A Central Banker, a Venture Capitalist and a Bank CEO Walk Into a Bar...

Canton’s Palace Theatre will screen four Three Stooges classics for its annual Three Stooges Film Fest, set for Saturday.
                                  Source: CantonRep.com

    They stand mute, shell-shocked and ashen-faced.  Finally, the central banker speaks up.

I can't believe what's happened!! Who could have known that lowering real interest rates to below zero for a decade following the sub-prime mortgage crisis - that we caused with low rates, excess liquidity and no regulatory oversight - could lead to high inflation? And who

could have known that raising interest rates to fight that inflation would lead to liquidity problems for banks? Sure, we told banks to load up on low-interest, long-term Treasury securities that would drop in value as soon as I raised rates and I told those banks they did not have to mark-to-market the falling value of those bonds but who could have known that would be a problem? We also neglected to monitor the falling value of banks' capital buffers over the last year but who would have thought that could lead to a crisis? Now I'm under the gun! I'm doomed!! 

   The bank CEO says,

I loaded my bank up with those long-term Treasuries that bore ridiculously low interest rates and knew that their value would drop precipitously when rates went up but I had no idea that rates would rise!! Someone should have told me you were raising rates! It came as a complete surprise! I suppose I could have protected my bank from these bond losses by hedging their interest rate risk but that would cost money leaving less for my bonus!  Now I'm not getting a bonus and my depositors will probably sue me for their losses!  I'm doomed!! 

    The venture capitalist, cries out,

I had over $50 million in cash at your bank! Someone might have mentioned to me at some point that deposit insurance only covers $250,000!! The deposit guarantee limit came as a complete surprise to me! Someone dropped the ball here!! I could have kept my money in short-term Treasuries, not put my money at risk and earned far higher interest rates but nobody told me to do that!!  I'm doomed!! 

     Quiet comes over the three as they stare at the floor. Minutes pass, then they break out in raucous laughter, give each other high-fives and slaps on the back. The central banker cries out between tears of laughter, "Bartender, bring us a jeroboam of champagne!" He laughs,

Like we are going to suffer! Ha! Losing money in bank failures is for the "little people," not us - the financial elite! We will just have the Fed and Treasury bail us out and lay off that cost on others! Sure, banks will have to pony up more into the FDIC insurance fund but they will just pass that cost onto their customers!  It's always win-win for us!  

    What happened in 2008 and recently at Silicon Valley Bank and Signature Bank is compelling proof that the western banking system has run off the rails. No one at the banks or their regulators is ever punished for their bad judgement and rank incompetence. The deep pocket of the state always opens to protect them. Had it been your community bank that failed, deposits over the insured limits would surely have been lost. 

Where Did This Banking Crisis Come From?

   Due to its pervasive incompetence, the US banking system has been on life support for over a decade. Pam Martins at Wall Street on Parade explains,

Citigroup/Citibank were the largest borrowers from the Fed’s emergency bailout programs during the financial crash of 2007 to 2010, secretly receiving over $2.5 trillion in cumulative loans according to a 2011 audit conducted by the Government Accountability Office on the Fed’s emergency lending facilities. In addition, Citigroup/Citibank received the following in bailouts: $45 billion in capital injections from the U.S. Treasury; the Federal government guaranteed over $300 billion of Citigroup’s dubious assets; the Federal Deposit Insurance Corporation (FDIC) guaranteed $5.75 billion of its senior unsecured debt and $26 billion of its commercial paper and interbank deposits. (Emphasis added)

By March 2009, Citigroup was a 99-cent stock. But for reasons that remain in dispute, the banking behemoth was not wound down. Citigroup’s Citibank was the largest borrower from the Federal Home Loan Bank of New York as of year-end 2022 with $19.25 billion in loans outstanding. That’s a 267 percent increase from Citibank’s $5.25 billion in loans outstanding with the FHLB of New York as of December 31, 2021. 

 Jared Dillian recently wrote about the Silicon Valley Bank fiasco,

The 16th-largest [bank] is big enough to be systemically important. If the Federales didn’t stop the run, it could have spread to several other banks. Hence, the unlimited deposit insurance. I disagree with it on libertarian principles, but we’ve abandoned free market principles to save the free market. I wonder where we’ve heard that before.

