The Fed is now in a tug-of-war between fighting inflation and saving the banking system

[GoldCore]

It feels as though we have had a few days off when it comes to news of bank failures, collapses and ‘rescues’. But, do not be lured into a false sense of security, very little is resolved and problems are systemic across the financial system. Below we discuss the fragilities exposed by the collapse of Silicon Valley Bank. The problems are unavoidable for the banking system and its players. It’s little surprise that we have seen a surge in demand for gold and silver investment. 

There is blood in the water …

The Fragilities in the Financial System

The collapse of Silicon Valley Bank (SVB) has brought the fragilities in the financial system to mainstream news outlets, which are now ‘investigative reporting’ on all aspects of the fallout.

After SVB’s collapse, depositors withdrew $109 billion from small banks, while large banks deposits grew by $120 billion. Moody’s noted that the 1.5% decline in year-over-year deposits in small banks was the first annual decline since 1986.   

U.S Bank Deposits

In testimony to Congress on March 28, Federal Reserve Board Vice Chair for Supervision Michael Barr blamed SVB management and Congress for the failure.

While it is true that SVB management failed to hedge against the risk of rapid rising interest rates, it is the Federal Reserve that created the false complacency for banks in the first place with the massive amounts of quantitative easing and holding interests at the zero bound for so long – even after inflation as clearly taking hold.

 

As the chart above shows bank deposits grew at a rapid pace in 2020 as central banks printed money at full speed and government programs handed it out to anyone that would take it. It was not only bank deposits that grew, but equity valuations were also inflated.

Federal Deposit Insurance Corp (FDIC) Chair Martin Gruenberg told Congress that the tripling of SVB’s balance sheet from 2019 to 2022 “coincided with rapid growth in the innovation economy and a significant increase in the valuation placed on public and private companies”.

The excess deposits that rolled into SVB were invested in securities deemed low risk by regulators; long dated Treasuries, and mortgage-backed securities. Interest rates had been low for more than a decade.

Why I Think This Is The Next Financial Crisis

 

For its own part, the Fed was still spouting that inflation was ‘transitory’, and that some inflation is okay. They cited a good thing that inflation was above the Fed’s target for a period of time because inflation had run below the target for so long.

It’s not only SVB that invested in these securities, the chart below from the Wall Street Journal compares SVB’s losses in long-date Treasuries, asset-backed securities (commercial and mortgage) with the losses ‘across all banks.

Federal Funds Effective Rate

We also remind readers that the Federal Reserve’s own assets are ironically also U.S. Treasuries and mortgage-backed securities. Therefore, the central bank is racking up losses – and it is now ‘carrying’ more than $40 billion loss in its balance owing to the U.S. Treasury. 

However, the Fed can ‘carry’ this loss as a ‘deferred asset’ for as long as it takes, presumably until the interest cycle eases and the value of the assets gains as interest rates decline.

The Fed is the King

It is always good to be King. Among banks, the Federal Reserve is the King.

Federal Reserve Earnings Remittances Due to US Treasury

As the Fed finally caught on that inflation was not transitory and started tightening policy, it did so at the fastest rate in over 40 years, which caught out banks holding longer-dated Treasuries rapidly losing value. This was not an issue until depositors started withdrawing deposits and assets had to be sold to cover the withdrawals – and for SVB, as they say, the rest is history.  

Source: Wall Street Journal  

As much as regulators and government officials are trying to ‘brush the problems under the rug’ the banking problems are not over. The excess money central banks created, and governments gave away during the pandemic is still at risk of being pulled out of banks, and upwards of $8 trillion in deposits at the end of 2022 was above the FDIC’s $250,000 limit (this is an increase of more than 40% from 2019), leaving it vulnerable to being pulled out as investors weigh the newly exposed risks.

What Does Credit Suisse Mean for Gold

 

A paper published by economists from several U.S. universities shows that because banks hold assets at purchase value until they have to sell them that bank assets are worth $2 trillion less than they appear to have on paper.

As a result close to 200 banks would be at risk of failure if half of these uninsured depositors pulled their money from the banking system. Researchers conclude that “Overall, these calculations suggest that recent declines in bank asset values very significantly increased the fragility of the U.S. banking system to uninsured depositor runs”.

The Fed and FDIC have both said they will loan banks money against assets at par value. However, this just moves the risk elsewhere or ‘kicks-the-can’ down the road and alters the market risk even further. The call for the FDIC to insure all deposits creates an even deeper moral hazard for bank management.

The Fed is now in a tug-of-war between fighting inflation and saving the banking system – and it is currently trying to do both. On one side they continually raise rates, while at the same time creating new lending programs for banks. But alas the Fed has no magic. Stretching to accomplish one goal means the other goal becomes unreachable. 

The Federal Reserve policy setting committee forecasts lower rates in 2024 and 2025. Everyone else expects that rates will drop 75 basis points this year after it becomes clear to all that banking has systemic solvency problems caused by rising rates.

 Investors who hold physical metals have placed themselves outside the circus tent of central banking.

Many times, before we have explained that being inside the system means unavoidable counterparty risk. Only gold and silver are assets which do not need validation from anyone else.

[HonestMoneyGoldSilver]

Reading this article one would conclude that SVB failed due to the Fed hiking rates. That is a gross over-simplification. 

