Is SVB’s failure really cause for a Fed pivot?
TL; DR
Some said we were on the precipice of a banking crisis when the Federal Deposit Insurance Commission (FDIC) moved in to take control of failed Silicon Valley Bank (SVB) and Signature Bank on the weekend.
The press said Republic Bank is next and plenty of others are shaky.
Maybe, but I think all of this FUD misses the point.
And that is that the recent bank collapses are unintended consequences of the QE Infinity experiment implemented by a Fed that did not learn the lessons of 1928/1929.
Whether the barbecuing of regional banks that might have been mismanaged and lacked proper governance causes the U.S. Treasury to pull out the big guns and the Fed to pivot, will come down to the efficacy of the safety net measures put in place on the weekend, and a range of other factors.
However, assuming the measures are sufficient and/or are bolstered, and given the hot 5.5% core less food and energy inflation print just released as I am writing, the Fed will probably continue tightening and we will go back to discussing the size of its interest rate hike, when it next meets on 21-22 March.
But if not, and if unsuccessful corporate debt refinancing at significantly higher rates and unrealised losses on balance sheets become a reality, it will accelerate a crisis of confidence. Such a crisis would occasion Powell’s Fed to step in, cut rates and return to the QE playbook.
I don’t think we’re there. Rather, it feels like this is one of those broken things that the Fed creates and ignores as it keeps tightening to finish the job of killing off inflation.
If that’s correct and regardless of its specific risks, SVB will earn the dubious honour of being the first post-GFC bank casualty and one of the all-time largest bank collapses.
Why SVB collapsed and should we give a toss?
The demise of SVB, is partly a story in ‘duration’ mismatch between unhedged ‘hold to maturity’ bonds/mortgaged backed securities as well as long term loans (assets), versus short-term deposits (liabilities).
It’s also partly what appears to be a $41 billion VC orchestrated bank run twice the size of SVB’s unadjusted capital base (after failing in a $2 billion equity fundraising to cover losses) and which in aggregate exposed a fatal duration mismatch, causing a liquidity squeeze and insolvency. Oof.
At the same time, Signature Bank experienced a $10bn run and was also bankrupted and shut down by the Federal Deposit Insurance Commission (FDIC) on Friday.
These businesses as they once were, have been done like turkey dinners.
And how could they not be, when $40 billion in deposits (twice your equity capital base) virtually stampedes out the gate and crystallises your liabilities, and your discounted securities (asset) gets torched by QT and you can’t wait for maturity to get your face value back and no investor will tip in even preferred equity, and the rest of your money is out on long-term loan (asset)…
That’s a perfect duration mismatch shit storm along with a generous sprinkling of faux governance and some curious VC schadenfreude.
We are already hearing reasons, apologies, if only the FDIC acted earlier, etc., and other pitches, but we will never know the real story and who really profited on a bank-specific basis, or whether this really was an off-market short.
But rather than wasting time on unknowns, the real point is that the failure of SVB and Signature is more a story about the ugly reality of Quantitative Easing (QE) Infinity and the behaviour across asset classes and investor types that it created.
What do I mean?
It was the free and easy long duration money produced by QE that grew SVB to the number 16 bank in the U.S.
Long duration technology companies and their backers/VCs that SVB specialised in were some of the biggest recipients of the largess from QE.
Was growth a case of genius businesses or smart financing? Nope, some cool ideas mixed with lashings of free money and a bunch of people trying to change the world.
But the QE elastic band that propelled these banks and the fintech, SaaS and other tech sectors that SVB in particular was highly concentrated in, snapped back after interest rates and inflation lifted off.
The increased cash burn and leakage for these tech businesses as inflation/high rates hit, plus quantitative tightening (QT) which drove interest rates higher and bond prices lower, all contributed to the duration squeeze.
QE/QT is the same thing because after you do enough of it, your economy gets hooked on it and it becomes QE Infinity, i.e., no real end in sight, particularly now that there is insufficient GDP growth rate to cover the interest servicing costs on debt.
The magic elastic band of free money giveth (QE) and taketh (QT).
But is the SVB/Signature breakage enough for the Fed to stop and pivot?
We have been waiting to see what else the Fed will break. It’s already broken the bond market and that’s way bigger than SVB.
So, is the breaking of these second tier banks really enough to lead the Fed to stop tightening rates and running off its balance sheet/QT?