The politicians are framing this as “saving innocent depositors,” but the majority of SVB’s deposits were placed there by about 35,000 depositors with $4 million in deposits each, on average. These people were not innocent. They were big boys and girls and supposedly sophisticated enough to understand the risks. As it turns out, they were as dumb as SVB management. Dumb people losing money is supposed to be a feature of capitalism. It has a cleansing effect. But we never let it happen.

When it became clear the bank run had the potential to cascade, the market quickly began to price out rate hikes, betting that the Fed wouldn’t follow through with them. That turned into a short squeeze in two-year notes, which dropped over 100 basis points in yield in three days. It was the biggest move in two-year notes since the Crash of 1987… 13.6 standard deviations, in fact. Something so improbable it was never supposed to happen.

David Stockman minces no words,

They have done it again, and in a way that makes a flaming mockery of both honest market economics and the so-called rule of law. In effect, the triumvirate of fools at the Fed, Treasury and FDIC have essentially guaranteed $9 trillion of uninsured bank deposits with no legislative mandate and no capital to make these sweeping promises good. 

It will warm your heart to know that regular folks like Oprah, Harry and Megan, Nancy and Paul Pelosi and hedge fund's Peter Thiel's holdings that are far in excess of the insured limits will be covered at government (your) expense. Yes, the Fed and Treasury assures us that no losses will be borne by the taxpayers but we know that is a big lie. Everything the government promises costs you money either directly or indirectly.

                                   Source: Sean Ring, Paradigm

The Fed was not alone in making a mockery of sound economics and the rule of law. In its desperate effort to salvage the reputation of Swiss banking the Swiss National Bank wiped out Credit Suisse's AT1 bondholders and sold the bank to UBS for just $3B, sweetened with a massive 108 billion dollar guarantee. The public's expectation is that shareholders will always get wiped out before bondholders. The SNB's act of reversing that expectation has completely rewritten the risk for banks' bond owners. 

    While each banking crisis comes with a slightly different flavor, the underlying problem is always the same: the bank lacks liquidity to meet withdrawal demands - a classic "It's a Wonderful Life" run on the bank. In 2007 US banks had funded mortgages that were under-secured, securitized and suddenly lost value as the housing market collapsed. In 2023 banks like Silicon Valley Bank, Silvergate Capital and Signature Bank found themselves with huge deposits but not enough good places to invest them. So they parked the money in very low-interest US Treasuries. When the Fed raised yields on Treasuries to fight inflation, the value of the earlier issued bonds sank. As withdrawals increased, SVB and others were forced to sell their low-interest Treasuries at a loss (a $1.8B loss for SVB) and the house of cards quickly collapsed. 

    This brewing problem was no secret.  Before the crisis hit, Jiang, Matvos, Piskorski and Seru issued a study called, “Monetary Tightening and U.S. Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs?” They wrote,
We provide a simple analysis of U.S. banks’ asset exposure to a recent rise in the interest rates with implications for financial stability. The U.S. banking system’s market value of assets is $2 trillion less than recorded on book values. We show that these losses, combined with a large share of uninsured deposits at some U.S. banks can impair their stability. Even if only half of uninsured depositors decide to withdraw, 190 banks are at a potential risk of impairment to even insured depositors, with potentially $300 billion of insured deposits at risk. If uninsured deposit withdrawals cause even small fire sales, substantially more banks are at risk. Overall, these calculations suggest that recent declines in bank asset values significantly increased the fragility of the US banking system to uninsured depositors runs. (Emphasis added).
Two other studies have shown that the unrealized losses in the US banking system are between $1.7T-$2T and their total capital buffer is $2.2T.  That means that they have just a 10-20% buffer as we rush headlong into another banking crisis where their stock prices have declined in value by a third in the last few weeks - ensuring that selling stock to raise capital is not an option. Here is what those losses look like in chart form. The green bars are bonds listed as "available for sale" and the blue bars show "hold to maturity" securities (in hundreds of billions of dollars). Does this instill confidence in you?

The Fed and FDIC were oblivious to this growing risk as proven by their failure to require banks to increase their shrinking capital in order to backstop their massive liabilities. Once the crisis broke, they had the gall to issue the following utterly false assurance that,
The capital and liquidity positions of the U.S. banking system are strong, and the U.S. financial system is resilient.

The next chart shows the recent surge in emergency bank borrowing from the Fed's Discount Window. Note the vertical line on the right edge of the chart that well-exceeds borrowing during the Great Financial Crisis of 2008. "Strong capital and liquidity positions?" A bad joke.