With SVB, higher rates hurt them more on the liability side than they helped on the asset side. According to Oppenheimer bank analyst Chris Kotowski, SVB is, "a liability-sensitive outlier in a generally asset-sensitive world"

SVB ostensibly failed for two reasons:

1) It didn't have a head of risk-management for 9 of the last 12 months

2) As a consequence of 1), SVB didn't hedge its interest-rate risks AT ALL, not even 1%, it was totally naked. This is criminally negligent and not reflective of how other banks operate

Conclusion:- If SVB was run normally and had followed any sort of fiduciary risk-management, it would not have failed

This article is actually quite misleading as it doesn't show activity in the derivatives markets, specifically IRD (Interest Rate Derivatives). Check out the official figures from the BIS for 2021:

OTC derivatives statistics at end-June 2021 (bis.org)

The chart given in the article from OP shows losses in the $500-600 billion range

The chart given by BIS shows the notional value of IRDs is roughly $500 TRILLION, i.e., 4 orders of magnitude greater, like £100 compared to £0.10

Any losses accrued by banks such as SVB should have been hedged by IRDs or other instruments. Every single bank does this, it's banking 101. If I may grossly over-simplify, SVB bought silver and left it out in the rain, then tried to sell it and got much less than spot. Every other bank kept their silver in a cool, dry vault and paid a premium for the privilege. SVB got their asses handed to them whereas the other banks got spot on their silver minus a small premium. 

The underlying reasons why SVB chose the investments they did is because they took in more money from depositors than they could lend out to borrowers to generate yield. That sounds like a good situation, right? Well, sometimes too much of a good thing is bad for you.

SVB found itself in that position as it essentially made itself into a monopoly on the west coast for tech start-ups and any entities involved in crypto. You can bank with SVB they told them (speculative tech growth firms and the crypto players) on one condition - you have to hold all of your assets with SVB and encourage all of your affiliates and customers to do likewise. We will offer you a pathetic rate of return on deposits but you will accept it as if you don't, we will stop lending to your network and providing you with banking facilities. Thus SVB had more money than it could spend.

In a stroke of "genius" by the management team, which was lacking a head of risk-management, SVB decided to lock up the excess funds they couldn't lend out to tech and crypto-friendly businesses, in long-dated Treasuries and mortgage bonds. Why they chose these assets is another somewhat complex topic but TL:DR, accounting loopholes and Basel III capital requirements with US exceptions for Tier 3 banks. Anyway, so SVB locked up their funds for >10 years with an average yield of 1.56-1.8%. They essentially bet that rates would stay at their historic lows for at least a decade if not longer. Hindsight is a wonderful thing but you don't need hindsight to understand that making such a bet leaves you wide open to changes in interest rates, which could only go in one direction - UP. When rates did go up and continued to rise, that put SVB in an unrealised $1.8 billion hole.

The businesses that SVB lent to were also experiencing difficulties due to Fed rate hikes and the general macro environment, talk of recession, etc, and they started pulling deposits from SVB to keep their businesses afloat. In order to satisfy the withdrawals (redemptions), SVB had to liquidate its long maturity assets at a huge discount and realise those unrealised losses. As this article alluded to, the Fed is in the same position but doesn't have to realise those losses until it chooses to sell (bonds marked available to sell vs bonds marked keep to maturity). In the case of SVB, you could buy 1 month, 2 month, 3 month, 6 month, 1 year or 2 year Treasuries with > 2.5 times the yield that SVB was making, i.e. the risk-free rate was > 4% and SVB was making 1.56-1.8%, this meant SVB's bonds had to take a $1.8 billion hair-cut, whereas the Fed's do not, neither do those institutions to whom the Fed is offering loans at par value. SVB then compounded their problem by attempting to raise funds at the same time they were holding a fire-sale. This led others to withdraw their funds from SVB and exacerbated the capital shortfalls, leading to collapse. 

As for the Fed and FDIC, they have acted in a shocking manner that is purely political and has no basis whatsoever in law or economic fundamentals. SVB and all those depositors should have been allowed to lose everything > $250,000, as per the law. By setting the precedent of making everybody whole, there is now an implied government-guarantee on all bank deposits at all banks, regardless of the competence or legality of the behaviour of management. I agree that creates a severe moral hazard but no more so than taking fist fulls of cash from SBF and them allowing him to stay at his mommy and daddy's house and use tor/VPN to conduct wallet transfers and engage in secret communications that he is legally barred from doing. The whole thing stinks from a political POV as the party in power - the Democrats - have been captured by big tech and crypto kings/clowns. In return, the government has stretched the credibility of the FDIC and the supposedly independent and neutral stance of the Fed and the justice system. 

Finally the Fed has no intention of saving the economy. Everyone believes (CME FedWatch) that the Fed is going to cut rates in 2023. It simply can't. Inflation is way too high and beyond that, the global hegemony of the USD is under threat from China (and the BRICS). There is no course other than raise rates, cause a recession, kill demand, control inflation, lower rates again, rinse and repeat. The Fed has acknowledged this with its forward guidance for 2024-25. If the Fed already knew it was going to cut in 2023, it would be obliged to give forward guidance to that effect

[Bigmarc]

Great website if anyone wants another point of view. 

https://truflation.com/

Its Blockchain based that uses on chain and off chain data of of over 10 million points (apparently). Notice how in the USA the government says it's 6% but the data shows 4% and in the UK it's the other way round, the government says it's 10% but the data points at 16%. 

I take everything with a pinch of salt nowadays (too much information about, none of it fool proof) but found it a handy tool to have. 

[Bratnia]

SVB had no risk officer for a year. When a new one was appointed they flagged that SVB were at risk of liquidity, and the director sold their shares and options - and then announced that risk, knowing full well that the response would be large-scale flight of capital.

Would have been better if on the risk being highlighted they instead took out insurance/hedges and only then announced that the bank had been exposed to such risk, but that the risk had been shut-down.

Just another case of the world we live in, where single individuals can cause harm/death to many. Events that will repeat in one form or another until individual stupidity risk is otherwise better managed.