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The Unlimited, Universal, Depositor Bailout
March 15, 2023
“I think we’ve spent five years, at least, talking about malinvestment as a consequence of low to zero rates. It causes distortions, it causes things that shouldn’t happen to happen, and it exaggerates risks in the future, which rational people think, “It’s not my issue, it’s not a concern today, and we’ll deal with that issue tomorrow.” The starting point of the unrealized—and now realized—losses were low interest rates, and those low interest rates were set by the global central bank community. They’ve been holding their thumb artificially on interest rates. The disaster this week has been hiding in plain sight for months, and developing for quarters and years.” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
What a busy week. I was eating breakfast this morning with my wife, and she said, “Kevin, doesn’t this remind you of It’s a Wonderful Life?” When people came in and they wanted their deposits out of the savings loan that Jimmy Stewart was running, and some of them accepted just what was going to be given to them to get through the next week, and then there was the one guy who said, “No, I want every penny that I have deposited.” Then we started talking about how Potter— Remember? Potter represents everything about the organization that wants to consolidate and devour? He comes up, and he said, “I’ll give him 50 cents on the dollar. I’ll pay him off right now,” because they wanted to take over. Doesn’t this week feel a little bit like that?
David: You know on Friday there was an offer because SVB had been closed, Silicon Valley Bank, and there was immediately blood in the water, and various firms from around the country were willing to— And this is prior to the deal that was put together over the weekend and announced Monday.
Kevin: The everything bailout?
David: Yeah. We got you covered. Uncle Sam’s got it covered. But there was offers of 60, 70, 80 cents on the dollar for deposits. Now the government’s going to make everybody whole. What this also reminds me of, Kevin, is that 16 years ago, March of 2008, we started this podcast, and so not only is this our 16th anniversary, but the environment was very similar. March, 2008, there was an atmosphere of concern and not necessarily total crisis at that point. It took a number of months for not only our exploration of ideas and the events that were unfolding, but those events themselves, they were building towards a crescendo.
Kevin: Yeah, I remember. March of 2008, it was like, “Gosh, is this leading to something bigger than we’ve ever seen before?”
David: And by October, November, December of that year, sure enough, we had the proof in the pudding. So I think there’s a lot to explore today. Let me start by saying the liquidity dynamics in the financial market have just shifted dramatically. Bank lending was a huge source of credit growth in 2022. That will no longer be the case in 2023. So ripple effects are always felt from a tightening of financial conditions, and we just got a big splash. Of course, as you look out, you’ll see ripples to follow.
Kevin: I wonder if this is going to be the slowdown that slows inflation. Banks are not going to be able to loan like they did last year, and like you said, liquidity, this could dry up an awful lot of liquidity.
David: High drama this week, I think was summed up really well by the Bloomberg Opinion columnist, John Authers. He has his superlative collection for March 13th. He says—these are the things that have happened that were just amazing this week— “The biggest one-day slump for the two-year Treasury yield, 61 basis points, since 1982.” The fall during the Black Monday crash of 1987 was 59 basis points. And by the way, Kevin, we’ve had a 100-basis point move in the two-year Treasury in three trading days.
Kevin: That’s got to be unprecedented.
David: Authers goes on to say, “The biggest one day drop in the two-year German bund yield, 41 basis points, since Bloomberg’s data started in 1990.” He goes on to say, “The biggest one-day decline in the two-year Japanese government bond yield, 20 basis points, at one point since the Bank of Japan introduced yield curve control in 2016, and the sharpest steepening in the US two-year to 10-year yield curve, 48.2 basis points, in the last 40 years, save only September 11th, 2001, when it steepened by 50.6 basis points.”
Kevin: Yeah. You discussed these points in a TV interview earlier this week.
David: Yeah. The rates market was pure chaos. Now we’re thinking banks, but think beyond banks because the real story is in the interest rate market. We think institution, and are we safe? But there’s far more to the story and that’s what’s been unfolding. John Authers mentions, “this is only the third decline of more than 25% in a week for the KBW Index of big US banks in 31 years. The only other instances were in the Covid lockdown and in the aftermath of the Lehman Brothers bankruptcy.” Again, this is his superlative collection for March 13th. “The KBW” —again, this is the bank index— “erased all its gains of the last 25 years, and it is now the same level it was on March 11th, 1998.”
Kevin: That’s a lot of years to lose. Okay. So just as a review for the listener who maybe hasn’t heard anything in the news: The last two weeks, we’ve lost two substantially— no, three substantially large banks.
David: You’ve got Silicon Valley Bank, Signature Bank in New York, and Silvergate in Southern California in La Jolla. They’ve all gone under. In the case of Signature and Silvergate, the depositor’s rapid departure was tied in no small part to the bank’s involvement in cryptocurrencies. Perhaps it’s not a surprise that digital natives form digital queues, and that digital bank runs are surprisingly swift.
Kevin: Well, and yeah, digital innovators I think also are part of the mix.
