MORE ON MONEY (SORRY)

MARCH 13, 2023 – My sincere apologies, Despite a whole litany of noteworthy encounters and experiences in my little world today, I choose to dwell yet again on the dismal science. But hear me—read me—out.

Today I received several generic email from investment firms reassuring me that the banking system was sound. Our son who’s the family’s professional finance guy (and international bank veteran) was too busy reassuring clients to have time to reassure his parents. Then, of course, POTUS himself took to the airwaves to reassure the nation. Perhaps at a previous stage of life I’d have needed or at least appreciated hand-holding as I considered “converting to cash before it’s too late.” This time around, I thought about the message from a broader perspective, namely the fascinating dance between finance (capital formation and liquidity) and the fundamentals of the economy—supply, demand, productivity, distribution, sales and marketing, and ultimately, consumption of goods and services.

The failure of SVB and Signature Bank remind me of the days when my law practice was swamped representing the Resolution Trust Corporation (“RTC”) during the savings and loan debacle of the late 1980s. The RTC was a government agency set up to manage failed S&Ls. Our firm’s job was to handle workouts and remedies associated with defaulted real estate loans held by the insolvent institutions. The RTC always took over a failed bank on a Friday, and by the following Monday, my colleagues and I were scouring loan files, often uncovering crazy stuff indicative of bad management and too little regulatory oversight exercised too late to prevent a meltdown.

The failure of SVB and Signature Bank bear little resemblance to the S&L meltdown. The root cause of the latter was economic: too many developers with too much access to too much cheap capital and too many favorable tax breaks got too greedy (along with all the people and enterprises that benefitted from the developers’ greed), then too desperate, until the whole financial system was put in jeopardy. The sudden drop in liquidity, in turn, had an adverse effect on the economy.

The demise of SVB was caused by factors different from those that triggered the S&L fiasco. The immediate cause was a drop in value of SVB’s mainstay assets: government bonds. Government bonds! These are considered the safest asset an investor can hold. But until they mature, their values fluctuate as interest rates change. Because of inflation-fighting policies of the Fed (increasing the fed funds rate), the value of non-matured bonds in SVB’s portfolio declined. When depositors panicked and rushed to the figurative teller windows, the bank had to sell those bonds to raise the dough to pay the depositors. Given that the non-matured bonds had lost value, they had to be liquidated at a loss, thus creating a liquidity crisis for the bank. Game over.

It didn’t have to be. If depositors hadn’t panicked, the bank wouldn’t have been forced to sell those bonds at a loss. It could’ve weathered the current elevated interest rate environment until yields declined and values recovered or simply held onto the bonds until they matured.

Or . . . if depositors insisted on withdrawing, not out of panic but out of necessity to make payroll and meet other obligations, the government could’ve loaned overnight funds secured by SVB’s portfolio.

Some would say the banking system is all a house of cards, smoke and mirrors, and we’re finally facing the inevitable day of reckoning after so much time fooling ourselves.

I say, not so. Banks are not a fiction built on nonsense.  They’re constructed upon a framework of trust; trust arising out of legally enforceable contractual terms, fact-based economic assumptions and a rational regulatory framework—properly calibrated and consistently enforced—to ensure sufficient liquidity and prevent undue risk-taking.

Panic is the ultimate enemy of trust. Panic induces more panic in the same fashion that a flaming tumbleweed ignites a brushfire. A brushfire, in turn, can incinerate surrounding houses just as an unraveling financial system can plunge the economy into recession or worse.

I applaud the president and all those investment firms reassuring their clients. But if we all understood better how the system works, we’d panic less—rendering the whole business more trustworthy, thereby reducing our inclination . . . to panic.

Tomorrow I’ll return to my staple topic: snow. (Just kidding.)

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Ó 2023 by Eric Nilsson