in Banking System , 568 references
Oh, so-called independent ratings agencies eh?
Just like the so-called "independent and wise" regulator called the OCC?
Or the so-called "independent, unbiased" auditor KPMG that passed on SVB's books just shortly before they blew up?
I'll be fair on the latter -- their job is to verify that what was presented is true; that is, there's no indication of fraud. That doesn't mean what they looked at doesn't smell like crap, provided the crap is disclosed accurately in the financials presented. So far nobody has said it wasn't.
But as I've pointed out since the inflation specter reared its head and was clearly not going to be "transitory" the very thing that made banks 10x more valuable in their stock price -- that is, a portfolio written at 4% interest where the prevailing rate is now 3% and there is time remaining on the bonds so you are (difference in rate * remaining duration) to the good.
But when rates rise and you hold the lower interest bonds the exact opposite happens.
This doesn't mean the bonds are not "money good" at maturity, but it does mean this, for say, a bond of $10,000, where there is 10 years left:
- The 2% one will pay $200 in interest per year for the ten years remaining or a total of $2,000 in interest plus the $10,000 principal, or $12,000.
- The 4% one will pay $400 in interest per year for the ten years remaining or a total of $4,000 in interest plus the $10,000 principal, or $14,000.
If you hold the 2% one and want to sell it to me you're going to have to discount the price so that on a percentage basis I make the exact same amount as the 4% bond or I'll buy that one instead of yours.
For those who say "well, but the Fed has eliminated the forced sale with the latest action" that's true, and fair too -- but what it hasn't done, because it can't do so, is eliminate the fact that over the next ten years your bond returns $2,000 less in cash flow.
Remember the basic principle of why you always make money buying things instead of selling them: If we both have overhead of rental for our office, but mine is $8,000 a month and yours is $30,000 a month then I have a $22,000 jump on you each and every month which means I can pay for a higher-quality staff or simply more of them, I can sell cheaper than you, I can buy better-quality inputs and out-compete you on quality, pocket some of that in additional profit, or some combination of all of those.
This is why you want recessions, bankruptcies and other similar dislocation events where those who do stupid things go out of business.
Yes, if you're the dumb one that's sad. Same for your employees; they lose their jobs.
But the economy as a whole benefits and in particular the consumer benefits wildly because they get better products and services, lower prices or both and in addition the owners of the companies that don't do stupid things make more money with which they then go into the economy and spend on that nice evening out including a $100 steak and a few $20 cocktails.
If you bail out the fools then that innovation doesn't happen. The consumer instead is forced to eat the overpriced products and poor service because the poorly run companies do not go out of business and the well-run ones don't get to feast on their remains at a huge discount.
MCSNet feasted on such remains at several points in time with one of the most-significant being an $8/ft lease for Class "A" office space in 2 Prudential Plaza -- an opportunity that arose because Donnelly Directory did a dumb thing and walked away from that space -- and the building needed it leased to someone who could pay for it now. We needed space at that particular time as we were out of places to put people at 1300 W Belmont and needed to hire several more warm bodies and we had cash because we were not levered up to our necks and thus didn't need anyone's approval process (e.g. for a loan at the bank) to be able to look at it, know it would meet our needs and sign the papers handing over a check for the first few months rent so the building folks knew we were both serious and could pay.
I wasn't responsible in any way for Donnelly doing the stupid things they did. I don't even know the specifics of those stupid things; I only knew who the former tenant was but not why they were suddenly gone and the building had not just space but space they needed leased right now -- and were willing to offer at a very attractive price to make that happen. All I know is that they had it available, we needed it, what we needed and what they had was a good fit and thus our name went on the door and there we were.
Banks are not entitled to rising stock prices; in fact banking is supposed to be a pretty boring and mildly-profitable business. Banking is an essential thing as people need a place to keep money and an exchange mechanism to get it from one place to another with decent reliability and security. When it stops being a boring, mildly profitable thing watch out because the odds go up a lot that someone -- or a lot of someones -- are doing something stupid.
It was screamingly obvious that anyone sitting on long-duration paper when rates started to go up had two choices: Sell it right now and accept a small loss or sit on it until it matured and accept the fact that you're going to get a lot lower return on investment until it does mature, which might take quite a while. If you choose to do the second you had damn well better make sure you won't have to sell it early later on because you have no control over market rates but what you can certain of is that "zero" is not and cannot be permanent. Hedging such a possibility costs money which is an even bigger kick in the nuts to go on top of your lower returns (as you have to pay for the hedge out of that return) when you just decided to take a 2% return on the paper for the next 10 years and the guy down the road is getting 4% on the newer issues! Now your net return (ex the hedge expense) might be 1% -- or even negative.