David: To some degree, I mean, if you’re talking about Silicon Valley Bank, they certainly did a lot of banking for venture capital companies. 88% of venture funded companies had accounts at SVB according to the bank’s own website. And so these are bigger corporate accounts. 95% of the deposits were in excess of the $250,000 FDIC deposit limit, which explains why you had something of a run last week. They knew they were uncovered. And again, it’s that concentrated multi-million-dollar corporate account, mass exit, that’s what was attempted. 212 billion in assets for the bank. So, not a small fry. So it doesn’t hit the bar for being systemically important, and so it’s not regulated in the same way. 212 billion in assets for Silicon Valley Bank, and a request to withdraw 42 billion last week. That hits the door. What happened last week?
Kevin: It’s not just last week. You brought this up to me last night and you brought this up on the interview, Dave. This has been happening for a while. You know, when you sit and you read the Financial Times and when you’re reading all this economic information that you’re conveying to us during the Commentary, there’s a reason for it because it’s not like this is a black swan event that you couldn’t see coming.
David: Now the old story of the king who has no clothes. The revelation is really one of perception. It’s not that something in reality shifted. It’s that perception shifted, or there was a social allowance that said, “Oh, that’s what it means for the king to be standing there buck naked in front of.”
Kevin: So if you read back in November what JP Morgan reported, you really wouldn’t have been surprised last Friday.
David: Well, that’s right because back in November it was already recognized that there was massive unrealized losses on its security portfolio. By year-end, you’re talking about a securities portfolio which had swollen to $120 billion. If you’re talking about the assets of the bank, 212, versus what is in securities, combination of mortgage-backed securities and Treasurys, that’s a big chunk. That’s a big chunk. Indeed, all three banks had outsized securities portfolios, which typically are made up of those two things, Treasury paper and mortgage-backed securities. And I think this is a critical point to linger on. Markets had the data for a long time, and just didn’t do anything with it.
Kevin: You’re such a skeptic, though, Dave, because really we talked to Bookstaber. He’s a regular interview here with us, and he was part of the mathematics behind the Dodd-Frank reform. That’s to protect us. And then of course, you’ve got the guys who are on the board of the Federal Reserve. These guys have got to be the smartest economists, the PhDs, out there. Isn’t it strange? Tell us a little bit about the irony.
David: Well, the conversation with Bookstaber is fascinating because he helped to craft Dodd-Frank, but he also acknowledged in our interview that what they set in motion was the next crisis. You solve one crisis, but the rules and strictures that you place in motion are the seedbed for the next crisis.
Kevin: So the people protecting us, however, are on the boards of these organizations that don’t exist anymore.
David: For me, this is irony and humor, and we’ve got Barney Frank, who sits on the board at Signature.
Kevin: That board’s not there anymore.
David: Dodd-Frank, the bill overhauling the banking industry post-global financial crisis. This is who he was, right? And yes, he proposed revisions to Dodd-Frank in 2008, endorsed them, which freed mid-size banks from stress tests.
Kevin: Which is what you were talking about. It kept it under the 250 billion. So they don’t have to be tested.
David: And in his case, he’s a part of a mid-size bank, $121 billion in assets in Signature Bank. So no stress tests. So literally we hear nothing, and then Sunday it’s closed. The second irony is that the Silicon Valley Bank CEO, now former CEO, Greg Becker, he’s sitting on the San Francisco Federal Reserve’s Board as a director, and is running a huge un-hedged securities portfolio. I mean, huge as in 120 billion, and un-hedged as in you’ve got full market exposure. You’ve got nothing covering volatility on the other side. Nothing.
Kevin: Do you think anybody’s going to talk about this though?
David: Risk mitigation by a director of the San Francisco Federal Reserve Board or lack thereof? I hope they do. But to me, again, this is the irony, surely a Federal Reserve director understands what happens to long bonds in a rising rate environment.
Kevin: No, but inflation was transitory, Dave.
David: And that’s the reality, is that there’s enough sophistication to be too smart for your own good. Inflation is transitory. We know it to be true. Rate increases are thus an illusion. Well, he’s now the former Fed director, as of Friday. Friday was the day the bank was seized, and yes, he was kicked off as a director at the San Francisco Federal Reserve and—this may have exacerbated things for him—was also the day that the bank paid executive bonuses.
Kevin: And they got theirs, didn’t they?
David: The day that the bank was seized. Just days after, by the way, that major insider sales were going on, including from Becker. It sounds to me like there’s a crowd out there in San Francisco. Becker may be hanging out with the Paul and Nancy Pelosi crowd. What do you do with the information you have? Well, you trade it, of course. So the last humorous point: Mad Money man Jim Cramer picks Silicon Valley Bank as a great stock to own, oh, just three days before it implodes.
Kevin: Three days before.
David: I’m just glad that nobody’s out there at home listening to what to do with your own portfolio, on a do-it-yourself basis.
Kevin: Jim Cramer. Wow. Wow. So it’s not all show. He knows really what he’s talking about, doesn’t he?
