Unrealized paper losses on all securities so far are estimated at $620 billion* as of year-end 2022. And that is why the Fed announced a new facility to provide cash to needy banks at the par value
of their high-quality bonds. A safety net for a systemic crisis—made by
the Federal Reserve itself. And the crisis will deepen so long as the
Fed keeps raising...
*New estimates bring that figure up to $1.4 Trillion billiom
The Fed raises interest rates, first and foremost, to defend the dollar. Paul Volcker in 1981 raised interest rates to the skies and established a dollar-based world system that is now beginning—just beginning—to unravel. I believe that this, above all, lies at the heart of the inverted yield curve. SVB and the US regional and community banks are only the beginning of the consequences.
What happens next? Obviously, Europe and Japan must match US rate increases and deposit guarantees, and as all those interest rates rise, a global slump will follow...
SPOILER ALERT: Enhanced swap lines—to keep dollars available to foreign central banks—were trotted out on Sunday. They signal that the dollar is still boss, and also that the entire global banking system, indeed most of the world economy—outside of China and Russia—is fragile.
What Elizabeth Warren, Larry Summers, and Paul Krugman All Got Wrong About SVB
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It’s a war for the dollar—and the big banks. The rest of us better hold on tight.
"When Silicon Valley Bank went down, many progressives, and much of the media, immediately pointed to malfeasance, special pleading and regulatory failures—a conditioned response with a strong pedigree. But if those were the real causes, then SVB (and Signature, and First Republic) would have been isolated cases. It’s clear now that they were not. A systemic crisis is unfolding—with a systemic cause.
The business model of SVB consisted of an attractive return on deposits, adventurous loans mainly to young companies in the tech sector, perks for big clients to keep their funds in the bank, and large investments in government bonds and mortgage-backed securities. The safety of the bonds worked to offset the risk of the loans, while the bonds’ return covered the cost of deposits—which grew rapidly as client companies and some cash-rich individuals parked their funds at the bank.
SVB’s growth was indeed rapid, but much of that was back in 2021, the pandemic recovery year. The return on deposits was sweet, and the ad said, in a way that is not now reassuring, that SVB is “fundamentally different from other banks.” It’s also true that SVB lobbied successfully for relief from some regulations on the ground that it did not pose a systemic risk. That looks bad, but SVB wasn’t a systemic risk—its peak deposits of $300 billion were a tiny fraction of US bank deposits.
The bank (I was told by an investor) did not have staff—or possibly, business customers—sufficient to lend out the deposits it attracted to the degree usual for larger banks. Hence much of its balance sheet simply converted short-term deposits into long-term securities, which formed about three-fourths of SVB’s portfolio. This—and not problems with loans—brought SVB to grief. By usual indicators (such as late payments or defaults), the loan book was in very good shape—for the moment.
> The problem was not (as Larry Summers declared) that a bank should not convert short deposits into long loans and investments. That is—more or less—what banks do. Loans and bonds are their business.
> It was also not (as Elizabeth Warren declared, along with other progressives fighting the last war) that the bank took on too much risk. Its loans were risky—because it specialized in start-ups, which are inherently risky. But they were not failing. Its investments, in bonds, were not risky in the usual sense—they were not in danger of default.
> In the same vein as Warren, Paul Krugman declared that tougher regulation (of loans) and larger capital requirements or liquidity cushions might have saved the day. Again, fighting the last war. SVB’s loans were all right so far. SVB’s bonds, of course, are liquid! Treasuries and high-quality mortgage-backed securities can be readily sold. SVB’s capital and liquidity would have passed tests until a few days before the crash. This is characteristic of bank failures: Capital looks ample until it disappears. In SVB’s case, the run drained $42 billion in one day—and that was that. The idea that capital requirements provide safety is an economists’ illusion.
The conversion of short deposits to long bonds is a play on the yield curve (the relationship between short- and long-term interest rates).
In normal times, longer bonds pay higher interest and the play is modestly profitable—and extremely safe.
But when the yield curve inverts—thanks to a tight monetary policy—eventually, one of two things must happen. Either the bank must raise its deposit rates and take the loss, or big deposits will leave for direct investment in short-term Treasury bonds and money market funds. This is the classic disintermediation that doomed the Savings & Loan industry in the 1970s.
As a bank catering primarily to small and medium-sized startups and some wealthy indiviiduals, SVB’s deposit base was unstable. Why did it fail when it did? The destabilizing factor was the Federal Reserve. Once Jerome Powell and his colleagues raised short-term rates above long-term rates, the bank was doomed. We may presume that the CEO knew this, or he would not have dumped stock months and weeks before the end. Others—oligarchs and big players on Wall Street—knew it too, and shorted SVB. SVB was the canary in the coal mine of the inverted yield curve.
