Well, this is what happens when the Federal Reserve takes the punch bowl away: The bowl breaks, and then the central bank and regulators respond with glue. The second-largest U.S. bank failure on record and then, what do you know, a bailout plan at the very last second.
The authorities were clearly concerned that systemic risks were real heading into this week after the collapse of Silicon Valley Bank last week. But protecting uninsured deposits across the entire U.S. banking system is yet another bailout in the long history of them for bad actors who made bad decisions.
The Fed is committed to raising interest rates again, but there is no 50 basis point hike on the way, and like the Bank of Canada, the U.S. central bank will quickly head to the sidelines. The rate-hike cycle is about to be done, and bond yields have likely peaked and are now on course for a classic recession-induced bull market. The rebound in equities will also be short-lived, because the earnings downturn has commenced and has much further to run.
Contagion risks have been contained and the markets have breathed a sigh of relief, but the contraction in credit is not over, even if a full-blown financial crisis has been averted. Banks will be forced to raise deposit rates and that will cloud the sector’s earnings outlook, and the regulatory backdrop is certainly going to become more stringent.
What happened to Silicon Valley Bank, and what its collapse means for banks and investors
The demise of Silvergate Capital Corp., also last week, was truly idiosyncratic in the sense that it was nothing more than a one-model cryptocurrency bank. But its failure attests to the fact that this is what happens after years of quantitative easing, zero interest rates and central bank financial repression. It is also a stamp on the theme that this era of free-money central bank policy is over and for good.
Silicon Valley Bank is more problematic in the sense that it was not some marginal financial institution. It was the 16th-largest bank in the United States, it had been around for 40 years and it was a lifeblood for helping fund tech startups.
What is happening now is trying to figure out what other skeletons are in the closet and cockroaches in the kitchen, and the knock-on effects from this imbroglio. Who knew that Roku Inc. had US$487-million of its US$1.9-billion in cash tied up at SVB?
Vox Media Inc. also had a cash concentration at SV, and the company’s credit cards were issued by the bank (they stopped working last Friday). Does this not risk knock-on effects of asset sales to raise funds, and on what scale? And margin calls that can end up spreading widely?
If there is a silver lining in the clouds, it is that big bank share prices are hanging on. So, this is an assuring sign that the big U.S. banks will be just fine – and why shouldn’t they? They have a well-diversified business (capital markets, wealth management and diverse lending across industries), are well managed for the most part, have become much more regulated since the global financial crisis of 2008-09 and, most importantly, they have liquidity.
But the situation for wide swaths of the smaller regional banks is far different – which is why Washington yet again has been forced to step in with a backstop. Even so, everything I am seeing take hold still leads to a possible credit crunch nonetheless, since small businesses do a lot of their banking with regional lenders.
Many of those small banks have large concentrations in their deposits and assets, and are hugely mismatched after the Fed for so long made the leveraged “carry trade” so profitable (borrow short-term and lend long). But that trade has disappeared since last summer with the inversion of the yield curve, and the capital depreciation in long-dated fixed-income securities.
What has been lacking outside the big bank community this cycle has been regulatory oversight, and that is because Donald Trump was so bent on deregulation, he went overboard by throwing out some of the Dodd Frank rules in 2018. That was when the Wild West was reopened for smaller regional financial institutions.
This is not a repeat of 2008-09, but why do we need to even go there? Lightning never strikes twice. But we know that Fed tightening cycles after any prolonged period of accommodation incentivize excessive risk-taking and always end with some sort of financial event. And here it is.
If anything, this resembles the bubble in the late 1980s, which was the leverage buyout craze that engulfed the commercial real estate market. It burst starting with the failure of Lincoln Savings and Loan in 1989. That collapse didn’t affect the big U.S. money centre banks, but it brought down most of the S&L industry (once populated with 3,400 banks and now down to barely more than 600).
The S&L debacle caused a four-year credit contraction that, again, coincided with recession (that evil word nobody ever wants to mention) and a muted recovery. This is the major point. History shows that a crisis very rarely stops at just one firm, since the prior bubble conditions promulgated by overly easy monetary policy are generally mirrored elsewhere.
What we can say with certainty is, at minimum, we come out of this with tighter financial conditions and the makings of a credit contraction. The major banks were already tightening their lending guidelines and boosting their loan-loss provisions before this latest fiasco, and this process will continue and accelerate. Of that we can be certain.
That is also why deflation, not inflation, is in our future. Not to mention that with tech-sector venture capital funding completely drying up, the outlook for capital expenditures will be clouded for some time yet. That the Fed’s Open Market Committee is even contemplating a 25 basis point hike at its next meeting in the current environment is incredible, if not unprecedented, and will only make matters worse.
This is why the bear market in equities is not close to being over and why the long end of the Treasury yield curve will be the place to be – risk for reward, now even more compelling than cash. You get the nice yield in cash, and a nice fat total return that the duration in Treasury bonds will provide with the price appreciation we have already been seeing, and likely will continue to see for months and quarters to come.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
David Rosenberg