David: The DIY in that case is do implode yourself, not do it yourself. It’s do implode yourself.
Kevin: So Dave, let’s go ahead and talk about the ingredients of this because it sounds like it’s complicated, but actually the genesis of this has to do with liquidity. It has to do actually with some of the safest quote investments in the world.
David: Well, we’re back to this issue of rates. Rates of the issue. The story is one part pandemic stimulus, one part safe-ish portfolio holdings, and one part inflation, and then one part central bank-induced tightening. They’re raising rates to counter inflation. So I mean, it’s almost like bookends on the shelf. We begin with the Federal Reserve and Treasury, original stimulus, and we end with the Federal Reserve and the Treasury, oh, fixing the problem they caused.
Kevin: Gosh, that sounds familiar, doesn’t it?
David: Yeah. Cause and cure. I mean, I guess if you’re looking at the original cause of the stimulus, because we’re talking about the pandemic, maybe we could blame the Wuhan lab, but if you’re strictly speaking within the financial markets, cause and cure on the Fed and Treasury, but we’ve seen this tape before. It’s the Arsonist-Fireman Syndrome. Light the fire, put it out, you’re the hero.
Kevin: Oh, so you’ve got Covid and vaccine. Covid and vaccine.
David: Well, in this case it is the Fed and Treasury stimulus and now we’re going to solve the results of stimulus with what? Ironically, more stimulus.
Kevin: So let’s back up because this is not last week’s story, is it?
David: No, no, and it’s clearly not a story supporting market efficiency because it’s been staring us in the face for months. The problem was in plain sight, and was one that we’ve discussed on the Commentary and in client presentations going back many months. So let’s lay it out. Trillions in Covid stimulus creates record bank deposits. Every bank in the country saw a surge in deposits. So bear in mind this was a uniform pandemic with an undeviating solution, not just here in the US but globally. What we’re going to do is we’re going to print now to save the day and we’re going to pay later via higher debt levels and increased rates of inflation. Banks around the globe, they’re in the same boat. And so this is, again, just a piece of irony. Excess liquidity, ironically, is at the heart of today’s liquidity spectacle.
Kevin: I was in college in 1984, and we had not had a large bank failure really since the 1930s, since we were talking about the days of the depression, but I remember Continental Illinois. That was big news, and that had a liquidity source too, didn’t it?
David: Yeah. So today’s problems are not unlike what we saw in that earlier era. Continental Illinois, the failure in 1984, they had big deposits, they were large deposits, uninsured, which were nice as long as they were coming in the door, but happened to be disruptive on the way out. This is a classic hot money problem. If you’re talking about emerging markets or banks or— Hot money is this notion that if it’s helpful on the way in, it can actually be disruptive as it leaves because you adjust to the new normal of having lots of money around. So today’s hot money was not really categorized as such, if you’re looking at these three banks. Their hot money scores—and this is going back to the fourth quarter—were 0.2 and 1.2. Extraordinarily low.
Kevin: Which is extremely low. If you were doing a bank rating, you would say, “Gosh, there’s not a hot money problem with those banks.”
David: Just to clarify, hot money is money that’s not there for long. You don’t know when it’s going to leave, but it may not be there for the right reasons. So for instance, a bank manager or bank president is going to look at a particular set of depositors and say, “I know they’re here just for the interest rate, and if I pay a little bit more, I’m going to get them from the neighboring bank, and if I pay a little bit less, they’ll be gone in two seconds. They’re not here because we’ve got a longstanding banking relationship. They’re not here for the relationship. They’re here for the money.”
Kevin: So it’s not a loyalty thing. In other words, they don’t have the loyalty. But honestly, talking about being a banker, we’ve got a client, Dave, you and I both know, and he runs a bank in Minnesota. And he told me a couple of years ago, he said, “Kevin, we’re having to turn money away. We’ve got so much money coming in right now on deposits. We don’t know what to do with all this money.”
David: This is really interesting because the three banks in question this week, they all sported safety ratings of B on an A, B, C, D scale. So a little bit more on that later, but these were not banks that were under stress. And what we saw was that digital banking certainly exacerbated the requests for the return of capital. That is where investors, depositors, are wanting their money back, and the result was a disruptive outflow, what we know as a bankrupt.
So expansion of deposits were so extreme that, to your point, the banking community was awash in new cash and having a problem with places to put it. For Silicon Valley Bank, deposits tripled from the fourth quarter of 2019 to the end of 2021. Again, the reason why I start with the trillions in Covid stimulus creating record bank deposits as a problem is because that’s when we start to see things balloon or mushroom out of control.
Kevin: Well, and you have a mismatch, don’t you? I mean, you’ve got some money that needs to be there for a short period of time, whether it’s hot money or just depositor money, but for them to get a return, they’re having to invest in longer-term types of securities.
David: Yeah, well that’s true. And so we have the tripling in deposits from the fourth quarter of 2019 to the end of 2021, and that’s specifically for SVB. But then you’ve got a 37% average across the industry in terms of growth and deposits over the same timeframe, so that they’re well in excess of the average, and you know averages—some were much lower and some were much higher, 50 to 100%.
