As we pointed out last year in August, there was a growing likelihood of bank stress (https://legendsoftware.com/…/Protecting-Company-Assets…) and this has finally started to show its face with SVB and Signature bank. This whole drama of inflation & deflation chaos has taken a lot longer to play out than I initially thought. Rest assured, the crisis has NOT been averted. Often government / central planner interference in markets delays the inevitable, but makes the final outcome much worse. This is the case with recent events. Last year, the Fed delayed banking stress through use of dollar swap lines with international entities (short term loans of dollars for FX from other central banks), and massive use of repo and reverse repo facilities – which allow US banks to do last minute cleanup of their balance sheets by taking short term collateral or cash loans directly from the central bank. This year, we’ve seen some bank failures and the prompt introduction of a new facility to inoculate banks against “bad” collateral. But SVB, while a poorly run bank, will not be the last to fail.

First, let’s take a brief look at the basics of banking. When you deposit a check into a bank – the deposit, or liability owed to an account holder, is transferred from the check writer’s bank to the check receiver’s bank. Simultaneously, these banks will transfer an asset to match the liability – usually within the US this asset would be bank reserves. So this way the liability owed the customer has a matching asset owned by the bank. The balance sheets are balanced. Bank reserves are essentially bank money. If bank reserves are not available, a bank might transfer a bond or treasury (government debt), mortgage backed security, or other asset. These other assets are subject to price fluctuations when they are resold however. So if a bank has to transfer a deposit, they may be forced to liquidate an asset that has depreciated in value.

Instead of just charging fees for transaction processing, banks make their cut as middlemen by putting your money to use while it is sitting idly. The government incentivizes them to put this money to use buying government debt, which pays a yield over time. One of the problems though is the massive regime changes the central planners force on the economy. For over a decade rates have been low and additionally the Fed has bought up excess mortgage backed securities (MBS). This means that MBS are extremely overvalued. They are a last resort asset. Government debt, much like the stock market, has only seen stable, high value with low yield for a decade. With bonds the yield or interest rate, and face value of the bond have an inverse relationship. Now that rates are more than double what they were a year ago, that government debt sitting idly from a year ago is worth much, much less if sold on the open market before coming to maturation. If a depositor withdraws cash and a bank has no spare reserves, they must sell that govt debt on the open market – for less than the value of the deposit they owe their customer – so they must sell additional assets. This turns into a death spiral.

Enter the government to save the day. Bail out SVB *depositors wholly, above the $250k FDIC limit so that nobody loses anything* to defuse the situation and create a new facility where dumb banks that did not hedge their asset risk can trade in crap bonds *at the value they bought them for* to the Federal Reserve in return for reserves. Problem solved right? No. As always, govt interference can delay pain but usually makes it worse in the long run.

Problem #1

To every action, there is a reaction. Now, by the govt bailing out another large bank because of fear of a financial crisis – “too big to fail” – the government is implicitly requiring large depositors, people with more than $250k in their bank, to move their deposits to larger banks such as JP Morgan in order to have their deposits entirely ensured. If they leave over $250k in a small regional bank and it goes under, the govt is implying that depositor will lose everything over the $250k limit because the bank failing is not “too big to fail”. So, the govt is encouraging a flight of capital from small, regional banks. This means even more banking stress on the banks that are already at risk. See this video clip below where Congress begins to discuss this with the Treasury secretary:

Problem #2

“Eurodollars”, or dollars overseas, are far more numerous than dollars in the US system. As financial conditions tighten, more of these foreign dollars will be “cashed out” and the related assets redeemed. The owners of these dollars do not have direct access to the Fed bailout facilities. They cannot easily trade in depreciating treasuries/bonds and be made whole. Nor can they directly access reverse repo/repo facilities. Furthermore, foreign banks sometimes do not even have direct access to US govt debt in the first place, which is used as collateral. Instead, they have a rehypothecated version of US bonds. US banks “loan” out US bonds they own to multiple foreign parties to make extra money. Sometimes these are rehypothecated as much as 100 times! Foreign banks need US dollars, but have no means to produce them so they must rely on overly complicated, and dangerous financial instruments. So in short, it is a powder keg waiting to explode and the Federal Reserve has no control over it. This worldwide issue will dwarf SVB.

The bond market curve inversion confirms this very real fear. Without getting into detail on that, you can checkout this explanation here:

Problem #3

The govt is spending more on bailouts – some of this interference does draw down on the Treasury General account – the government’s “checking account” with the Fed. Normally the treasury keeps a reserve for dealing with emergency FX situations (ie dollar going down). Instead they’ve used it to help bolster the banks. If more banks fail, this could accelerate the debt ceiling crisis by making the govt run out of funds more quickly.

We are at an odd & dangerous juncture. The world needs more collateral – more US treasuries – more US debt – precisely when the US wants to scale back on govt. spending because it causes inflation. Should we cause massive deflation/bankruptcy in the world & then the US by huge spending cuts? Or ramp up inflation by more spend, spend, spend? The pendulum of inflation/deflation swinging back and forth gets faster and faster over time until it seems to be both at the same time. We are at that point. This pendulum has been kept going by govt interference that wants to maintain “stability” by prolonging a broken system, rather than letting it die. The only outcome is the eventual death will be a lot worse & a lot further reaching. The global monetary system should have died in 2008. We are paying the price now.

Problem #4

The sentiment of average people is shifting to fear & people like sheep can be led where central planners want. All this chaos, why when it can be so easy to make it go away? Let’s just make things simple and guarantee everybody! Let everyone have an account at the Fed which will work with the big banks who survive and with other central banks directly. Problem solved. No bankruptcy again! And no more “eurodollar” that is outside the Fed’s control. A Central Bank Digital Currency – One system for all….with no freedom.

Jonathan thinks and writes about the financial system and how it impacts the lives of ordinary people. While recognizing that we have little to no control over the powerful forces that control each and every one of us, he at least explains it so we can understand what is happening, and why…