yes, we are realizing there were (are) more banks and other businesses on thin ice than we knew.
Question 4: So, what next?
I think there will be more failures.
I think the Fed will continue to raise interest rates - maybe a little less than originally planned - because it still hasn’t conquered inflation, and needs to keep its credibility. The ECB is still catching up to the Fed, and raised rates a half point last week despite the banking crisis.
Central banks will generally try to maintain financial tightening policies to fight inflation but will now include more offsetting policies to ease the burden on certain systemically important sectors like banking. What that will mean I don’t know. It does undo certain aspects of the financial tightening.
Does that unleash inflation again? Can they fight inflation with one hand, and add liquidity with the other? I kind of doubt it, but it’s a new, bizarre financial-monetary world that we are all still struggling to understand.
If inflation subsides, we’ll all slide to the other side of the pond before the rest of the ice thaws, thins, and breaks under our weight. If not, the Fed will be in the very bad position of needing both to tighten and to ease monetary conditions at the same time.
Sadly, this will lead to more regulation. If the 2023 crisis taught us anything, it’s that the regulators were, at best, asleep at the wheel, and, at worst, a big part of the problem.
Since we mentioned regulators.
The other common element between 2008 and 2023 is that in 2008 banks followed the regulators’ prescription of holding more safe assets. And they held the very assets the regulators and rating agencies themselves said were safe. They were not.
In 2023, SVB and First Republic did the same. They were both following the regulators’ prescription to the T. They were holding lots of safe assets that were safe in the sense that no one defaulted on them, but they were not as valuable as originally planned.
I’ll be watching for the next bank problems. If it’s just poorly managed banks, and we learn that regulation wasn’t working right, then we’ll have a hard time but be okay. If we start to learn that there’s something else that’s common and lurking out there like poison in the assets banks are consuming, then we’ll have more problems. At this point, I don’t think so, but I’m watching.
The other thing I’ll be watching are the inflation numbers and overall economic slowdown. Lower inflation and a broad economic recession will be the biggest signs that interest rate hikes are done.
A final yet unpleasant reminder is that monetary policy works with long and varied lags. The things we are seeing today are likely the result of interest rate increases that happened 6-12 months ago. So, it’s not done playing out.
I hope to make sense of it for you, and let’s all pray we make it to the other side of the pond without falling through the economic ice.
Thank you for reading.
A rare photo of SVB’s headquarters, taken in February 2023 ;-) Photo by Adam Bixby on Unsplash.
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