But to your point, Kevin, the business model of banks embraces this asset liability mismatch. They’re borrowing from a depositor. You put money on deposit with them, they consider that borrowed money and then they’re going to loan it out, invest it. So you borrow short, lend long. That’s the nature of the banking business. You capture the difference between those two as profit—it’s known as net interest margin—and then, to multiply the benefit of net interest margin, you leverage your portfolio. Some banks are leveraged eight times, 10 times, 12 times. And of course there’s risks to the business model, but the biggest, or the most catastrophic risk, I should say, is when depositors want their money back en masse and all of a sudden the investment committee who’s been making these longer-term allocations with the money now has to meet the immediate demands, and maybe they can’t get it. Or maybe it costs them to go get it. That scenario can turn into a liquidity crunch, which is why liquid securities are preferred by banks. And this is really critical because this here is a causal issue. First, we’re talking about low rates on liquid securities, and then second, you’ve got the issue of inflation.
Kevin: Okay. So let’s clarify this because sometimes a banking crisis is a credit crisis. In other words, people are not able to pay their loans back. This isn’t really a credit crisis, is it?
David: No. In the case of banks under pressure across the country and around the world, it’s not credit concerns or default rates that’s causing chaos. It’s boring investments in mortgage-backed securities, and again, you think about a mortgage, what are you talking about? You’re talking about something that doesn’t come due for another 15 to 30 years. It’s boring. And it’s boring investments in Treasurys. And usually banks will go out a little bit further on the yield curve so that they can capture a little bit more interest income, again, so the net interest, what they pay you versus what they make, is a little bit fatter. And they know they’re going to sit on that for a while. Well, guess what? Both of those categories of boring investments, mortgage-backed securities and Treasurys, have lost considerable value as interest rates have risen through the course of 2022.
Kevin: Isn’t this the consequence— We didn’t know exactly what the consequence would be, but the years that we were talking here on the Commentary about artificially low interest rates—purposely, artificially keeping rates too low. This is a consequence of it, isn’t it?
David: I think we’ve spent five years at least talking about malinvestment as a consequence of low to zero rates. It causes distortions, it causes things that shouldn’t happen to happen, and it exaggerates risks in the future, which rational people think, “Well, it’s not my issue, it’s not a concern today, and we’ll deal with that issue tomorrow.” The starting point of the unrealized—and now realized—losses were low interest rates, and those low interest rates were set by the global central bank community. They’ve been holding their thumb artificially on interest rates.
The disaster this week has been hiding in plain sight for months, and developing for quarters and years. You’ve got higher inflation rates, which lead to higher interest rates, and even these liquid securities, which are so critical to the banks, they get marked down in value. Yes, other risks exist. We’re talking credit duration. That’s typically what you think about when you’re thinking about risk to a bank, but that’s not the issue this time. It’s embedded in the securities portfolios.
Kevin: We would have no problem in this banking system crisis if everybody just laid low and didn’t take their money out because you wouldn’t have to realize those losses that are on the books because you could hold those bonds to maturity, right?
David: Well, and banks have a different accounting opportunity. The problem we were just describing is: throughout 2022 as rates are rising, the accounting for profit and loss at banks is not required in real time—and that’s for good reason. Your long-dated investments are generally held to maturity with the par, or the face, value being returned at the end of that timeframe. So who cares how steep the discount? If you take a loss on paper in the interim, you shouldn’t be punished. You shouldn’t have to close your doors as a bank because there’s short-term volatility. You’re a long-term holder. Ah, but then there is the depositor preference. If the bank must sell because the depositor is asking for their money back, then losses go from the unrealized paper variety to realized losses.
Kevin: It’s the peak behind the kimono.
David: So this is where Silicon Valley Bank has had 16 billion in unrealized losses for some time because of the increase in interest rates and the impact that that’s had on their $120 billion securities portfolio. 16 billion in unrealized losses. Deposit outflows converted the unrealized into realized losses, and the bank’s unhedged bond portfolio—which was bought at peak prices, by the way; we go back to the 2019, 2020, 2021 period—it forces the events of last week because you’re talking about a wipe-out of bank equity capital. It was destroyed.
Kevin: So let’s look at this picture, going back to Jimmy Stewart. They were going on their honeymoon. He had money. He had saved up to go on his honeymoon. Then the credit and loan starts to fail. There were people who would just take a little bit, they weren’t taking all of their deposit out, but remember that one guy we talked about earlier. He said, “Give me my money.” “I want every penny, 100%.”
David: It was like 200 and something dollars. “Give me my money.” This is it. If for any reason the depositor requests a withdrawal and the bank has insufficient liquidity to meet the request, then you go to either liquidating loans or assets must be sold regardless of the going price. In this case, we have a global banking system that has feasted on boring paper pumped into the system by the world’s treasury departments far and wide.