I think the answer remains ‘No’ unless:
the measures announced recently are proven to be inadequate to stop duration squeezes infecting other banks that are found to be swimming naked; and/or
if unrealised losses on balance sheets become evident due to an inability of banks and any other corporation to refinance in these higher interest rate environments.
And I don’t think we’re there yet.
Importantly, this time around we have not yet seen a run on the major banks.
While there may be contagion in the <$250 billion regional bank category that do not have to mark to market (meaning more zombies might be hiding in the lab) this is not an industry wide issue at this stage of the game, albeit there is always the potential for it to become one.
So far, it’s more about the banks with <$250 billion in assets which don’t (legally) have to mark their assets to market value.
Clearly this rule should be changed, and after SVB and Signature perhaps we will see the Dodd-Frank provisions that were hobbled by the Trump Administration in June 2018, once more become applicable to the smaller/regional banks.
As a refresher, I warned on 26 May 2018 that the regulatory roll-back of the Volcker Rule (section 619 of Dodd-Frank) and the raising of the SIFI threshold from $50 billion to $250 billion and associated exemptions from periodic stress tests, were problematic to say the least.
We are now seeing the effects of those rollback on the so-called small ‘systemically unimportant’ banks. And it’s notable that it has taken less than 12 months of a higher interest rate environment (that’s still very low in historical terms) to show why vaulting the SIFI threshold and tearing up the Volcker Rule was a seriously stupid idea.
You might recall that Powell was initially opposed to the roll-back at the time, but as with everything where Trump was concerned, Powell caved and supported the shredding, while Elizabeth Warren and Bernie Sanders warned of the moral hazard that would be created. And they were correct.
Perhaps the Fed will be wanting to save face on this matter, and Biden will be supportive of tougher regs?
Now what?
Certain measures have been put in place to wallpaper over these issues by the FDIC, Treasury and the Fed.
These include customer deposit protection and a $25 billion Bank Term Funding Program (BTFP).
The BTFP is a loan from Treasury to provide loans to banks so they can avoid crystalising losses from duration mismatches like the one I described above, if there is a big call or bank run while the bank waits for bonds to mature to get the face value back.
If the BTFP feels like more moral hazard to you, that’s because it is, but it may be better than the alternative.
From here, I think there are probably two key scenarios that might play out, and a few to either side.
Scenario 1 is that to the extent the banking industry picks up the tab for the FDIC depositor bail-out (given no taxpayer money is to be used for these purposes) and assuming the BTFP works in its current size or even if the $25 billion limit has to be increased (which it might have to be), it is ‘crisis averted’. We then go back to talking about how high the next rate rise will be on 21-22 March following today’s 5.5% core (less food and energy) inflation and the recent 311,000 job adds.
I think that this is what Powell is hoping for, and if his old boss Yellen can demonstrate ‘nothing to see here’ because it’s not systemic and she has it backstopped, Fed Chair Powell can continue the fight against public inflation number one.
And whether he is successful or not in that fight is irrelevant because it is a political fight levied on him by Joe Biden. Biden feels that getting inflation under control is more important to more people than an all-time high bond or equities market is to Wall Street and rich people.
Scenario 2 is that none of this works due to contagion/wretched sentiment, and the sheer number of zombies that have been hiding behind prudential roll backs of Dodd Frank and accounting. If there is meaningful contagion across a squadron of sub $250 billion regionals which experience similar duration squeezes while they have to deal with digital runs, then that ends in reset.
That scenario would probably lead to Joe Biden reconsidering his views and leaning on the Fed to halt rate rises and QT. We would then see a fast and decisive Fed pivot with rate cuts and new liquidity injections (Fed balance sheet goes back up to $8.9 trillion and perhaps beyond) and the QE Infinity train fires up, yet again.
And it’s this scenario the bond market was pricing in on Monday, but not necessarily today (Tuesday) as I write.
Sure, at some point we will have to reboard that train due to 700 years of money creation and the profound debasement that has resulted.
But we’re not there yet given the stickiness of inflation and Powell’s not yet done. This might be a put, but it’s not the pivot.
As for SVB? It’s really not the point. SVB is collateral damage from the flipside of irresponsible QE Infinity.
In the meantime, keep calm, carry on, and watch the closer to home AUKUS SUB show instead.
Mike
Next Level Corporate Advisory is a leading independent M&A, capital and corporate development advisor with a multi-decade track record of providing customised transactions and transformational strategies to companies seeking to level up, in and out of Australia.