Gambling for Resurrection and Moral Hazard
Cheap money's killing spree... They're all as bad as Silicon Valley Bank... Gambling for resurrection and moral hazard... Mike Tyson on interest rate hedging (well, sort of)... The banking system is super fishy... A 'Fed pivot' still won't save us...
Cheap money's killing spree is just getting started...
We're now almost six weeks beyond the reign of terror's first victim – Silicon Valley Bank.
As I (Dan Ferris) noted in the March 17 Digest, it seemed like geniuses ran the technology-focused bank as recently as a couple years ago. Everything appeared to be going right...
Silicon Valley Bank's deposits more than tripled in two years to $189 billion in 2021. Its total assets tripled to $211 billion. And its revenue and earnings per share soared as well.
But it was all an illusion.
You see, its tech-startup clients started the bank down the wrong path after the COVID-19 pandemic. They raised a ton of cheap, easy money in the post-pandemic speculative frenzy.
Then, Silicon Valley Bank's management team used their clients' deposits to buy U.S. Treasury securities. That's where the problem came in...
They bought these securities at the lowest yields in history. And since bond yields and prices have an inverse relationship, it meant they bought them at the highest prices ever.
When you buy assets at exorbitant prices, big losses are almost inevitable. That's exactly what happened to Silicon Valley Bank...
The Federal Reserve is an accomplice in this killing, too. Its rapid interest rate hikes last year crushed the value of the bank's U.S. Treasurys and other investment holdings.
Finally, when Silicon Valley Bank fell short on cash last month, it had to sell securities to raise more. And given the circumstances, it was forced to sell them for a $1.8 billion loss.
On March 8, management announced the loss and its plan to plug the hole with new equity and debt. A day later, depositors saw the writing on the wall and withdrew $42 billion.
Depositors would've withdrawn another $100 billion on March 10 if the government didn't shut down the bank. Overall, they tried to withdraw 81% of the bank's deposits in two days.
No bank can survive that type of run.
Just like that, the country's 16th-largest bank took its last breath. Silicon Valley Bank didn't quite make it to its 40th birthday. And it became the largest bank failure since 2008.
Cheap money's killing spree was underway.
Now, you might recall that I made fun of Silicon Valley Bank's management in that initial Digest...
These executives couldn't do their main job – manage the risk of changing interest rates.
I even got a little snarky about it...
Rising rates should be good for banks, right?
I mean, they make all their money from interest. So more interest should mean that they make more money, right?
And of all the people in the world, you would have to put a bank's management team right at the top of the list for managing a changing-rate environment well, wouldn't you?
Like I said in that Digest, a bank's management team should be the most skilled people at that job. And as I continued...
If a bank can't do it, who can? More to the point... who would want their money in any bank that couldn't manage a changing-rate environment well?!
Well, apparently, Silicon Valley Bank's management wasn't so good at it. (They all got fired when regulators took over the bank at the end of last week.)
But here's the thing...
My comments implied that management's inability to manage interest rate risk at Silicon Valley Bank was unusual. And they hinted that most other banks can surely do much better.
After all, only three banks have died so far. And they were all tech-focused in one way or another. (As you'll recall, New York-based Signature Bank also failed. And California-based Silvergate Capital announced plans to liquidate its holdings last month.)
So in that case, maybe only tech-focused bank managers can't manage interest rate risk. Perhaps that's the flaw that the homicidal maniac known as cheap money preys on.
Or...
Maybe the whole banking system is bad at managing its interest rate risk...
That's what a recent research paper from four university professors suggests. (You can download their report right here.)
In their research, the professors used call reports filed with the Federal Financial Institutions Examination Council from 1,288 banks. This data represented 94% of all U.S. bank assets.
The professors also collected information from the Securities and Exchange Commission filings of 240 publicly traded banks. This data represented 68% of all U.S. bank assets.
The professors scanned both sets of documents for information about the banks' use of interest rate swaps – a standard hedging tool. And among other findings, they reported...
