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Capital markets have been very volatile this week, with a great deal of discussion regarding the disruption within the banking industry. A very informative article hit our desk this morning, explaining better than we could what is going on. We have provided excerpts below. While the capital markets, which have been very volatile the last few days may have already discounted the fundamentals (who can tell?) the long term problems are not going to be solved quickly. Be careful out there!

Excerpted from: Myrmikan Research, as of 3/15/23

“SVB Financial Group was banker to the Silicon Valley start-up industry and captured
a large portion of venture-bound funds, with deposits soaring from $62 billion at the
end of 2019 to $173 billion by the end of 2022. The bank attracted these cash balances
in part because it offered founders special perks. Its website still advertises: “We offer
financing to accommodate: Private aircraft financing; Ownership stake in a private or
public company; Ownership in Venture Capital or Private Equity fund.”1 SVB’s balance
sheet includes $9 billion of loans against private residences, $9 billion backed by income
from “innovation sector” business loans, and $1.6 billion against “premium wine.”
Founders who took advantage of these perks were required to maintain their
corporate cash balances at SVB. Whereas individuals rarely hold more than the $250,000
balance covered by FDIC insurance, corporations hold millions to fund working capital
and, in the case of venture companies, to hold their development capital.

“As a result, of the$173 billion in deposits, $165 billion were uninsured.

“….in this story, the culprit was the bond portfolio. The sudden influx of deposits from the Fed’s QE had given SVB little time to look for loans, so they used the funds to buy bonds instead. As of the end of 2022, SVB held $117 billion in securities, mostly securitized mortgages purchased from quasi-government agencies (like Fannie Mae). These are AAA rated bonds with virtually no default risk, the kind of investments that regulators want banks to own. SVB held its securities in two buckets: available for sale (AFS) and held to maturity (HTM).

“The Fed’s rapid tightening of financial conditions sharply curtailed the market’s appetite to fund venture companies: shrinking money supply reduces the quantity of available dollars, and higher interest rates entices capital in other directions. SVB began to see deposits fall as its customers spent their development dollars, requiring it to raise liquidity. On Wednesday, March 8, the bank announced a $21 billion sale of AFS securities in which it realized a loss of $1.8 billion “after-tax” (the assumption being that the loss would reduce income taxes—but, of course, there will be no income taxes this year). The
bank also announced plans to plug the capital hole by raising $1.75 billion in equity.

“Presumably it was the equity offering that prompted investors to read the bank’s
recently filed 2022 10-K, which revealed that the bank held $91 billion in its HTM bucket,
$86 billion of which had maturities stretching out at least ten years with a weighted
average yield of just 1.63%. The unrealized loss of $15 billion was only slightly less than
the reported $16 billion in net equity
. Interest rates have continued climbing since, and
bond prices falling, which rendered the bank insolvent. It probably did not help matters.

“Sunday morning, Treasury Secretary Janet Yellen told CBS News: “During the
financial crisis, there were investors and owners of systemic large banks that were
bailed out . . . and the reforms that have been put in place means we are not going to do
that again.”  But then they did do it again. A few hours later, right after Asian markets
opened, the Treasury announced that all SVB depositors would be made whole and have
immediate access to their funds.

“The bailout was arranged by the Federal’s Reserve new facility, the BTFP (Bank
Term Funding Program). Under the program, Banks can borrow 100% of the face value of
U.S. Treasuries, agency debt, and mortgage-backed securities for up to a year at no cost
. In
other words, although the market now properly prices long-dated Treasuries at 70 cents
on the dollar, the Fed will lend a full dollar for up to year. The idea is that if depositors
are assured that banks can meet their withdrawal requests despite large mark-to-market
losses on the banks’ balance sheets, they will leave their deposits in place.
The Fed’s actions may solve a liquidity problem temporarily, but it does nothing
to address the cash flow and solvency problems.

“Let’s think about what happens next: to meet the withdrawals, smaller banks will
have to pledge their underwater bonds to the Fed for cash. The large banks will get deposit
inflows, enabling them to keep their interest rates low while using the funds to purchase
high-yielding, short-term Treasuries, boosting their market share and profitability.
What could entice deposits back to small banks? Banks cannot raise deposit rates
without locking in negative cash flow.

“What happens after a year if banks cannot repay the BTFP facility, especially as their loan book deteriorates due to the looming recession?  if the banks fail, then a year from now it will be seen
that the Fed was purchasing Treasuries and MBSs at prices that imply 1.5% interest rates, not 5%.
The market has, of course, anticipated all this already. In a single day, the yield on
the 6-month Treasuries plunged from 5.17% to 4.81%. Even more impressive, the 2-year
plunged from 4.6% to 4.0%. These movements anticipate that the Fed is done hiking
though also take some of the pressure off mark-to-market losses

“These events are setting gold up for another epic run.

“Now inflation is still running at 6%, yet the Fed has already rolled out a new QE to support bank balance sheets. The oncoming recession, caused by liquidating malinvestments made during the boom, will put even more pressure on the banking system. And at some point insurance companies and pension funds will start to fail if the Fed keeps rates high. From a geopolitical perspective, only U.S. banks are eligible to use the BTFP. Non-U.S. banks active in the eurodollar market who may be in a similar situation as SVB are on their own. Notably, Credit Suisse has been teetering on failure for the past few months, if
the market for its credit default swaps are at all accurate. Its shares traded down 29% this morning as the market bets it will not survive, which would all but force the Fed to reopen massive swap lines with the ECB. The U.S. rates market, which last week was projecting the fed funds rate would be 0.6% higher by September, is now pricing in 0.6% of cuts by then. Nor should it be lost on the market that the Fed itself is essentially a giant SVB: it purchased trillions of dollars of fixed-rate securities at ridiculously low interest rates and is now carrying enormous unrealized losses. Since its own deposit rate—what it pays
on reserves and on its reverse repo facility—reflects the Treasury rate, it also has large operational losses, previewing what is in store for the private banking system.

“Powell has lost. Like Arthur Burns in the 1970s, he has discovered that abruptly higher
rates threaten stability long before retail prices stop rising. At this point, it is hard to know
which is better for gold: more rate hikes that accelerate a major banking crisis or a pivot to
more money printing now.”

All of the above supports the tune that we have been singing for over ten years. In one form or another we have said:

“Twelve years of interest rate suppression causes all sorts of unintended consequences”.

“For every action there is an equal and opposite reaction”.

“Suppressed interest rates drive individuals and institutions to ‘reach for yield’, which inevitably ends badly”.

“Suppressed interest rates are guaranteed to encourage “misallocation of capital”.

“Interest rates are the business world’s economic ‘pituitary gland’, governing (rather than bodily functions) economic activity by way of reward/risk relationships. When nature is interfered with,  bad things happen. The purchase of zero interest fixed income securities, which has been the case for over a decade, is like investing with ‘risk and no reward’, as opposed to high reward and low risk.”

Roger Lipton