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Global Financial Crisis 2.0
This is just the beginning
The U.S. banking sector is in dire straits with no quick or easy fix.
U.S. authorities and especially the Federal Reserve went “all in” in their efforts to quel the panic caused by the failure of the Silicon Valley Bank.
Issues (contagion) caused by Credit Suisse and its impending failure are unlikely to abate.
We have entered a Global Financial Crisis 2.0.
Sometimes you throw in the “towel” with your longer-term forecasts just before it starts to manifest. This happened to me Thursday past week, when I wrote:
I made a bold call on 23 November, 2022, telling people to expect the “collapse of everything” to begin within the next four months. Apparently, this has not happened, and the likelihood of a such an event commencing within the next three weeks is relatively small (not nowhere near zero though).
The problems of the Silicon Valley Bank, SVB, escalated the next day.
The failure of SVB seems to have been a combination of compromised loan and securities books with a low share of retail deposits. Rapidly risen interest rates led Treasuries it held to lose value in crushing manner forcing the bank to fire sales and creating a dire re-capitalization need. Bank management, for some reason, made all this public leading to a run on its deposits succumbing the bank.
New York based Signature Bank failed because of a bank run caused by the failure of the SPV. According to the management of the bank, they had no problems until the run on deposits of the bank commenced late-Friday past week. On Sunday regulators announced a takeover of the bank to “protect its depositors and the stability of the U.S. financial system“. This week started with a panic. The usage of the discount window of the Federal Reserve grew to a record (including the Global Financial Crisis of 2008!).
The collapse of SVB (and Signature) is a mere symptom of a much wider problem. We touched it in our in-depth analysis on the U.S. economy in the turn of the month. First, I warned in my newsletter that the U.S. banking sector was much more fragile than previously understood. A bit later it was revealed that, due to the rapidly rising interest rates, the U.S. banks were sitting on a massive stockpile ($620 billion) of unrealized losses.
Then, in our Deprcon Special Issue of the U.S. economy, we wrote:
When recession starts to bite, this will, most likely, start a vicious cycle of de-leveraging, where increasing defaults of corporations and households sours the loan portfolio of banks leading them to tighten further, which leads to further defaults, and the cycle repeats. This is a classic process leading to a banking crisis.
This process is yet to begin. Thus, the failure of SVB and Signature Bank, the largest bank collapse in the U.S. since the fall of Washington Mutual on 25 September 2008 (remember that Lehman Brothers was an investment bank), were just the beginning. Also, the European banking sector is teetering on the brink, faced by prospects of the collapse of (formerly venerable) Swiss banking giant Credit Suisse, which is also one of 30 global systemically important banks, or G-SIBs.
Alas, we have entered a global financial crisis 2.0.
I have gone through the likely procedure to be enacted in, at least, with SVB in a Twitter thread, earlier. There are many good analyses on the direness of the situation in the U.S. banking sector (see, e.g., this) in addition to mine. We have gone through the options remaining with Credit Suisse in our Deprcon warnings (see this and this). So, I will not dwell on these any further here.
Rather, in this entry I will go through the repercussions of it all detailing why we are just at the ‘first innings’ of this crisis and what’s likely to happen next.
Into the (global) hole
ZeroHedge has a good collection of indicators showing the massive hit to risk appetite, inflation expectations, dollar liquidity and other systemic risk factors, the collapse of SVB inflicted. They tell a compelling story that something “broke” on Monday, on a global scale.
The main issue here, like with all banking crises, is trust. This was, again, clearly illustrated with the renewed problems of Credit Suisse. At the time of writing, the troubled bank had secured a CHF 50 billion ‘lifeline’ from Swiss National Bank, which has not halted the prices of credit default swaps, bought to shield against the failure of the bank, to proceed ‘through the roof’. In the background, search for her rescuer is most likely to be intense.
The banking issues on both sides of the Atlantic caused a massive spike in the FRA-OIS spread.The higher the FRA-OIS spread is, the higher the rates banks charge from each other in their bank-to-bank lending activities (FRA), compared with the risk-free rate (OIS), implying a declining trust in the interbank money markets. This is troubling, because banking is a business of trust and the collapse of trust between banks is what, e.g., started the global financial crisis in 2007-08.
The breaking of trust of the general populace to banks is what forced authorities to react, strongly.