     This banking crisis again convincingly proves that the Fed is an utterly incompetent bank regulator. Silicon Valley Bank was allegedly overseen by the Federal Reserve Bank of San Francisco.  The SF Fed raised no red flags and took no action to warn that SVB was in a perilous situation due to the falling value of its government bonds. You may find it interesting to learn that Greg Becker is one of the members of the SF Fed. Who is he? He was the CEO of Silicon Valley Bank. The way the Fed system is set up, with the "supervised" banks' management sitting on the Fed's Board, is a massive conflict of interest - just as it was designed to be. 

    This crisis also proves the Fed is utterly incompetent to "manage" the massive US economy by setting interest rates that should be set by market forces. This chart shows that it kept rates at near zero levels (actually at real negative rates) for nine years (from January 2009 through January 2018). Then again pegged rates to the floor. Result? The US got the highest inflation in forty years. Who could have seen that coming? Evidently not the Fed's 400 PhD. economists.      

    You may have read in the main stream media that the recent $30B bailout of First Republic Bank by JP Morgan, Bank of America, Wells Fargo, Goldman Sachs, Morgan Stanley and others is proof that the banking system is sound. In fact, it makes things worse. Bill Ackman denounced the bailout saying that spreading the financial risk to achieve a false sense of confidence in the troubled bank is bad policy, amounts to a fictional vote of confidence and spreads the default risk to our largest banks. The facts behind that bailout are also instructive. These "generous savior banks" were desperately trying to cover their own backsides. They had underwritten First Republic's August 2022 secondary stock offering. The price of those shares had fallen from $135 to just $34. They had to stop their own bleeding and try to protect themselves from suits from their own customers to whom they sold these worthless shares.

    Another growing, but unpublicized, problem is that commercial real estate loans at small and mid-sized US banks have grown from $869B in December 2017 to almost $2.0T.  These loans now make up nearly 70% of the $2.9T of total CRE loans outstanding and they are not exactly in rude health. Vacancies in office buildings and malls continue to grow leading to rising mortgage payment defaults. Two funds, Pimco's Columbia Asset Management Fund and Brookfield's Asset Management Fund recently defaulted on some of their mortgage payments. This may well be the focus of the next banking crisis.  What else is afoot that puts you at risk?

Central Bank Digital Currencies

     The current financial crisis will be used to justify a dramatic departure from banking history. The Federal Reserve Bank (and other central banks) have been very open that they are in the process of creating "central bank digital currencies" (CBDC). The Fed is well on its way to rolling one out. It will initially be used to facilitate large transactions between national and international banks. It is called "Fed Now." The claimed benefit is that money transfers can be made faster and at less cost through the CBDC than through the SWIFT system used by banks today. This new system is already in the works and will be "beta" tested in the near future. Some two hundred banks have already signed up to participate. Hundreds more will follow. 

     But the Fed's ultimate goal is to hold all dollars in accounts at the central bank. Convenience and security will be the sales pitch for the program and will be rolled out during the next crisis.  The results are foreseeably dystopian. All of your money will be under the direct and complete control of your government. It is easy to see that gives it total control over not just your money but also over you. Should you fall out of favor with those in charge, you might find your money frozen. Should you wish to buy some product or service not on the "approved list," you can be barred from doing so. Should you try to contribute to people, parties or entities or travel to a place not on the "approved list" you can be barred from doing so. This will work substantially like Communist China's Social Credit Score that defines a person's ability to be employed, bank, and where they can live and travel. This is not doomsday conjecture on our part. It has already happened in the "Free West." In Canada, truckers were striking in opposition to government mandated Covid vaccines that had not gone through the normal testing and approval process. Those truckers, and people who contributed to them, had their bank accounts frozen by Trudeau's government. He was able to do that under Canadian law (the 1988 Emergency Act) that gives the executive virtually unlimited powers during "emergencies." Your country likely has similar laws on the books and what constitutes an "emergency" is never well defined and is subject to similar abuse.   

    There are further ramifications for CBDCs. Should you want to diversify your money into other currencies you can be barred from doing so. Should you want to send money out of the country you can be barred from doing so (capital controls). Should you want to save your money when the government wants you to spend it "to stimulate the economy," you can be assessed penalties for you recalcitrance. When your government wants to impose "negative interest rates," it just debits your account. You have no say in the matter. In short, a CBDC is your government's financial noose around your neck. You will have no financial or personal privacy. Your travel and expenditures will be an open book. History convincingly demonstrates that governments never evolve into being more free. They always evolve into being more autocratic. The Covid lockdown is a recent example of your government "never letting a crisis go to waste" to expand its powers and limit your freedoms.