Over three quarters of all reporting banks report no material use of interest rate swaps... Only 6% of aggregate assets in the U.S. banking system are hedged by interest rate swaps.
In other words... roughly 94% of all U.S. bank assets are unhedged and fully exposed to interest rate risk.
In the simplest terms, bank assets are loans and bonds.
So if interest rates fall – which makes bond prices go up – these banks are OK. But when rates rise fast like they did in 2022, it pushes bond prices down sharply. And in that case, these banks could run into trouble.
As long as they don't run out of cash like Silicon Valley Bank did, they'll survive. But if they get short on cash, they'll need to take big losses on any assets they can to raise more.
We could be looking at more bank runs and more failures.
In their research report, the professors also noted...
We find slightly less hedging for banks whose assets were most exposed to interest rate risk. Banks with the most fragile funding – i.e., those with highest uninsured leverage – sold or reduced their hedges during the monetary tightening. This allowed them to record accounting profits but exposed them to further rate increases.
So the bank managers who took the most interest rate risk are the ones least worried about it.
I guess that makes sense...
If you don't understand risk, you'll probably wind up taking more of it than others do.
Those same clueless folks sold their hedges so they could report profits, too. That made their balance sheets weaker.
Even in a finance-themed TV show, this would seem stupid and far-fetched...
Or maybe you think it's too far-fetched for the financial world – but that it might fly in a politics-themed series. The professors are way ahead of you...
You see, they accused the bankers of "gambling for resurrection."
That's a common political term. It refers to when a politician is weakened domestically and tries to distract the electorate with a risky international move – like going to war.
Here's how the authors described their assertion...
Reduction in hedges by the banks with more fragile funding is suggestive of gambling for resurrection. Selling profitable hedges allows weak banks to increase current accounting earnings. At the same time these banks have taken a large risk, which is profitable for bank shareholders on the upside, but the losses are borne by the [Federal Deposit Insurance Corporation ("FDIC")] on the downside.
That seems like a fancy way of saying the banks thought they could distract us from their losses on their securities portfolios by reporting profits earned from selling their hedges.
Gambling for resurrection.
Selling a hedge isn't a big deal on its own. The problem comes when you don't replace the hedge or do anything else to minimize the losses on the underlying securities you still hold.
Maybe the banks were gambling for resurrection. But I think they were just clueless about risk – the same way everybody else has been clueless about risk the past several years.
That's how people – including allegedly knowledgeable, sophisticated finance folks – behave when money is cheap and easy for a decade or so.
They act like risk is an antiquated concept. So they take on more of it while failing to acknowledge that they're doing so. Or worse – and probably likelier than you'd ever believe – they take on more risk while failing to understand what they're doing.
Given that near-zero interest rates reigned for most of the period from 2008 to 2022, do you really think nobody else made a bad enough mistake to blow up their balance sheets? Could Silicon Valley Bank and the other two tech banks really be the end of the trouble?
I seriously doubt it. And to explore why I say that, let's talk about another term the professors probably should've included in their paper (but didn't)...
Moral hazard.
That's a term for taking more risk because you don't share in the downside if you're wrong.
Moral hazard is common in corporate America today...
Most executives these days have little or no real skin in the game.
With their promises of bailouts, the Fed and the FDIC create the incentives that lead to moral hazard in banking. But they're just the fronts for the U.S. government behind it all.
Without a giant, overbearing central government and its central bank – both of which can print all the money they want – moral hazard might not be pervasive.
Bank managers earn compensation from growing earnings. And they know that the government will backstop losses for depositors.
So what do you think they're going to do?
They'll ramp up risk and grow their earnings as much as they can – and as fast as they can. And they'll do that even if it means taking on more risk.
The government isn't 100% to blame for moral hazard in the U.S. banking system, of course...
Some financial companies' management teams have plenty of skin in the game.
For example, Warren Buffett owns nearly 40% of Berkshire Hathaway. That's a lot of skin. And it shows on the company's balance sheet...