In comes the Fed (again)
In the cusp of panic during past weekend, U.S. authorities took some drastic actions. The Federal Deposit Insurance Corporation, FDIC, announced that it will create a Deposit Insurance National Bank of Santa Clara (DINB), where all insured deposits of failed SVB will be transferred. Soon, however, it became evident to the FDIC, the Biden administration and the Federal Reserve that this is unlikely to be enough. The panic from SVB had already collapsed another bank (Signature) and reports were pouring in, also through social media, that bank runs on other regional banks were forming.
This led to three-way response of the authorities.
First, there was a joint statement from the Treasury, the FDIC and the Fed, announcing that all depositor funds (also uninsured deposits) of the SPV and the Signature Bank were guaranteed. Secondly, the Federal Reserve provided $300 billion worth of liquidity into the system and announced that it will make “additional funds” available to all banks in a Bank Term Funding Program. Thirdly, in a highly exceptional move (effectively confirming that there was a risk of a major run on U.S. banks) President Biden appeared on national television to assure that deposits in the U.S. banks are safe.
In the Bank Term Funding Program (BTFP), the Federal Reserve “offers loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions pledging any collateral eligible for purchase by the Federal Reserve Banks in open market operation”. It will be backed up by $25 billion from the Exchange Stabilization Fund of the Treasury.
The ‘eligible institution’ is defined in 12 CFR § 201.4, which states the Federal Reserve can extend primary or secondary credit to depository institutions. To obtain primary credit, the institution must be financially solvent (sound), but secondary credit is:
[…] a backup source of funding to a depository institution that is not eligible for primary credit if, in the judgment of the Reserve Bank, such a credit extension would be consistent with a timely return to a reliance on market funding sources. A Federal Reserve Bank also may extend longer-term secondary credit if the Reserve Bank determines that such credit would facilitate the orderly resolution of serious financial difficulties of a depository institution.
Moreover, ‘eligible collateral’ is defined in 12 CFR § 201.108 . That includes a long list of assets, but in in practice it can be any asset that the banks holds to which some price can be assigned.
In other words, it does not matter whether the institution is solvent or not nor what asset it offers. Anything goes.
I cannot stress enough, how exceptional this is. Basically the Federal Reserve has written an open check to all depository institutions including, technically at least, investment banks. As noted by strategists from J.P. Morgan, this can all but reverse the quantitative tightening, QT, of the Fed, because banks are likely to gorge on the loans. They estimate that the BTFP can lead to close to $2 trillion worth of central bank reserves injected to banks, based on the par amount of bonds held by U.S. banks outside the five biggest. However, the actual sum could be even bigger, because the BTFP offers loans to all “eligible” depository institutions. We keep monitoring the situation.
All this implies that authorities were mortally afraid of a nationwide bank run. There simply is no other explanation for it. The U.S. banking sector was at the ‘brink’ for the first time since 2008, and the massivity of the response reflected this.
These truly exceptional measures seem to have helped and there has not been any further reports of bank runs, for now. However, there will be repercussions. For example, European authorities have already strongly criticized the U.S. authorities of “tearing up the rule book” considering how to handle the failure of ‘non-systemic’ banks agreed after the Panic of 2008. The most worrying thing is that U.S. authorities are effectively ‘all in’.
With the exception of issuing a digital dollar (a central bank digital currency, CBDC, which is not ready yet and it has its own, serious problems), there’s very little more the Fed can do. Treasury Department guaranteeing a total of around $18 trillion of deposits (around $5.1 trillion of demand deposits) in the U.S. banking system, with an annual budget of around $5.8 trillion, is a non-starter.
Europe is unlikely to be far behind.
Europe: Humpty Dumpty on the wall
Problems of Credit Suisse are pressing (I think that the bank is “done”) and they can easily lead to a serious contagion among European banks. On paper, everything seems to be ok with European banks but, like we have been warning for some time, their balance sheets are likely to be riddled with toxic assets. In May 2020, we wrote:
Only a few banks were allowed to fail and, in total, 114 European banks received government support during the crisis. But, the most destructive policy was for banking regulators to allow Europe’s banks to continue to carry U.S. mortgage-backed CDOs and other exotic—yet nearly worthless—financial products on their balance sheets with imaginary values. This meant, of course, that while many of the OTC products had little or no value, banks could pretend that they did.