But The US Economy Is Improving, Right?

    US political leaders and the main stream media are constantly saying that the economy is recovering and that growth in GDP is improving. In other words, "all is well." Let us take a peek behind the curtain  to see how things are actually going. First, "real" interest rates (net of inflation) are still negative meaning that the Fed is still being very monetarily "accommodative" - meaning it is still juicing the markets with cheap money while pretending to fight inflation. This is a chart of the real (net of inflation) 10-yr. Treasury rate. Despite its evident alarming appearance it seriously understates the actual inflation rate, meaning the rate is even more negative than shown.   

Real wage growth continues to be negative and that will inevitably lead to an ever growing clamor for wage hikes that must then be either absorbed by employers (leading to shrinking profits or bigger losses) or passed on to consumers (leading to more price inflation).

Real interest rates need to be at least 2% positive for an economy to function normally. The Fed has a long way to go to reach that point. The problem is that if rates were raised to that level, the economy would collapse because over-extended debtors can not handle those rates. So real rates will not return to normal. How does Powell's inflation fight compare to Paul Volker's? During the 1980's period of high inflation, Fed chairman Volker took real rates up to positive 5% (red line) and held them there for five years to break the back of inflation (black line). Powell will not do that. So, expect inflation to remain stubborn.

   We are also told that hiring has been strong. Yet most of that hiring has been in the leisure and service industry - meaning minimum wage jobs. They will never replace the high-paying manufacturing jobs that have been off-shored over the last twenty years. How about high paying tech jobs? Not such good news there either.  Here is a list of some of those laid off just in the last four months - over 63,000 with many more to come.  


    What does the commercial property market look like? Grim and getting grimmer. This chart shows losses to date (blue) and expected losses to come (black). 

Residential property sales are falling significantly because the cost of mortgages have risen dramatically as the Fed raises rates.  This makes mortgage payments ever more unaffordable and reduces the number of people financially able to buy a home. 

    How are bonds doing? There are around $10 trillion of U.S. corporate bonds outstanding today. About $1.7 trillion, just under 20%, mature in the next two years. Most of those loans were taken out when rates were absurdly low. Rates are now high and may be going higher. Many borrowers will not qualify for renewal of their loans forcing them into defaults with banks suffering the losses. Recall that 1000 of the Russell 5000 companies are financial zombies - unable to pay the interest on their existing debts. The Fed is "damned if it does" (keeps raising rates to fight inflation bringing on a deep recession) and "damned if it doesn't" (lowers rates and ignites run away inflation). By constantly - and incompetently - toying with the economy, the Fed has created a monster that it cannot tame. There are no painless solutions.

    Household debt is now almost $17T. Personal credit card debt in the US has just set new record highs and with real wage growth still negative and card interest rates at near 20%, it is only a matter of time before that turns into a crisis. Fully 63% of Americans are living paycheck to paycheck - including nearly half of those with six-figure incomes! Continuing inflation will only make that worse. For those who are retired, the specter of underfunded pension plans and social security schemes are more crises in waiting. In 1950 there were seven times more people under the age of 15 than those over 65 who were taking money out of it. By 2050 that ratio is expected to be 1:1. All retirement/pension programs are based on the flawed concept that contributions by young workers can support the benefits paid to older workers. As the demographics change, that becomes a bankrupt concept. When the system breaks, as it must, there will be chaos.

    Murray Rothbard has identified those responsible for these problems and they are the usual suspects.
When the government and its central bank encourages the expansion of bank credit, it not only causes price inflation, but it also causes increasing malinvestments, specifically unsound investments in capital goods and underproduction of consumer goods. Hence, the government-induced inflationary boom not only injures consumers by raising prices and the cost of living, but also distorts production, and creates unsound investments. The government is then faced repeatedly with two basic choices: either stop its monetary and bank credit inflation, which then will necessarily be followed by a recession which serves to liquidate the unsound investments and return to a genuinely free-market structure of investment and production; or continue inflating until a runaway inflation totally destroys the currency and brings about social and economic chaos
As government expenditures continue to vastly exceed tax revenues, only bad choices lie ahead. US revenue (black line below) must be constantly "supplemented" by Fed money printing to pay the ever-growing expenses or the whole system goes "tilt.

