ISMS 11: US Banking Crisis and Fed Rate Cut

Did the Fed finally break something with its aggressive rate rises? I’ve been repeating in my investment strategy that the Fed will eventually break something, and yes, they did. They did.Was the collapse of the Silicon Valley Bank the beginning of the 2023 US banking crisis?Has quantitative tightening ended?Are we in quantitative easing?Could this spread throughout the US?Or the global banking system?Was this caused by the government or the bad behavior of banks?Is the dollar going up or down due to what’s happening?Could this trigger a much-anticipated recession in America?And how does this impact Feds tightening and inflation the Fed is meeting this week?Did the Fed finally break something with its aggressive rate rises?Was the collapse of the Silicon Valley Bank the beginning of the 2023 US banking crisis?First, we start with the situation of Silicon Valley Bank, which is going bust. In Silicon Valley Bank’s case, first of all, there was a huge influx of deposits into Silicon Valley Bank over the last couple of years, as well as the whole banking sector in the US.Where did these deposits come from? In the US, those deposits came from the US government pumping money into the hands of individuals and companies through the various and massive stimulus programs during the covid shutdown. Those stimulus packages passed by Congress went into the banks as deposits from individuals and companies.Consider the fact that most countries around the world couldn’t do this. Thailand where I am right now, there’s no way the government could print all that money because the currency would have collapsed. And therefore, most governments did not have the privilege of having a reserve currency asset and the ability to print as much money as needed. So America is quite unique in this, and that’s one of the reasons why what’s happening in the US is may not spread to such an extent globally.What did Silicon Valley Bank do when they got all these deposits?Well, they didn’t have enough loans available to lend this money out. A bank does basically three things with the deposits that it receives: 1) it can hold it as cash, 2) it can buy some security or investment, like a security that could be traded, or 3) the traditional business of a bank, is they lend out money.Now if they had a lot of opportunities to lend that money out, they would have locked that money up in loans. Now imagine that a bank had 5% cash, 5% securities, and 90% loans. If people wanted to pull their deposits out of the bank, the bank would have 5% of the money available of their total, and then another 5%, they could sell those securities and repay deposits.Now they could also go to the government to the Fed and borrow some money to repay deposits to prevent a bank run. But it’s not so easy to get out of loans, right? If you’ve lent money to a company and need that money back, you can’t get that. So the loans are very illiquid, but securities are very liquid.After the 2008 crisis, new regulations tried to force the banks to hold more cashNow, let’s add that after the 2008 crisis, basically, the US government came up with new regulations that tried to force the banks to hold more cash and more securities, with the idea being that the combination of cash and securities would be highly liquid assets. And basically, the banks would then be able to pay back if any depositors came, they would be able to pay back.In fact, at the peak liquidity of the banks, you had almost 20% of the US banking sector’s assets in cash and almost 20% in securities. That means almost 40% of the bank’s balance sheet was in highly liquid assets.Now also what the US government did is they said, look, if you buy US Treasuries, we’ll count them as purely risk-free, meaning that you don’t have to put aside any capital for that. And remember, the US government was borrowing tons of money. So they needed the banks to own these treasuries. So they provide an incentive for the banks to own government securities, knowing that 1) those are risk-free assets, and 2) knowing that the federal government was borrowing a ton of money, and they needed the banks, not just the Fed, to buy those to buy the bonds that the Treasury was issuing.I thought that US Treasury bonds were risk-freeAnd now we have all this risk that we’re talking about? Well, where US Treasuries are risk-free is they are credit risk-free. In other words, it’s almost impossible to imagine that the US government wouldn’t print the money needed to pay back the debts that they owe.Now, when they print money to pay back debts that they owe, of course, they’re devaluing the US dollar, but still, you’re gonna get paid. So when we talk about risk-free, we’re talking about credit risk-free, but that doesn’t mean that they’re not interest rate