This was taken from our 2019 Special Report, where we summarized the situation in the European banking sector as follows:
In practice, the balance sheet of European banking sector was divided into three layers. The first included the good assets, held ‘mark-to-market’, meaning that their value was based on actual daily market quotes. The second layer included assets that had lost value, but which the banks could pretend had not. The third layer, “the dark pit”, included assets that were nearly or totally worthless, but are nonetheless held on bank books as if they still had some value. […] Using traditional accounting, a large part of the European banking sector has probably been insolvent for the past 10 years, a conclusion that is also suggested by the group’s stock price performance for that same period.
This is likely to be the “material weakness” in the financial reporting of Credit Suisse discovered by U.S. financial authorities. There, most likely, are many more such discoveries to come.
Recession, the harbinger
In our entry, The anatomy of a financial crisis, we wrote:
Recession leads to diminished income and defaults by both corporations and households, while expectations may turn corporations and investors to shy away from investing creating a recession in the process. This increases the share of non-performing loans in bank loan portfolios, reducing the value of loan collateral and increasing bank rissks and capital needs.
As write-downs and losses increase, mistrust among other banks and depositors and investors does as well. The bank’s share price will usually start to reflect this.
And, we continued:
If suspicion spreads, banks will be apprehensive about counterparty risk and will be unwilling to lend to one another even on an overnight basis. If allowed to continue, this will have a calamitous impact on liquidity in money markets. In the worst case, possibly fueled by rumors and insider information, a bank run will ensue, where depositors try to withdraw their money suddenly and simultaneously.
In years past, depositors would queue outside of bank offices to obtain cash. Now withdrawals are largely electronic. At the same time, the bank’s investors and institutional counterparties rush to lower their exposure by frantically selling its stocks and bonds as well as derivatives and other interbank liabilities.
This latter process has now effectually started, but without any noticeable economic trigger. It’s extremely worrying that U.S. bank failures started at the end of an economic downturn, effectively brought upon by a maturity-mismatch. The problems of Credit Suisse are also not directly related, at least that we know of, to state of the overall economy.
I studied financial crises for 10 years in the academia, and I can state that I have never been this worried on the global banking sector before. This is because all the effects of approaching recession on the banking sector are yet to be felt.
Recession brings about a wave of defaults and bankruptcies of households and corporations. This process has already started in Europe, which has seen a massive increase in corporate bankruptcies.
This is a harbinger of serious problems for banks.
The schizophrenia of a central banker
Another worrying question is, how does the Bank Term Funding Program of the Federal Reserve affect the banking sector? How widely banks are going to take use of it? Will it lead to a strong easing of the financial conditions and recovery of the money supply effectively increasing inflation pressures?
This would cause a major headache for the Fed taking into account that the ‘sticky price inflation’, a weighted basket of items whose prices change relatively slowly, has risen to levels not seen since August 1982. This directly implies that inflation expectations have become anchored to a higher level, making inflation “sticky”. Even at itself, this will force the Fed to rise rates, but if also ‘flexible inflation’ picks up again, driven my incresed supply of money, the Fed would be in a very serious trouble.
So, the Fed may find itself from a position, where it grows its balance sheet (through BTFP and other liquidity-support for banks), while it simultaneously rises rates, possibly aggressively. Considering the completely opposite aims of such measures, it would be rather ‘schizophrenic’.
Yesterday, the ECB hiked rates by 50 basis points (0.50%), but the ECB President Christine Lagarde did not commit to further rate hikes. She also stated that the two aims of the ECB, price stability and financial stability, are different. This also reflects the serious conundrum central banks find themselves in.
To summarize, we have most likely entered the next global financial crisis, fed by the approaching recession, which will again be something not seen before. The main culprits, why we’re here are the central banks, which now, following their original role, have also been our saviours. They, however, are about to enter some truly uncharted waters.
The information contained herein is current as at the date of this entry. The information presented here is considered reliable, but its accuracy is not guaranteed. Changes may occur in the circumstances after the date of this entry and the information contained in this post may not hold true in the future.
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FRA-OIS spread is the difference between the U.S. three-month forward rate agreement (FRA) and the overnight index swap rate (OIS). The three month forward agreement is an agreement between banks to settle a committed amount (essentially a loan) after three months time with a fixed interest rate. Essentially, it’s rate banks use to loan to each other for three months. The overnight index swap rate refers to an overnight rate obtained from a central bank overnight lending window. Effectively, it’s the rate banks can borrow from a central bank, risk-free.