Berkshire Hathaway keeps at least $30 billion in cash on hand. It's protection in case the company endures a tough year in its catastrophe-insurance business. And Buffett has made it clear that's more than enough cash to handle the worst imaginable scenario.
On top of that, the company holds another roughly $95 billion in U.S. Treasury bills. It has another $334 billion or so in stocks and bonds. Put simply, it's a financial fortress.
Berkshire Hathaway is a fortress because Buffett thumbs his nose at Wall Street's short-term culture. And he focuses on growing shareholder value only after taking actions to preserve it.
U.S. banks don't do that.
The proof is in the four professors' research. And it's in the bank failures we've witnessed.
Now, maybe you know more about banks than the average American. If that's the case, you might be thinking, "Dan, you don't hedge securities you don't plan to sell."
On a bank's balance sheet, those types of securities are called "held to maturity." And the banks plan to do exactly that – hold these securities until they mature in the future.
At that point, they'll get the principal back. And they'll have already received all their interest payments.
I understand the idea that you might not hedge an investment you never plan to sell. And in theory, that type of plan should be OK.
But in the words of boxing champ Mike Tyson...
'Everybody has a plan until they get punched in the mouth'...
Making a plan shouldn't mean you're pretending to know you'll never get punched in the mouth – figuratively speaking, of course.
No one can know that. The future is unpredictable.
If most banks simply hedged out the interest rate risk in their "available for sale" securities (the ones they plan to sell before maturity), they would be way ahead of the game today.
Instead, the killer known as cheap money is still lurking in the shadows.
Silicon Valley Bank's management team did get one thing right. They nailed the bet that the bank's failure wouldn't matter for depositors because the government would bail them out.
I guess we've finally found out what bankers are good at – gaming the system.
And of course, backstopping all of Silicon Valley Bank's deposits wasn't really about helping 'the little guy'...
Most of the money the FDIC used to bail out the bank went to the 10 largest accounts...
The FDIC took a loss of about $18 billion related to paying Silicon Valley Bank's depositors. The 10 largest accounts backstopped by the government held $13.3 billion – an average of $1.33 billion each. So the FDIC likely used most of the money to bail out billionaires.
It really doesn't matter if the funds came from the FDIC or were paid out of Silicon Valley Bank's assets. What matters is that the FDIC doesn't usually insure deposits that big.
Insured banks finance the FDIC's deposit-insurance fund. And the fund is backed "by the full faith and credit of the United States government."
To backstop billionaires' deposits, the FDIC had to say not doing so would cause systemic risk. That's rich considering that Jerome Powell, Janet Yellen, and Joe Biden all rushed to assure the American public how safe the banking system is in the days after the failure.
So let's get this straight...
Are we supposed to believe the U.S. banking system is fine – but only because the feds backstopped Silicon Valley Bank's uninsured billionaire depositors?
If that doesn't smell fishy to you, you haven't spent enough time around rotting seafood.
And most of the banking system's failure to hedge against interest rate risk is doubly incredible...
It suggests bank managers aren't as competent and risk averse as they should be. And even worse, it suggests they paid no attention to the Fed's numerous statements about its intentions to raise rates.
It's not like the Fed caught everyone off guard...
Just read the Fed's statement from each of its meetings last year. They all had the same type of language. In January 2022, before the hikes even started, the Fed said...
[T]he Committee expects it will soon be appropriate to raise the target range for the federal funds rate.
Every time after that, the Fed said something like...
[T]he Committee anticipates that ongoing increases in the target range will be appropriate.
Despite everything I've told you, it's still hard to believe that the entire banking system is totally unprepared for the Fed's most loudly telegraphed rate-hiking cycle in history.
For the reason why that happened, I return to my initial assertion...
Cheap money killed Silicon Valley Bank. And worse, the killing spree is just getting started.
The three tech-focused banks that failed are like three "canaries in a coal mine."
The Fed taught us all to ignore risk and to expect it to lower interest rates at the first sign of trouble. It kept rates near zero for most of the nearly 14 years from December 2008 to March 2022.
That was long enough to teach most folks to forget about risk and to "buy the dip" every time.
