Funny Money Territory
SVB went belly up last week and banking regulators were quick to squirt it down with a firehose. Why not, we are in funny money territory now. The markets breathed a sigh of relief.
First of all, you can barely call SVB a bank. Traditionally a bank lends out its deposits but gets a pretty conservative chunk of collateral in return. Well run banks take smaller profits for less risk.
SVB is more like a private equity fund, taking investor (depositor) money and taking big risk with it. Where’s the collateral? SVB lent to start up companies so you might as well look under a rock for that. No matter. The regulators don’t even want a hint of failure to eek into the markets. You’ll see why in a minute.
The FED Put is Still Alive
Let’s talk about the bigger problem, one that didn’t get much attention but deserved it. The regulators/Fed announced a facility to allow “banks” to cover unrealized losses in treasury bonds they own. Large banks borrow bonds in the REPO market to post as collateral when they borrow money from the FED. Bank debt is so large that it is difficult to borrow treasuries to facilitate this. There is so much demand, or was, that even $30 trillion plus of treasury supply isn’t enough. JPM runs the REPO market like a casino.
Let’s say a bunch of smaller banks want to sell some loans to a big bank. The big bank to “buy” those loans has to borrow “money” from the FED. The big bank calls JPM to borrow $100mm of treasuries for a year to post as collateral to the FED. JPM says sorry, we don’t have any bonds out for that term but we do out six months and a day and the borrow gets done that way. In reality JPM doesn’t really have those bonds available but they do know that the bank that is currently borrowing those bonds will turn them back in six months. So the big bank is borrowing the same bonds that the other bank is borrowing. The big bank will deal with borrowing more bonds in six months and a day. What happens then when there is nothing to borrow? It has happened several times over the last few years, and it creates havoc in the REPO market. One day we saw such massive short covering in bonds on the close that the REPO rate went negative by 4%. Ho hum.
So, banks carry large amounts of bonds on their balance sheet. The 2008 banking crisis saw a rise in interest rates that caused massive losses in banks’ bond portfolio. Banks were so levered (and still are) that these losses wiped out their capital. No matter how much money the government threw at the crash (remember TARP?) the market kept going down: if the banks are bankrupt nothing else mattered.
Then in March 2009 the government got FASB to do their dirty work. Much to the shock of most who always respected FASB as a disciplined institution setting accounting rules and guidelines that assured investors of transparency, out of the blue they abrogated the mark to market rules. Banks were able to just mark their bonds up to par. Losses magically went away, and the stock market took off (just look at a chart). It never looked back until now.
Moral Hazard Contagion
When SVB went down professional traders/investors began looking more closely at financial firms’ balance sheet and made discoveries that were harrowing. Many/most large banks were carrying massive unrealized losses in their bond portfolios. Why should banks incur the cost of hedging interest rate risk when regulators didn’t require them to recognize losses?
Everything above the covers always looked good but now investors were looking under the covers, something they should have done back in 2008. The FED said heck, investors are starting to understand (or admit) that for a levered institution perhaps unrealized and realized doesn’t matter, they are still losses.
Out came the firehose and the FED basically said don’t worry we will cover any unrealized losses you have. Problem solved. Another finger in the dike.
Instead of solving the problem by actually reducing leverage in the banking system they just find more ways to hide it. This creates moral hazard and makes the problem worse the next time.
We are moving closer and closer to a socialized financial system, one like China where there are no profits and thus no incentives. One where “capital” is allocated not by merit but by fiat.
