The Banking Crisis Chapter 2: SVB

Hey everyone,

Wow. What a weekend.

After the emergency piece covering USDC's depeg, the drama surrounding Silicon Valley Bank (SVB) continued into Sunday when the US government announced they'd jump in to save the day.

We're at a real inflection point in the market. We have some of the biggest names in tech and the investing world, comparing SVB to the collapse of Lehman Brothers in 2008, the event that kicked off the great financial crisis.

We've also been speaking to notable investors within traditional asset management, who echo the same sentiment. On the other hand, we have some corners of Twitter breathing a sigh of relief from the Fed's intervention, with Bitcoin gunning for $25k.

These are genuinely crazy times.

It all starts with SVB

During the pandemic years, they were the go-to bank for the tech sector. Startups loved them as they were more willing to provide riskier loans and services that bigger banks needed to prepare to give to early-stage companies.

To earn a yield on the ~$200 billion of customer deposits it had amassed, SVB invested the funds into long-dated US government bonds. These assets provided the best return within the zero-rate environment over the past decade.

But, then, when interest rates rose, the value of those investments got smashed (remember, bond prices move inversely with rates).

Once market participants caught wind of SVB's losses, the run on the bank began. As customers withdrew their funds in hoards, SVB couldn't sell their assets quickly enough to cover withdrawals, leading to its shuttering on Friday.

This bank run happened within 48 hours, making it the US's largest and fastest bank failure since the global financial crisis.

It turns out that SVB wasn't an isolated incident. Last week, crypto-friendly Silvergate and Signature Bank (a New York regional bank) were shut down in the wake of their poor risk management.

All of this ties into a broader finding from the FDIC that US banks are sitting on bond losses of $600 billion. That's a big bag.

It's no wonder that the US Treasury, the Fed and the FDIC - in a joint statement on Sunday, decided to intervene and backstop all deposits for the now-defunct banks and provide broader support for the banking system.

Money printer go “brrr”?

Financial markets would've been royally screwed if the Fed didn't intervene.

Contagion on the order of 2008 would have run rampant - it would be the bomb on Hiroshima, the dinosaur extinction-level event.

Without a backstop for depositors, the US' engine of innovation in all its fledgling startups would be toast, thousands upon thousands of people would be out of jobs, and billions in savings would be eviscerated.

Naval summarises the implications of a large-scale bank run succinctly; everyone in the US runs to pull their cash out of the bank, banks don't have enough to cover withdrawals, banks go under, forced selling ensues, consumers get decimated, and the economy and markets collapse.

Thankfully, that hasn’t happened. The Fed answered the call for intervention.

Before we break down the Fed's rescue package and its implications for the market, it's worth noting that the Fed's support package only helps depositors - SVB's equity and bondholders are being wiped out, which is necessary to prevent excessive risk-taking in the market. Ensuring investors take losses when investments fail is crucial to avoid reckless behaviour and ensure responsible future risk-taking.

The Fed's support is twofold:

• They are covering all customer deposits stuck at SVB & Signature and,

• The new Bank Term Funding Program (BTFP) will offer loans of up to one year to commercial banks, where US Treasuries and other assets are posted as collateral.

However, a vital component of the BTFP that people missed is that commercial banks taking loans can use the par value of the assets they post as collateral to determine the loan's value, not the market value.

It's absurd. And to show you how absurd it is, Pomp, an early Bitcoin investor and well-known entrepreneur, had a great example:

And they say the game isn't rigged for institutions.

We going… Up?

Markets are ripping off the back of the Fed's announcement. With minimal details provided, the market speculates that the Fed will pivot suddenly. We're nearing peak irrationality.

Bitcoin is up 15% in the last 24 hours, bond yields are falling drastically (pricing in an interest rate decline in real-time), and even Goldman Sachs is now calling for a pause in rate hikes.

The Fed continues to cause unnatural distortions in the market, much like they did in getting us here in the first place!

Remember, they were the ones who kept rates at zero for a decade and put out forward guidance that this would be the case forever. Then, when circumstances changed, they jacked rates up at the fastest rate in history, tanked the economy and screwed every bank that allocated capital based on their forward guidance leading to $600 billion in unrealised losses on their balance sheets.

And, now we have a bank run and a potential credit crisis to deal with.