risk-free. In other words, what does that mean?Remember that the Treasury rate for a 10-year bond, going back a few years, was about 1%. Imagine a bank buying a huge portfolio of these 1% government bonds. And then, all of a sudden, the Fed starts to raise interest rates.Let’s say that you own three-year government bonds. And then the Fed starts raising interest rates, and suddenly, someone out in the market could buy a three-year government bond at a, let’s say, 4-5% interest rate. And now you’re holding one that only pays 1%, holy crap; yours is not worth that much compared to others. To get other people to buy the bond you may want to sell, you’ll have to reduce the price. And it’s going to be a price reduction somewhere between 10% and 30, or 40%, depending on the maturity. In this case, we said three-year maturity. And so that means probably a 10 to 20% loss on that bond.Did the Fed cause this problem?Well? Yeah, I think so. Basically, what the Fed did is the Fed aggressively raised interest rates, knowing that all the banks were sitting on a large amount of US Treasury bonds. Now, in the case of US Treasury bonds, whenever you own a bond, you’re exposed to interest rate risk. So what is the risk management of a bank?Well, the risk management of a bank basically looks at all these different risks and says, how do we hedge this particular risk? So technically, the bank’s not really in the business of trying to make a lot of money on this; they’re in the business of raising deposits and lending those out.So what they want to do is protect the risk on their portfolio so that the value of the bond doesn’t collapse, and then all of a sudden, the bank is wiped out? Well, basically, what happened is that many of them, the larger ones, in particular, did do some hedging to try to cover this risk. Now, in the bank’s financial statements, you can see analysis, the type of analysis that they do, which is looking at interest rate risk, and they basically say if the interest rates go up by 100, or 200, or 300 bps, it would cause this amount of potential interest rate risk.Now, if you’re holding a bond to maturity, it’s a little bit different, right? Let’s just say that you as an individual bought a US government bond, that’s a 10-year bond, and you’re gonna hold it for 10 years, and it’s earning 1%. Now, if US Treasury bonds, 10-year treasury bonds now are trading at 5%. If you wanted to sell that bond into the market, yes, you’re going to experience a loss because that bond is no longer attractive because it’s only paying 1%. So you got to reduce the price to equalize the return of that bond between this from 1% to 5%.However, if you say, well, I don’t really care, I bought this bond for 10 years, I’m gonna hold it for 10 years to maturity, then you are not going to experience this risk, or this lower price, in fact, you’re going to get all of your money back. And so when you get all your money back at the end of the 10 years, you have gotten a pure 1% return.And that’s part of what Silicon Valley Bank had done is that they had put there, the excess liquidity that they had, they had put into held-to-maturity bonds. When you hold to maturity under US accounting rules, you don’t need to account for this interest rate risk, because you’re going to be holding to maturity.And there’s a lot of debate about if you were to put that security up for sale; that’s called available-for-sale securities. And for that one, you are going to have to mark it to market and say, well, there’s a big loss on this. But if you hold it to maturity, then you don’t have to. Well, also, what you’re doing is you’re not marking it to market through the P&L. You’re marking it to market through the balance sheet and the equity section of the balance sheet.Silicon Valley Bank received a lot of deposits, they have a lot of customers, and they’re happy with their deposits there. And then something went wrong. And when that one thing went wrong, all of these friends who are all tech startups and tech companies, all of a sudden told each other, hey, take your money out; there’s a risk at Silicon Valley Bank.And all of a sudden, Silicon Valley Bank had a run on the bank, meaning that its deposits were withdrawn superfast. So they sold their available-for-sale securities first because they’d already marked down the value of those. So they didn’t have any major loss from those.But then they had to sell their held-to-maturity assets. It is just like if you owned a 10-year bond, you’re not going to sell it, you’re going to hold it for 10 years, but then you have an emergency in your family, and you are forced to sell it.What is a liquidity event? How does it happen?This is kind of a liquidity event where you need the liquidity. And what happened is that Silicon Valley Bank had to start taking losses on their...