We have regulators who, in the face of these facts, are supposed to make sure that all the banks, not just some of them, are ok under that scenario. If someone's paying 4% interest as a bank and has a portfolio full of long-duration paper they took on in 2020-2021 its a certainty they are paying out a higher coupon than the risk-free rate (that is, either Treasuries issued during that time of reasonably short duration) or one which has proper hedging costs included and the hedges are on when one adjusts those costs for risk, interest and duration exposure.
Sheila Bair is now opining that The Fed "should hit pause" to assess the impact of the policy changes. Sorry Sheila, nope. The Fed knew what that impact would be because its a mathematical certainty; what happens to long-duration bonds when rates go up is known just as is what happens when they go down. Banks profited mightily, and it is reflected in their stock prices that have in many cases risen by 10x and they've engaged in billions in buybacks on top of that over the last 15 years. That's "profit" that they effectively siphoned off from the common person who got nothing for their deposits during the same time banks were selling assets they paid 100 for at 120 -- and pocketing the difference. Now that its the other way around they're crying poverty and demanding protection -- that is, to steal again -- when it was their decision alone to engage in the buybacks and other spending, never mind not issuing stock into that price ramp and sitting on the money said secondaries would generate to offset the inevitable when rates went back up.
I started this blog in 2007 -- originally on Blogger (which is why you can't see any of the replies; they didn't transfer) -- because during the 2007 1Q earnings calls, which I started paying attention to in a big way after a financial dislocation in Asia a few weeks earlier, WaMu was paying dividends without having the cash income to pay them. They were doing this by booking negative-amortization "gains" -- perfectly legal but it was wildly unsound to spend the gains as they're not cash and they will only turn into cash if the person who has the mortgage can pay yet the dividend is gone from the bank's operating checking account right now whether the mortgagee can pay down the road or not.
OCC/OTS (at the time there were two) along with The Fed -- both the DC and all the regionals -- sat on their hands and let this go on. It wasn't a secret either as the details were disclosed in the quarterly filings which anyone could see.
18 months later, roughly, it all went to Hell.
It was 100% predictable that it would go to Hell, and thus I said it would, because it was obvious -- either the people doing that crap were going to stop doing it or it was going to blow up in their face. Rather than stomp on it as soon as that was detected, which is the regulators job, they sat in their offices and did God-knows-what -- everything except forcing the banks to cut that crap out.
15 years later here we are again and once again the regulators sat on their hands and doing nothing about that which is obvious and, if not stopped, is going to lead directly to ruin.
Let me be clear: So long as you shut the bank down before the bondholder capital is exhausted deposits are not at risk. The stockholders and bondholders will get hosed but that's the price of owning said instruments issued by a company that is doing stupid things and those who buy such an instrument without paying attention to what management is doing deserve it. While we need banks because the functions they provide are indeed crucial to our economy as I pointed out last time around the name on the door is immaterial to the function, and if the existing banks fail the real estate and other assets they own, when acquired at 10 cents on the dollar, mean the new bank is more efficient than the old one and that is a good thing from the perspective of the common person using the service.
So what should you expect as a consumer or business?
- If you have "open lines" available expect them to get slammed down to the outstanding balance at any time. Revolvers in the corporate world and HELOCs and credit cards in the personal arena are particularly subject to this.
- If you need new lines in the coming months and years you are likely to find its very expensive -- if available at all. Credit cards already are but part of bank analysis on this when offering one to you is the availability of other backstops you may have in the credit markets. Expect the banks to consider all of those (including alleged "home equity") as zero. On the corporate side if you're privately-held and need access to capital you may find the terms unacceptable -- if its available at all from a bank.
- Depletion of deposits is not going to stop, and forces the first two to ratchet tighter. Why would you sit in a bank at 2% interest (which is all they can pay since they have long-dated paper they can't sell without a crippling loss, and its paying 3%) when you can get 4% or so in direct, short-term government securities? We're talking bills here with a 4 week duration or similar; unless you have reason to believe you might need it right now why would leave that in a bank? Now look at this from the bank's point of view: They can't entice you with higher returns as they don't have the ability to pay them.
No, there isn't an "answer" to this either folks and as long as government deficit spending continues it will get worse, not better. Simply put that has to stop and the distortions that were into the system have to come back out or the ratchet job will continue until more and more things break.