Again, you think, “Oh, well, this is Silicon Valley Bank.” Think about what the real cause is here, and reflect on the global banking community doing the same thing. When the ECB is driving rates to zero, and people are speculating on the value of their bond portfolios going up as rates go deeply negative, that’s a different kind of fixed income investment. And that’s what was being popularized through that timeframe. So what do you get when you buy a zero-yielding bond? Maybe this is a good case in point. So central banks far and wide throughout a period of exceptionally low rates, we’re talking about trillions of dollars. No exaggeration. Do you remember, we talked about there being over $17 trillion in bonds which were trading at negative yields?
Kevin: Right. Right.
David: People are buying bonds at zero, at negative, yields, and hoping that yields go even lower so the value of the bonds goes higher. This is what happens in reverse. If yields begin to go higher, the value of the bond ends up going lower. So your long-dated paper has now lost considerable market value when marked to market. And this is the game over for a number of banks.
Kevin: So think of liquidity like ocean waves coming in, okay? Remember Banda Aceh? That tsunami? Before that tsunami hit, that water receded—I think they said as much as a half a mile. People were out picking up seashells, whatever.
David: So last year was like a reverse tsunami. A normal tsunami, you’re right, you’ve got the water recedes prior to the crashing of the wave on the shore. In this case, you’ve got 2020 to 2022, it was like a liquidity wave hit the global banking sector.
Kevin: And then it receded.
David: And then receded as 2022 progressed, as rates were increasing. And this is where competition and market dynamics— you’ve got to appreciate, this is how people act. When you think about the value of capitalism, it’s when you give people the freedom of movement, the freedom to do something, they will act in their own self-interest, and that’s what they were doing. You look at a one or two or three percent yield on your bank deposit versus a three or four or five percent yield in short-term Treasury paper, and you say to yourself, “Maybe I didn’t pass high school or college math, but I know I’m going to make more money if I just go across the street.”
Kevin: And that’s where the “give me my money” comes from. “Give me my money.” This is why depositor money started coming out of the banking system last year.
David: Last year was the first year since 1948 that bank deposits fell. Net withdrawals of $278 billion from US banks. Here’s the problem. Assets bought—again, compliments of the Fed and Treasury liquidity infusions in the context of the pandemic—and they were bought at an inopportune time. Trillions in securities at low to zero yields, and those same assets are being repriced today at considerably less value. As depositors are asking for their money back, what could be held on the balance sheet as an unrealized loss is being realized as a loss, and the difference between the purchase price and the liquidation value ends up destroying the equity capital of the bank.
Kevin: So let’s pretend like you’re the FDIC two weeks ago, not one week ago, two weeks ago. Would you, looking back, have published that there were all these unrealized losses? I mean, do you think they regret it?
David: Yeah. I mean, if you’re looking for a trigger point, how do we keep these numbers? I mentioned JP Morgan and the discussion about the losses at SVB going back to the fourth quarter. This is not new information, but the repackaging of the information in a way that analysts could look at it and go, “Wow, this is a big deal.” We get the selloff in bank shares last week, and it comes days after the FDIC publishes the number. US lenders realized losses of $31 billion last year, 2022, on those securities portfolios, but were, at the time of publishing, sitting on unrealized paper losses of 620 billion.
Kevin: So the Federal Deposit Insurance Corporation came out and said, “Gosh, we lost 31 billion last year,” but there’s actually 620 billion still waiting to be lost?
David: Could be, under the wrong circumstances. If there’s a reason for people to move to the exits and for you to have to realize the losses, 31 is just getting the party started. First olive out of the jar. Roughly a third, 620 billion is, call it 30% of the industry’s overall equity capital of 2 to $2.2 trillion. Obviously, losses are not evenly distributed across institutions. Some are just fine. Some are completely insolvent. Most banks, in fact, hedge their interest rate risk in the derivatives market, and are thus not facing an existential threat. Why some guy working at SVB and also at the Federal Reserve Bank of San Francisco decides it’s a good idea to not hedge tens of billions of dollars in fixed income? This is beyond me. This is beyond me. And that’s just a matter for speculation. Risk oversight, sun was in his eyes, I don’t know.
But the hedges create an offset to the loss, protecting the bank’s capital. This is one of the reasons why you’re not talking about every bank being in the same position. You may be sitting on a ton of securities, mortgage-backed securities and Treasurys, that you may not be facing the same losses because, well, maybe you’re one of the smart ones that was hedging your risk. You can hedge your duration risk. You can create derivative products to hedge your credit risk. In this case, you’re talking about specific derivatives for this specific kind of risk.
Kevin: But there’s a cost to hedging. About three years ago, I was coming into the office, and I got hit from behind by an uninsured driver. And the uninsured driver, I mean, her excuse was, “I just didn’t have enough money to pay for insurance.” And so you do maximize gains as long as something doesn’t happen, if you don’t buy those hedges.