Jeremy Siegel puts it in perspective with his observation that,

The last two years contain the biggest policy mistakes in the 110-year history of the Fed by staying so easy when everything was booming Congress pretends to judicially consider whether it should raise the debt ceiling. Remember that it does not matter which party controls Congress or what is happening around the world. It has raised the ceiling more than one hundred times including ninety times since 1940 and twenty times since 2001.

It will continue to spend more money than it takes in because that is the only way it can buy votes and stay in office. If social benefits were pared back it would be curtains for those now in office. So, more spending and more inflation is baked into the cake.

Europe and the Middle East Are Also in Crisis

The Bank of England pretends to address 10.4% inflation with an interest rate of 4.25%. Strikes continue throughout the nation as workers press for pay raises to counteract the high inflation brought about by Parliament's excess spending and the BOE's expansion of the money supply. Everyone clamors for a painless solution. There is none. So, the pain will continue. Alister Heath at the Telegraph writes,
Even before any looming financial bust, Britain’s “real” economy was in tatters, brought down by extortionate, incentive-sapping taxes. We need to face the facts: another financial crisis and recession is now likely. House, bond, commodity and stock prices are falling, and this time central banks no longer have the tools to reflate artificially. We are entering a period of radical uncertainty – one that will surely destroy Hunt’s fiscal forecasts and send the national debt surging – at the worst possible moment.
The most striking way to depict how the British economy is doing is to show this chart of the FTSE 100 (UK stocks) priced in gold (real money). It is not a pretty picture and speaks volumes about the state of the British economy. It took years of economic mismanagement to get to this point.

    In France, Macron has decreed that the retirement age will increase from 62 to 64.  We have no quarrel with the change (as it must be continuously increased as life expectancies rises). The French pension system is also a run-away train about to go off the rails. The problem is the means he took of achieving this result. He did not submit the change to the National Assembly for legislative approval out of concern that its chance of passing was nil. The result of this action was predictable: millions are marching in protest and government workers are striking. Evans-Pritchard again,

France has entered a Marxian state of pre-insurrection. Orderly protest over the retirement age has mutated into a deeper crisis of the regime, with political violence feeding on political repression in a vicious cycle with no visible end. Emmanuel Macron has chosen to rely on decree powers as a method of government since losing his majority in the Assembly last June, rather than trimming his sails and accepting that he no longer has the votes for his assault on sacred modèle français. The French people were open to reform in principle. A working consensus could have been found with the right political chemistry. But Mr Macron's idea of consultations is to lecture the slow-witted. Five of the country’s seven refineries are closed by strikes. At least 42 departments are running out of fuel. Trains and flights have been disrupted for weeks. Some 7,200 tonnes of rubbish rot uncollected on the streets of Paris. 


    Similarly, Israel's Netanyahu sought to strong-arm a limit on the power of the Supreme Court because it has been a thorn in his side ruling against some of his programs. He proposed to change the way judges are selected and to allow a mere majority of the Knesset to overrule the court's holdings. The people see this as a power-grab that will dramatically alter the governmental balance of power and they too have taken to the streets to protest. Due to public outrage he has recently agreed to delay pushing for that change.

Germany is struggling with strikes and energy shortages and Italy continues to march toward a financial reckoning when the European Central Bank is forced to cut back its purchases of Italian government bonds. As set out above, the Swiss National Bank had to bail out Credit Suisse, one of its two historic and premier banks. Life in the European Union, as elsewhere, is becoming increasingly fraught. 

Final Thoughts

    In the wake of the recent banking crisis, many people are feverishly examining their investment and retirement statements trying to figure out what to do. They might consider doing what central bankers have seen fit to do with their money for the last ten years. That has not been buying meme stocks or US government bonds. With governments locked into ever higher deficit spending and money printing, continued price inflation (currency debasement) is our likely future. One needs to hedge against that risk. Here is one way to do that.

                                  Source: Wealth Megatrends


Important Message: The foregoing is not a recommendation to purchase or sell any security or asset, or to employ any particular investment strategy.  Only you, in consultation with your trusted investment advisor, can select the strategy that meets your unique circumstances, investment objectives and risk tolerance.  © All rights reserved 2023