Perspective on Risk - March 13 (short update)

Some Initial Thoughts; Banks Intermediate

If you’ve been reading you know this was not my preferred or expected path. Fed fired the ‘systemic risk exemption’ panic gun early. I was wrong in my expectation.

Some Initial Thoughts

• There are 4,000+ banks in the US. 99.9% of them are fine today.

  • If you have over $250,000 in a bank and you are worried, just buy some short-dated Treasury securities

• The Fed used the failure of the crypto-bank Signature as the fig-leaf to use the ‘systemic risk exemption.’ It makes the Fed’s moves easier (politically) when it is not reacting to a single institution.

  • But I hate that they have declared a crypto-adjacent bank ‘systemic.’ I hate bailing out crypto. More on this is a subsequent Substack.

• The Fed has reduced immediate uncertainty and bought the banking industry time.

• The Fed’s actions could indicate:

  1. The likelihood of contagion is higher than we all perceived;

     1. Rather than being worried about deposits flowing from one firm to another, I suspect they evaluated the likelihood that other banks would have to taint their HTM portfolios and immediately recognize losses, forcing unexpected capital breaches.

  2. The Fed realizes the unprecedented rate of its interest rate increases is the proximate cause of the problem (the Fed caused the risk).

• My Life Insurance colleagues need to get their ducks in a row. While your liabilities are LESS runnable, the market will look past the regulatory measures of solvency to your economic solvency.

Banks Intermediate

Market Structure

Borrowers like to borrow for term. Depositors generally want immediate access to their money. Banks bridge these contradictory desires.

In general, corporate loans are only 3-5 years. This limits the amount of interest rate risk from that intermediation.

But there are two industries where the length of the loans is quite long; project finance (big in Europe & growing in the US) and home mortgages. Here the maturity of the loans can be up to 30 years and the effective duration of the loans are generally around 6-10 years.

In the 1970s and 1980s over 700 savings and loan (S&L) associations were closed. S&Ls were the main way long-term mortgage finance was provided, and rising rates made the sector insolvent.

Today, mortgages are securitized, and various financial institutions buy these securities as investments.

Silicon Valley Bank

SVB can be thought of as two banks in one:

1. A bank that made loans against private shares for venture capital clients

2. A mortgage intermediary

SVB had over $80 billion of long-duration mortgage securities on its books, funded by hot money.

The Fed’s Action

In addition to closing SVB and Signature Bank, the Fed announced a new Bank Term Funding Program. The Treasury essentially puts up $25 billion in loss-absorbing capital enabling the Fed to make multiples of this available as funding. The Fed will be providing term funding against:

U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral.

and importantly they will do so at PAR, so if you have a security with a face value of $100, but a market value of $50, you can obtain funding based on the $100 value (less a small haircut).

1. Basically, this enables the banks that have these long-duration securities in hold-to-maturity portfolios to obtain term funding.

2. This eliminates the interest rate risk.

3. It keeps these banks from having to sell the securities for liquidity, thereby tainting the accounting treatment and forcing IMMEDIATE loss recognition, and instead just earn low or negative returns over a long period of time. The Fed bought the banks time.

4. The US Treasury is essentially taking the counterparty risk of bank failure.

The long term issue is to figure out a better market structure to fund long-term assets.