David: Right. Well, I mentioned the banks that may not have an issue because they were hedged. You may still, if you have an exit from your portfolio—again, withdrawals from your bank—you have to then sell the asset and unwind the hedge, and the hedges create an offset. So it’s not a loss issue, but it can add to volatility as both bets are unwound to meet depositor withdrawal demands. And so that issue of having a lot going on in the fixed income derivatives market and in the fixed income market, even the volumes can create an uneasiness.
Kevin: So for the depositor, though, who wants safe money, there’s absolutely nothing wrong with going to greener pastures. You like short-term Treasurys?
David: Well, sure. I think that’s the issue. When we look at the $278 billion of net withdrawals from the banks last year, that’s what’s happened. This is not rocket science. Money has moved to greener pastures. Short term Treasurys are one destination. We certainly like them. We’ve advocated them over the course of the last two years. What is the threshold for investors where interest rates—currently at a 15-year high off of obviously very low levels, but we’re now at a 15-year high when you’re looking at one and two-year Treasury paper—when they make the returns on bank deposits look like some sort of a holdover from the pandemic zero-rate era? That’s where you got the 278 billion net withdrawals from banks.
Of course, the gross numbers are larger, but a net withdrawal of 278 billion is because people are like, “Color me stupid, but I can’t stay, not for that differential. By the way, inflation’s on the rise and I could use every penny just to pay my bills.” See, inflation is one of those things where, if small local banks had assumed that the relationship mattered and the money wouldn’t migrate— Inflation creates an existential crisis for people where, if you’re running out of money before you’re running out of month, you look and you say, “Where can I pick up a few shekels here and there? Where can I earn a little bit of extra money? How can I stay when on offer just across the street is an extra 1%, 1½%?
Kevin: That’s called the free market. But we were going back memory lane to the beginning of this Commentary back in 2008, March of 2008. We didn’t have an inflation problem in 2008, and then when the banking problem happened, depositors were insured up to a $100,000, remember? I mean, that was a standard for a long time. And then they raised it to 250,000. Now, what is this new coordinated effort? Sounds like everything’s just insured no matter what.
David: Well, I mean, the reality is we were introduced 16 years ago, not to the month, but roughly 16 years ago to quantitative easing part one.
David: And here we are with the soft version of QE even as we talk about QT, or quantitative tightening, as this Fed’s trying to shrink their balance sheet and raise rates and all the rest. But this is the coordinated solution. The bailout bank term funding program swaps those securities which the bank is holding onto. It swaps them at par—at their full-face value—for a short-term loan. They can be used as collateral for a short-term loan—near zero interest rates, by the way. And that loan alleviates all the liquidity and solvency problems, then, between the Fed and the Treasury, makes depositors whole on every insured and—this is a unique aspect in this particular go-round of bailouts and guarantees—every uninsured dollar. That is, every dollar above the 250,000 mark. This is a stroke of genius in terms of solving the problem.
Kevin: The Candy Man. Remember the song The Candy Man? The Candy Man can.
David: Right. If there are further financial market conniptions, it’s not because of what’s going on with banks, bank balance sheets, and securities holdings. If there’s further financial market conniptions, it’s because there’s other frailties that exist within the system and are being exposed. So we go back to John Authers’ list of sensational things that happened this week. And it has to do with the German bund, and it has to do with the Japanese government bond market, and it has to do with the steepening of the yield curve, and a major decline—three-day decline—of 100 basis points in the two-year Treasury. All of these things happening simultaneously. There is the reality, which is frailties throughout a very, very leveraged financial system. This banking problem may actually go away tomorrow.
Kevin: But see, you said last night when we were talking that this is the biggest bluff in the world, and I was sitting there talking this morning to my wife when we were eating breakfast, and I said, if perception changes from security to insecurity— Granted we’ve gone from 100,000 guaranteed to 250,000, now unlimited, uninsured, insured, whatever. This is the biggest bluff in the world. What if people change? What can people do?
David: The Fed and the Treasury nailed this in terms of their risk assessment. They looked at this and they said, “This is a big deal. This is a big enough deal for us to have an extinction event for our banking system. So carte blanche, we cover it all.” Doesn’t matter the number of banks— I mean, so you’re right, it’s the biggest bluff in history, in part because you have to maintain confidence at this juncture. Now the price of that confidence be damned. We don’t care about that today. If you look at the repeating cycle of crisis after crisis after crisis from 2008 to the present, even take it back to 2000, 2001 and the tech blowup, it’s this repeated theme of we’ll do what it takes and worry about paying the price later. Last week, we’ve got the new budget numbers. We’ve got the idea that taxes are going to have to be increased to pay for it. We don’t mind adding not just a trillion here or a trillion there, but another 18 trillion to our debt load, as if these things don’t matter. And I think this is again where confidence is what has to be maintained. First and foremost, the opportunity to see crisis of confidence within the banking system, they brilliantly coordinated a solution, the bank term funding program. Nobody should be worried.
Kevin: So when this happened Friday—
David: The cost, the cost is in the currency.
Kevin: Yeah, we’ll lose it.
