Saturday, March 25, 2023

Banks of America (again)

After the 2008 financial crisis I personally got interested in the markets and started seeing them closely. The first thing that caught my huge interest then was the banks i see around me, failing. My first article in this blog was about "Banks of America". We have come a full circle - as the banks of America are failing again now. For anyone who has followed this thing for years closely - its very clear. The problem then and the problem now are exactly the same. It was just a temporary pause for few years. In 2008 the banks had assets that had its value gone down significantly. It was housing bonds then, now its the low-yielding bonds from the ZIRP decade. The problem is pretty much the same.

I was talking to someone who owns a home in California few months back. I asked him what is the interest he pays on his home. Every one refinanced at a lower rate, and he did too. He told me, he was able to refinance his old mortgage for 3.05% and was very upset, he couldn't utilize the still lower rate it got to at 2.75%. It immediately occurred to me, if there is a transaction that benefited one side a lot, there must be the other end that heavily lost. That exactly what happened. The person on the other side were the banks. The mortgage  was probably 30-years maturity paper and the bank is stuck with it.

The duration risk on the bonds are cited as the main reason for Silicon Valley Bank to fail. When interest rate rises, the low-yielding bonds will lose value. This caused a huge hole in the bank's balance sheet. I believe, even though it could be one reason, there is something more to it. Regional banks are heavily exposed to the commercial real estate market, which we know is not doing well, because employees are not coming back to the office. Also it is not a surprise that the over leveraged technology companies - that ran only because of cheap money had a big role to play. It's not a coincidence that most of the failed banks are from the state of California. I work in technology and i see first hand, how leveraged the industry operates in. Most of the time, almost in all IT companies - work happens not to make the customer happy but instead to get a new investor. Significant time is spent on, doing prototypes, demos to attract new money as investment. This used to be very common in research institutions. Most of the time of research graduates, are spent on applying for grants than on doing actual research. With the Fed hiking rates up to 5% now - all the cheap money is gone. What is left is the mal-investment and accumulated debt from the boom days.

Initially when the 2008 housing crisis started., we were told the issue was isolated to subprime. Eventually, we would find out - it was not subprime but the entire mortgage market. The falling assets problem is same now - Not only the banks have the problem, all insurance companies, pension funds, hedge funds, other financial institutions would have the same problem. If banks are losing asset value because of holding low-yielding long term paper - lot of people hold them. Opening a Fed window for the smaller banks alone to exchange their worth-less bond and getting the full dollar - is a moral hazard. The problem is just showing up in the weaker sections of the economy now. History suggests - there is a contagion effect to it. We will soon find the same problem repeating in other forms at different places. 

Fed raising rates, exposed the underlying problem. There is a bank run on the regional banks. People use their mobile phones and transferring money out for 2 reasons. They are afraid they will lose their deposits and more importantly want to move to other money market funds that may yield 5%. The Bank wasn't paying much interest anyways. With fractional reserve banking - No bank can survive this outflow, as we know it. 

Opening a window at the fed to accept the depreciated asset and giving them on-par price - is a fraud. More over the bad assets are being dumped at the fed, because no one would buy it. Exactly the same thing that happened in the 2008 housing crisis. The mortgage backed securities were dumped at the fed and they remain in the Fed's balance sheet even now. The Bernanke promise of selling them back to the market when things improve never happened. It was a lie. These low-yield assets that are being dumped at the Fed by these failing regional banks - will also stay on the Fed's balance sheet until their maturity. The money the fed pays for it, would reach the economy making the inflation problem far worse.

This can be solved only by the US government (with the Fed) guaranteeing 100% of the bank deposits. Or else the Fed has to lower the interest rates drastically - to add value to the low-yield paper from the last decade. The Fed cannot do the later with CPI hovering around 6%. We will find out in the next couple of weeks on how this unfolds. If they do any one of the above - it would be admission of a financial crisis in-action. Symptoms would be suppressed for a while - but it will show up in a different form say double-digit hyper inflation soon. 

The Fed's balance sheet is already expanding. They were doing a $85 billion in QT every month. They just added $95 billion this week and $400 billion in the last month (the returns from the special window for the smaller & regional banks). So the pivot the market was looking for - has already happened from QT to QE.Jay Powell saying that - its not a QE program because he is not controlling long term yields is a loser's argument. Yesterday in the post-FOMC press conference, he said what happened in SVB and Signature banks were "outliers" and doesn't affect the broad banking sector. After famously using the terms auto-pilot, transitory - outlier might be the next one in that list.

Europe would have the exact same problem. They had negative interest rates for a long time in the last decade. With multiple countries in the Eurozone with different cultures and countries - it is going to be really hard for the ECB to maintain decorum. We already have seen Credit Suisse fail., and there are reports late this week on Deutsche bank having  their credit default swaps prices rising abnormally. 

The Central banks are coming to the rescue again. In fact they have too. After all - they are the ones who kept the interest rate too low for too long. They want to pretend the Central banks are the lender of last resort. Actually they are the lender of only resort. There cannot be a financial system, where no one loses.

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