And remember, the so-called "Fed put" – the idea that the Fed will always lower rates to bail out investors in a crisis – originally had other names...
First, under Fed Chair Alan Greenspan, it was called the "Greenspan put."
Then, under his replacement Ben Bernanke, it became the "Bernanke put."
Then, under Yellen, it became the "Yellen put."
Then, under Powell, it became the "Powell put."
Now, it's just the Fed put. That's because everybody thinks the Fed is trapped no matter who's in charge – and eventually, it will cry "uncle" and start cutting rates again.
I understand why folks can feel that way...
Greenspan took over for Paul Volcker as the head of the Fed in August 1987. For much of the next 35 years, four different Fed chairs beat it into us that they would lower interest rates, print money, and buy securities to prop up the markets at the first sign of trouble.
And investors have learned well...
For months, everybody has talked about the Fed 'pivoting' from raising rates to cutting them...
That's just another way of saying that you no longer care about risk because it doesn't really exist as long as the Fed is there to bail you out.
That's really dumb. And of course, it's just plain wrong.
The Fed can only do so much. And everything it does just winds up creating more risk.
That's why the bailout for the financial crisis was much bigger than the bailout for the dot-com bust. And it's why the bailout for the COVID-19 crash was bigger than the one for the financial crisis.
The next bailout will be even bigger. That's just the world the Fed has created.
Admittedly, I think we're closer to a Fed pivot than we were at the start of the year...
But I still bet a Fed pivot is further away than most folks would ever believe.
And whenever it does happen, don't count on it keeping the stock market elevated...
By now, I shouldn't need to repeat yet again that Fed pivots historically precede market declines – not rebounds. Most bear markets throughout history occurred after Fed pivots.
The futures market currently expects another quarter-point rate hike at the next meeting in early May. That would take the federal-funds rate to a range between 5% and 5.25%.
Bernanke studied the Great Depression and vowed not to repeat the mistake of not-too-tight monetary policy. And now, Powell has studied the 1970s inflationary era and vows to keep policy as restrictive as needed to get inflation back down to 2%.
Inflation is falling. But it's still at 5% on a year-over-year basis.
That tells me Powell has a long way to go. And you better take him seriously...
We can't know for sure what will break next. But with the banking system in a riskier condition than most folks thought possible, something else is bound to break before long.
Cheap money is ready to claim its next victim.
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Today's mailbag includes feedback on Wednesday's Digest about the debt-ceiling "debate" and yesterday's edition about stocks climbing the proverbial "wall of worry." What's on your mind? As always, you can tell us at feedback@stansberryresearch.com.
"In [Wednesday's] Digest, you stated that...
But this limit – a vehicle that originally began to help fund World War I – is set by the same body that approves the federal budget and appropriates funds.
It's like the chicken-or-the-egg dilemma. Which came first? It doesn't really matter... The end result of the arrangement is the same: more chickens and eggs. More spending and debt.
"It's actually more like putting the fox in charge of the henhouse: once he's finished devouring all the chickens and eggs, what's he going to do then?
"At least in the U.S., there's a 'debate' about the debt ceiling. Here in Canada, there's no debate at all. Bozo Brains Trudeau continually runs massive deficit budgets which all pile up the national debt to record levels. There's no limits on the debt here." – Paid-up subscriber Ray R.
"In your article on the 'wall of worry' you listed seven sources of worry. These seven sources are all out of the reach of each of us as investors. There is a story behind each of the seven, and all of those stories are result of factors completely out of our control.
"Sadly, the majority of them were created by our so-called leaders who are singularly to blame for the present conditions we find ourselves in.
"We are left with little choice of alternatives as to where we can put our money. Under the mattress? Buried in the backyard? In interest bearing accounts? Bonds? It's frustrating!
"The only place we have any chance of making any kind of a return is in the stock market. Consequently, the market continues and everything remains the same." – Stansberry Alliance member Paul M.
Good investing,
Dan Ferris
Eagle Point, Oregon
April 21, 2023