David: The cost is—
David: And this is the grand irony, is this week we have inflation numbers. Next week we’ve got the Fed deciding what to do with interest rates to fight inflation, which is not going away, and we’re solving problems within the financial system by throwing more money at a problem, papering over a problem like we did with QE one, two, three, and four, and it’s not going to be inflationary? This is not going to cause malinvestment? I mean, I grant you it’s genius to solve one problem, but at what eventual cost?
Kevin: Well, on Friday when this happened, our answer on banks for many years, for 36 years that I’ve done this, has been to go to the rating services. And so I immediately checked Silicon Valley Bank and I thought, “Well, what’s the rating on the bank?” It was a B rated bank.
David: Yeah. And this is where the details matter. And here is what you can do about it. Three banks bit the dust, each one of them rated above average as an institution, a B rating. All three of them, no hot money concerns. What are you going to do about it? I would start with getting a rating on your bank. You can call us at (800) 525-9556, or you can go online to mcalvany.com.
Kevin: But the letter rating isn’t all you need.
David: Yeah. Just request a bank rating for free, and you’re right, the letter A, or B, or C, or D is not what you are looking for. That may give you a false sense of security. What that is looking at is a variety of factors that relate to credit risk, duration risk, portfolio composition. No one was really thinking that the biggest risk of all sitting within the banking system would be US Treasury bonds and mortgage-backed securities, and yet that’s where the risk is. The implosion here is not because Silicon Valley Bank is dealing with tech entrepreneurs. It’s not because Signature Bank is dealing with cryptocurrency deposits.
Kevin: People can just get higher interest elsewhere.
David: And that causes a mark to market on their securities portfolio, which reveals the weakness which is endemic across the banking industry nationally and globally. So that’s the big reveal. The second big reveal is that governments—ours and others later this year, I’m sure—will solve the problem in a similar way. We’ll just throw money at it. This is one of the reasons why I’m pretty comfortable owning gold in here. Why? Because I know what they’re doing to save our financial system, and I appreciate their best efforts, but their best efforts are going to cost me in college tuition three years, four years, five years from now, double what it is today.
Kevin: Yeah. But we know about inflation, we still use banks. Okay. So you get a letter rating on your bank. You still have to have a deeper discussion.
David: Call us, or whatever. It’s the detailed discussion our team can walk you through. And looking at the details— I mean, have you ever wondered about the rating of your bank? All you have to do is call and talk to our advisors and just get an idea of how safe it is. Looking at the bank, looking at your cash holdings, looking at your investments to ensure that you as an investor are properly diversified. The number again is (800) 525-9556. You can click on the show notes or just go to mcalvany.com and you’ll find ways to get your bank rating. But to be able to assess the stability of your current bank, or even to help you find a new one, that’s the conversation you want to have. The details matter. You can look at everything. Like short-term growth in assets. Silvergate had assets that grew over 100% last year.
Kevin: That’s amazing.
David: Silicon Valley Bank had assets that grew over 55% in the year 2022. Far larger in 2020 and 2021. Signature, north of 42% in 2022.
Kevin: So that is a common theme was massive growth in deposits.
David: Massive growth in deposits, which, again, you can’t put all that money to work in— Your loan committee can’t handle that kind of volume in terms of putting it out into loans with small businesses in your local community. Takes a lot of work to know the people. It’s a lot easier just to buy a mortgage-backed security and leverage it up.
So that gets to portfolio composition. One, you want to look at short-term growth in assets. Two, you want to look at portfolio composition. That’s commercial, that’s consumer, that’s mortgage loans versus the now problematic securities portfolio. You want to look at non-performing loans. Again, that’s not the issue today because in the case of all three of these banks, they were almost non-existent. It’s not a credit issue here. It’s a portfolio composition issue. You can also look at hot money ratios. Again, not an issue with these three banks, but it certainly can be.
The common themes amongst the failures concentrated on large account size. Notice that the bailout measures had to be changed. Cover all deposits, not just the stated $250,000 max per depositor, the way the FDIC has advertised it previously. This time is different because the majority of deposits were well in excess of the FDIC limit. The other common theme: sizable security portfolios. Sizable security portfolios. Like I said earlier, the BTFP program, the Bank Term Funding Program, ensures that contagion is not likely from this point forward. Contagion I don’t think is going to spread, but this is an excellent reminder of how fast things can go sour in the financial sector and how important it is to stay on top of your cash holdings, what bank you use, and why you need to own gold. Gold protects investors from this exact situation.
Kevin: Yeah. I was talking to someone this weekend, and they were like, “Oh gosh, what do you think is going to happen to the stock market on Monday?” And I said, “Well, I think it’ll probably go up because they’re waiting for the Powell Pivot.” Is this in a form? The Powell pivot, is this going to take care of business on inflation, to a degree?