✓✓ Deposits starting flowing out. These deposit outflows prompted the bank to sell bonds, incurring a loss. A Twitter mob sparked the run. A raft of supposedly sympathetic start-up companies with payrolls were caught in the crunch; they were showcased in the news. Larry Summers, among others, then demanded that the Federal Deposit Insurance Corporation issue a full guarantee of all of the uninsured deposits. To the dismay of the sensible former FDIC chair Sheila Bair, SVB was retroactively judged to be a “systemic risk”—allowing big-dollar depositors to exit unscathed.
What would have happened had all deposits not been guaranteed?? Businesses with payrolls to meet would have received a dividend from the FDIC for that purpose. Some big depositors would have had to wait for their funds—and would have taken some losses when they got them. Peter Thiel, for instance, had $50 million in the bank when it closed. The overall effect of letting him and others take losses would have been a warning against special treatment for plutocrats. What happened was the opposite. Now, with First Republic, that issue may come up again, on a larger scale.
✓ This brings us to the bigger problem. The US banking system as a whole holds nearly $3 trillions in mortgage-backed securities, largely based on the vast flood of mortgages issued in recent years when interest rates were historically low. Most of them are good mortgages; all of them have lost market value. They can be held without marking to market (writing down their values on the books) only so long as banks class them as hold-to-maturity. Which banks can do only so long as they do not need the funds. . .
Unrealized paper losses on all securities so far are estimated at $620 billion as of year-end 2022. And that is why the Fed announced a new facility to provide cash to needy banks at the par value of their high-quality bonds. A safety net for a systemic crisis—made by the Federal Reserve itself. And the crisis will deepen so long as the Fed keeps raising rates.
So why did the Federal Reserve invert the yield curve? To fight inflation? To kill jobs and stall wages? If so, the stupidity—or the economistic groupthink—is shocking. Most price increases have already faded from the economy (for now). Though job growth is strong, wage increases lag prices: Real wages have fallen. The Fed obviously operates in total disregard of its full-employment mandate—nothing new in that—and indifference even to the textbook logic of labor markets. Why is that? Among specialists, opinions differ on how smart top officers of the Federal Reserve actually are. Personally, I vote for dishonest over stupid.
The Fed works—as a wise Republican monetarist told me many years ago—for the biggest banks. The big banks are not the friends of smaller banks, even if they scramble to help out when the smaller ones are in danger. And the big banks, which operate across the globe, depend on the God-almighty dollar.
The Fed raises interest rates, first and foremost, to defend the dollar. Paul Volcker in 1981 raised interest rates to the skies and established a dollar-based world system that is now beginning—just beginning—to unravel. I believe that this, above all, lies at the heart of the inverted yield curve. SVB and the US regional and community banks are only the beginning of the consequences.
What happens next?
✓Obviously, Europe and Japan must match US rate increases and deposit guarantees, and as all those interest rates rise, a global slump will follow.
✓ If they don’t follow suit—and perhaps even if they do—hot money will flow massively out of European and other foreign banks, notably Japan, and out of commodities, such as oil and copper. The money will flow into the United States. Into the money market funds and the biggest banks. Enhanced swap lines—to keep dollars available to foreign central banks—were trotted out on Sunday.
They signal that the dollar is still boss, and also that the entire global banking system, indeed most of the world economy—outside of China and Russia—is fragile.
Hold on tight."
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Top economist Mohamed El-Erian says the ‘relentless appreciation of the dollar’ is terrible news for the global economy
The British pound, like most major currencies other than the dollar, has been under siege throughout 2022. And the situation deteriorated dramatically last week, when the U.K.’s new prime minister, Liz Truss, unveiled a spending plan to boost economic growth.
Investors fear the plan—which will require £45 billion in new debt, and includes the largest tax cuts seen in the U.K. in 50 years—will only serve to exacerbate inflation, undoing the work of the Bank of England’s interest rate hikes.
Despite a negative reaction from markets last week to the new fiscal measures, U.K. Chancellor of the Exchequer Kwasi Kwarteng said over the weekend that there’s “more to come” on tax cuts, sending the pound tumbling to a record low against the U.S. dollar on Monday.
The once-dominant pound sterling is now down more than 21% this year compared to the dollar, and it’s not the only foreign currency that’s struggling. The Japanese Yen is also down roughly 20% on the year vs. the dollar, while the Euro and the Thai baht are both down more than 15%.
The dollar has ruled the roost in 2022 amid the Federal Reserve’s aggressive interest rate hikes, Europe’s energy crisis, and China’s COVID lockdowns.
As Fortune previously reported, investors looking to protect their capital in these trying economic times see the greenback as a safe haven, because the U.S. economy is “the cleanest dirty shirt,” according to Eric Leve, chief investment officer of the wealth management firm Bailard.