Despite the Fed's intervention targeted at easing the market's concerns, there are reports that people in the US are lined up at their regional banks today to withdraw their funds. And, tied to this, US regional bank stocks are getting completely clobbered on market open - increasing the risk of broader bank failures outside of SVB and Signature.

Sell pressure on these bank stocks is so severe that trading for over 30 banks has been halted. It's frightening thinking through the absolute worst-case scenario.

But, as this situation unfolds, it's crucial to remain level-headed and conduct scenario analysis on the current facts so we come to a clearer understanding of what lies ahead.

Scenario Analysis

My decision tree for the scenario analysis is straightforward. It all comes down to what the Fed will do at its next meeting. Mainly, what the Fed prioritises will determine where markets head for the rest of the year and beyond.

a) Save the banks

Here, the Fed prioritises bailing out the banks and fighting further contagion risks by re-instituting quantitative easing. We return to a COVID-esque distortion in markets where excess liquidity provided by the Fed artificially props up asset prices.

In this scenario, the Fed pivots imminently - halting the most aggressive rate hikes since the 80s.

The reality of this decision would be that, despite having hiked interest rates by 4.5% already, inflation remains persistent. Stopping rate hikes and easing monetary policy would lead to even higher inflation, further exacerbated by inflationary pressures from the multi-billion dollar bank bailout program.

If they choose this route, the Fed will be kicking the can down the road. It'll delay the inevitable consequences of irresponsible monetary policy.

I can't tell you what happens in the long term when this loose monetary policy and quantitative easing corrects itself. And neither can the experts. It's unprecedented on a historical scale. We are experiencing, first-hand, the greatest monetary policy experiment in history.

It could be a currency collapse in line with Ray Dalio's analysis of long-term debt cycles, a Federal Bank failure or just a market correction of biblical proportions.

Only time will tell on that, but we'll likely see short to medium-term relief if the money printer really does start to go "brrr" again.

b) Breaking inflation

On the other hand, if the Fed doubled down on breaking the back of inflation through prolonged rate hikes and continued quantitative tightening, the market nosedives for the rest of the year. This will be when the market and economy truly get crunched.

Firstly, the contagion from broader bank failures may play out - it just depends on how far and wide the Fed casts its safety net. In this scenario, they're probably not going to be too generous, with inflation being its priority.

Secondly, it'll be a fool's errand to predict what terminal rate the Fed will need to get inflation down to its 2% target. So the only thing worth remembering on this path is that they'll do whatever it takes to get there.

Come hell or high water; they’re beating inflation down to 2% - whether they take markets, the economies and consumers down with it - it doesn't matter.

In this scenario, we get another 20-30% off of the MSCI World Index (aggregating all equities globally) like in 2022. That'll take us to global equities being down 50-60% over two years, on par with the financial crisis of 2008/09.

From there, we may finally have our "generational buy" bottom. With that size of a correction, all of the excess, irresponsible liquidity would've been wiped out. The tourist investors and “stimmy” party animals would be long gone, leaving only the war-torn survivors.

At this time, with a severe enough correction, markets will be able to move forward into a new long-term leg up.

Whether this process plays out this year or into 2024, one can't say for sure. But, on average, all market corrections last anywhere from 24-36 months, taking us to the end of next year, where we may be at the actual bottom of the market.

It sounds simple when we lay it all out like that. But remember that this year has taught us to expect the unexpected; anything could happen in the coming weeks.

So, our key event to watch in line with our scenario analysis will be when the Fed meets next week, Wednesday, March 22nd.

While scenario analysis is excellent for thinking through the second and third-order effects of events, it doesn't account for the uncertainty and the Black Swan events that will undoubtedly play out.

Buckle up

Remember everyone, our goals within the markets are to preserve capital and to generate reasonable returns given a certain level of risk one is willing to accept.

In that order.

I also encourage you to do your own scenario analysis - review your critical thinking process and challenge my assumptions. That way, we'll all be able to iterate and find the real source of truth, which benefits everyone when we venture into markets.

And hey, if you're feeling down about the chaos, just remember that FTX depositors aren't getting anything from the Fed's bailout.

It could always be worse.

That’s all for today. If you found this post insightful, share it with a friend or anyone who might appreciate it.

Thanks for reading,

— Luca