David: Yeah. On the one hand, it’s tightening that he’s tried to bring to the financial markets and has not been able to. So now we’ve got some tightening of financial conditions. Look, this week we’ve got the inflation number. CPI came in at 6% for February. Core, still slightly higher month over month than estimates, 0.5 versus 0.4. So it’s moderating year on year, but it’s stubborn month on month when you’re looking at core. Powell’s job is made very difficult by the bank and financial market concerns. We have triple witching this week, Friday, so we’ve got options expiration. In the middle of all this chaos, you’ve got people trying to figure out how to position for month and quarter end. This is fabulous stuff. Fabulous stuff. Odds are, the market stabilize. Odds are, the market stabilize. Odds are, the new cycle forgets anything happened with acronyms like SVB. They’ll disappear from public awareness as fast as SBF did. Remember what that is? If you can’t, don’t worry about it. That’s my point.
Kevin: No, you caught me there.
David: Sam Bankman-Fried. But tightening of bank credit, if you want to look onto the horizon, this is where I think you should pay attention. Contagion, is that our concern? No. Frankly, it’s not. Could it happen? Sure. But I think they did a good job of throwing the nice big wet blanket over the issue. Tightening of bank credit will play significantly into the economic activity in the third quarter and fourth quarter of this year, which will drive recession fears, and it may even give birth to recession realities.
Kevin: So is inflation dead?
David: Inflation’s not dead. Powell may have to kill more banks to take proper aim at inflation. If he’s going to hit that mark in the months ahead, it’s going to come at the cost of what we’ve just seen happen. You continue to raise rates and you’re driving up the theoretical losses on bank balance sheets. So do you want a bank rating? Yes. Do you want to know what the percentage is in securities? Absolutely. And I hope your bank is hedged, but there is no way. With the bank rating, there is no way of knowing what percentage is hedged. You would’ve thought that someone as smart as a director at the San Francisco Federal Reserve Board would be hedging a $120 billion portfolio. It just makes sense, and yet it wasn’t. What you can know is the potential risk, and you can make informed decisions from that point forward. Powell, to kill inflation, will have to kill a few more banks. If he hits the mark, if he kills inflation, that’s the cost, because higher rates mean lower bond values, means a real cost to the portfolios that got stuffed full of them in the context of ’19, ’20, ’21 into ’22.
Kevin: So if a person says, “All right, well, where do I hedge my risk? I mean, where do we go at this point?”
David: Well, I think to understand where we’re pursuing opportunities as a company, as individuals, on the asset management side, how we’re mitigating risk in the months ahead and looking for opportunities, I invite you to read last week’s Hard Asset Insights by my colleague Morgan Lewis. If you go to mcalvany.com, hit the menu up in the right-hand corner—those staggered bars, three bars—the dropdown menu will give you the option to go to Market News, and there you’ll see Hard Asset Insights. Click on it, read it. It’s a measured and balanced view of why gold should be considered and how you should be considering it, whether it’s in the equities exposures, which Morgan alludes to—precious metals equity mining companies, or in the form of a Vaulted account with the Royal Canadian Mint, or as an allocation inside of an IRA. I think the article articulates both the pros and the cons, what’s going on in the markets right now where you could argue for a gold position as well as against a gold position. Yes, get your bank rating. Yes, do your homework and read Hard Asset Insights this week.
Kevin: And yes, remember Jimmy Stewart and what we’ve been talking about. I’ve been thinking about this solution, Dave. You keep trying to push home that the solution is really inflation. The solution is the devaluation of the dollar. Potter, think of Potter, picture that in your head. Potter was talking about paying people 50 cents on the dollar. That’s what’s happening. But everyone is getting 50 cents on the dollar, and then 20 cents on the dollar, and then 10. The inflation is Potter.
David: Well, you’re right. It’s just spread out over enough time. You don’t see it as a steep discount on the front end. They just spread it out, and it makes you feel better.
Look, last week, we get a picture of our current debt situation and what it’s going to look like over the next 10 years. We look at a new budget and we look at a fresh version of largesse, whether it’s government spending on defense or on any other social program that you may think is completely legitimate or completely illegitimate. We have too much debt. The interest payments on that debt, we’ve covered in weeks past, are unaffordable. As a percentage of our current revenue, they’re unaffordable. As they continue to ratchet higher, it makes everything we’re talking about that much less sustainable.
So why do we consider gold as an alternative in this space? Why do we consider it here and now? Because I think the best and brightest minds are going to continue to come up with the same solution: paper over the problems, make this moment of urgency go away. They’ve done it so well in the past. But ultimately it causes a change or recalibration in the price of gold. When we started this Commentary 16 years ago, we were talking about $600 gold, $700 gold. It had risen off of a $300 price. We’re now talking about $1900 gold. Is it uncomfortable now to be considering higher numbers? No, because we know the trajectory of the US dollar. And to the degree we can figure the trajectory of the US dollar, you can see the inverse move in gold. There’s every reason to lose faith in the US dollar, and I think that’s every reason to gain a little in an ounce of gold.
Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com. That’s M-C-A-L-V-A-N-Y.com or you can call us at (800) 525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.