But economists warn that the dollar’s strength can also be a nightmare for the global economy.
“What is clear is we have this relentless increase in yields, this relentless appreciation of the dollar. They are both bad news for corporates and for the economy,” Mohamed El-Erian, the president of Queens’ College at the University of Cambridge, told CNBC on Monday.
Echoing Leve’s comments, El-Erian explained that with “fires burning” all over the developing world—and now even in places like the U.K—the dollar is the currency of last resort for investors.
“The reason why this last leg up in the dollar is happening is because we are the safe haven and one consequence of that is our currency gets stronger,” he said.
The strong dollar: A global wrecking ball
This isn’t the first time that El-Erian has warned about the potentially disastrous implications of a rising U.S. dollar.
In a Sept. 6 Washington Post op-ed, El-Erian explained that a strong dollar can be a “mixed blessing.” On one hand, the strength of the greenback helps to reduce U.S. inflation, but at the same time, when the dollar remains persistently strong, it can bankrupt developing nations as their dollar-denominated debt costs soar.
That’s exactly what happened in the Latin American debt crisis of the 1980s. Developing nations in Central and South America amassed billions in dollar-denominated loans with low-interest rates throughout the 1970s. Then, when the U.S. raised interest rates dramatically to fight inflation beginning in1982, debt costs soared sparking a crisis that plunged Latin America into a “lost decade,” according to the Federal Reserve.
And El-Erian warns that a strong dollar can have a number of devastating effects outside of emerging market economies as well.
“The longer and higher the dollar soars above the rest, the greater the risk of more prolonged global stagflation, debt problems in the developing world, more restrictions on the free flow of goods across borders, greater political turmoil in fragile economies and greater geopolitical conflicts,” he wrote in his Washing Post op-ed.
On Monday, El-Erian also noted that the recent strength of the U.S. dollar only adds to three key paradigm shifts that have made for an “uncomfortably high probability” of a global recession.
The top economist broke down these shifts in his latest Bloomberg op-ed over the weekend.
First, he noted that central banks around the world have moved from supportive to restrictive policies practically in unison to counter inflation. Second, he explained that global economic growth is “slowing significantly” as the world’s three most important economies, the U.S., the E.U., and China, all continue to lose momentum.
And finally, he said that the process of globalization that helped bring about a deflationary trend worldwide over the past two-plus decades is now fading because of “persistent geopolitical tensions.”
In his interview with CNBC on Monday, the top economist explained that these paradigm shifts have only been made worse by government policies, and called on policymakers to stop adding to the volatility, hinting at the new U.K. tax cut and spending plan.
“It’s not just about the big paradigm shifts,” El-Erian said. “This is about governments and central banks being sources of volatility rather than volatility suppressors. They are adding to the volatility, that’s particularly clear with the government in the U.K., but also in the U.S. with the Fed…it is quite a mess in some of these markets and these are the main markets for the global economy.”
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From SVB to Signature to Zions, why people are worried about banks
Banks are teetering as customers yank their deposits. Markets are seesawing as investors scurry toward safety. Regulators are scrambling after years of complacency
"...Since the Fed began raising interest rates, banks have faced growing unrealized losses.
These unrealized losses are especially notable as a percentage of a bank’s deposits — a crucial metric, since more losses mean a greater chance of a bank’s struggling to repay its customers.
At the end of last year, U.S. banks faced more than $600 billion of unrealized losses because of rising rates, federal regulators estimated.
Those losses had the potential to chew through more than one-third of banks’ so-called capital buffers, which are meant to protect depositors from losses, according to Fitch Ratings. The thinner a bank’s capital buffers, the greater its customers’ risk of losing money and the more likely investors and customers are to flee.
But the $600 billion figure, which accounted for a limited set of a bank’s assets, might understate the severity of the industry’s potential losses. This past week alone, two separate groups of academics released papers estimating that banks faced at least $1.7 trillion in potential losses.
The most skittish bank customers tend to be those whose deposits are uninsured...
The Federal Reserve and other regulators are rushing to reassure everyone. Last weekend, the Fed announced a program that offers loans of up to one year to banks using the banks’ government bonds and certain other assets as collateral.
Crucially, the Fed said it would value the bonds at their original value — not at the lower levels that banks stood to receive if they tried to quickly sell them in the markets. The Fed’s goal was to send a reassuring signal that banks would not have to transform unrealized, potential losses into crippling actual ones.
At least so far, that program hasn’t been much of a game changer. Banks borrowed only about $12 billion — a small fraction of the deposits that were pulled out of SVB alone before its implosion.
But banks gobbled up a whopping $153 billion in loans through the Fed’s traditional lending program. That was up from less than $5 billion a week earlier and was the largest amount borrowed in a week since the 2008 financial crisis.
The fright that began with SVB has continued to spread to other banks..."
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