On that fateful Sunday evening, just one month ago, when the Fed announced its new 13(3) funding facilities in order to stem the fallout from the SIVB and SBNY failures, I ended my note to clients with the following paragraph:
In the near term, the road will surely be bumpy. The regulators made a huge mistake in letting duration gaps widen to SVB-type levels. But I do suspect this type of rate risk mismanagement was not endemic in the broader financial system. Lots of seasoned CFOs and bank treasurers understand how to hedge MBS. This risk has been around a long time. The more savvy institutions will come through this much stronger, and those with either juniors in risk management or cavalier attitudes toward interest-rate risk will get swallowed. Capitalism will still work!!
Looking back, I see very little reason to adjust my sanguine reaction to the failures. That said, in the hours after I hit the send button, I received a deluge of pushback on my view. I was admonished incessantly about the impending tsunami of pain. Many even told me that immediate Fed rate cuts were coming as early as that Monday morning.
Now, to be sure, I had some nail-biting moments on the first few days after the failures, especially as EDZ3 ripped 200 bps and short-rate vol exploded to fall 2008 levels. But, as the equity and credit risk asset markets quickly found support, my anxiety level tumbled. It turned out that the preponderance of commercial bank treasurers still understood the basics of hedging MBS (as surmised). And the preponderance of regulators did not follow the rule book used at the San Francisco Fed. Fast forwarding to the present, my confidence in this initial view has never been higher.
So, with the bank-run dust now settled, I have had a chance to reflect more generally on the shorter-term macro impact, as well as the longer-term regulatory impact, of these failures. Before I discuss the macro below, let me first say a few words on the regulatory front. And in order to tee that up, I want to highlight that, before publishing my initial note, there was an internal delay of about four hours. I was ready to go around 8pm Miami time, but my aggressive language related to the failures of regulators raised some internal eyebrows. In the end I dialed it back a couple notches and ended up publishing around midnight. For the record, these were my toned-down comments in that note:
The somewhat annoying part of all this, however, is that regulators allowed these levered losses to occur with FDIC-insured deposits. I honestly thought the OCC, FDIC, and Fed had learned their lessons from 2008. I thought they were on top of the duration gaps at those entities they both regulate and insure with taxpayer dollars. The biggest surprise in what happened with SIVB and SBNY is NOT that a bunch of tech bros mismanaged the negative convexity risk inherent in Agency MBS. The real shock is that regulators, with a deep understanding of the risks in MBS securities, did not spot the potential for a large duration mismatch to develop inside the portfolios they oversaw. Hopefully, more robust checks and balances on the regulatory side are forthcoming in short order!!
I’ll leave it to the reader’s imagination when it comes to what I first wrote that evening about the regulators. It suffices to say, though, that with two open independent investigations into the failures now ongoing within the Federal Reserve system, my initial “aggressive” take on the regulators’ actions (or lack thereof) was more than justified. This was not some complex, hidden arbitrage using off-balance-sheet Cayman Islands subs. This was an “in your face” duration gap gone wild. It was good old-fashioned excess spread collection in good times, with a taxpayer put in bad times. The incentives will always be there for malicious (or ignorant) executives at any FDIC-insured depository institution to overcollect spread and pay themselves excessively in low-rate/high-carry periods. Then, when it inevitably goes bad, they leave the taxpayers stuffed. It’s a tale as old as time — and something that should certainly have been stopped by the regulators in charge of protecting taxpayers from the well-known moral hazards associated with deposit insurance. I would go so far as to conjecture that the primary reason a decision was taken to bail out all uninsured depositors in full at SIVB and SBNY was the obvious culpability of the regulators themselves. There were some serious mea culpa vibes underlying that decision.
Of course, there will also be investigations and steward inquiries into the behavior of the bank executives. Clawbacks are surely coming!! However, the most interesting part of this story will center on the investigations of the large depositors. For example, what sort of “perks” came to those top 10 uninsured depositors who held over $13b at SIVB? That could get quite messy as it unmasks the ugly underbelly of exchanging cheap deposit funding for investment banking perks — something that is almost surely prevalent across the entire commercial banking system. Isn’t this precisely the type of activity that Glass-Steagall was put in place to stop?? Just sayin’!!
Anyhoo, let’s leave the regulatory fallout for another time. It is going to play out over years, not quarters. The macro fallout is much more pressing. In thinking about how these failures will influence both the broad economy and the financial services sector more specifically, it is useful to take a step back and look at some of the longer-term trends in commercial banking. From 1934–1990, the number of FDIC-insured banking institutions in the US was steady, in the 13,000 to 14,000 range. The peak was actually 14,469 in 1983. Then, as the savings and loan crisis began to bite in the late ’80s, a precipitous and steady secular decline ensued. There were under 10,000 banks by 1994 and under 8,000 banks by 2001. The Riegle-Neal Act in 1994, which opened up interstate banking for the first time, really set the stage for a much more aggressive pace of consolidation. Fast forwarding, by year-end 2022, only 4,127 FDIC-insured commercial banks were left. Now, did this 70% decline in the number of depository institutions over the last 40 years create a headwind for economic growth? That would seem like a difficult thesis to prove. And by most any measure, the US is still HEAVILY over-banked. Canada has 34 commercial banks. Australia has 97. And Japan has 195. How in the world can any respectable macroeconomist run around saying that a few regional bank failures are going to shave $100s of billions off US GDP? This storyline feels more like a natural evolution of survival of the fittest than some tragic culling of essential banking services. Yes, SIVB and SBNY were large institutions, but there are 4,000-plus others waiting in the wings to pick up any broken pieces. Not to mention a plethora of non-bank lenders that would love to access the client bases of SIVB and SBNY. Without broader systemic risks coming into play, as they did in 2008 and 1998, it is extremely difficult to see these events having any meaningful macroeconomic consequences. And thus far, there seems to be nothing systemic in play. I will therefore stick with my initial assessment of a month ago: The road may be bumpy, but this is not the Armageddon moment that the front end of the Treasury curve initially priced in. It’s Spoos and HYG that called this story right!! Good luck trading.