An End, And A Beginning

Ten Thoughts: An End, And A Beginning

March 26th, 2023

A Photo Taken During the Banker's Panic of 1907

1. The age of easy money has ended. 

The years of low-to-no interest rates have finally come to an end, and now we are just beginning to see the consequences. I write this some 2 weeks after the failure of Silicon Valley Bank (SVB), the bankruptcy of Silvergate capital and a general fallout in the VC / Crypto community. Last week, Credit Suisse failed and was bought by UBS. Speculators drove down First Republic Bank's stock some 90% YTD, and the impact of the bank failures and general fears in the banking sector have had similar effects on other regional bank's prices. Deustche Bank is now the target of another bearish campaign, and European investors are reeling after coming to grips with the reality that AT1 debt securities are actually very risky. Unemployment is around 3.4%, and inflation is running at about 6%. Even in the midst of all this chaos, the Fed has been forced to raise interest rates, now targeting a Fed funds rate of 5% after a 25 BP (0.25%) hike this past week. "Easy money", as we all knew it, is gone. Queue the credit crunch, the panic, and the impending fallout. What a great time to be getting started in the world. 

2. We're beginning a new era, phase, reality - whatever you want to call it - that will likely be characterized by a tightened credit environment and less than optimal financial conditions. 

It won't be ideal for Wall Street or for the average taxpaying citizen, but as you can imagine it will hit those with the least the hardest. In real terms, it means that millions will likely lose jobs by the end of this year, and millions more might lose their jobs by the end of the next. It will be much, much harder for small businesses to get loans to start their business. Similarly, new homeowners will have a harder time securing a mortgage, and existing homeowners who might have hoped to take out a second mortgage or refinance at a lower interest rate will find greater difficulty doing so. A high interest rate environment doesn't just mean that your credit card rate will increase - which it likely will - it means that the broader economic landscape, domestically and globally, will be under increased pressure, and that pressure will in large part be felt by you.

3. It seems cruel that the layperson is consistently the party the takes the biggest hit when things go wrong in Washington and on the Street. Unfortunately, it's always been this way and is not likely to change. 

During the financial crisis of '08, it was low and middle-income families that were hit hardest by the crash. Millions lost their jobs, their homes, and their livelihoods. The government stepped in to stimulate the economy, boosting the money supply. Unfortunately, the bad boys on Wall Street pocketed most of the money for themselves. That did not deter the government however, as they continued to funnel money into the system and tried to find new ways to put money in the hands of the average taxpayer. Eventually, they did manage to reach the common person (through stimulus checks, tax credits and the like), however they also created a highly-leveraged corporate environment. This meant that when Covid-19 hit (which also impacted poorer US citizens disproportionately across socio-economic classes), the players who were propped up on government spending (and arguably manipulation) went into a freefall. They were bailed out, of course, while millions of people in the U.S. again lost their homes, their small businesses, their jobs, and in many cases their lives. In came the Fed again to print more money, this time even more aggressively than after '08. Unfortunately, through processes that I won't delve into in this section, it led to the mismatch of supply and demand that we've been seeing for the past year or so. The consumer has money to spend and the producer doesn't have enough inventory for them to spend it on - so prices go up (inflation). So since 2021/2022, the citizens who have made the least money have been having to shell out a larger proportion of their income for basic needs like food, shelter, and utilities. Now that the Fed is attempting to reverse course, it is these same people who will bear the burden of increasing rates that I discussed earlier. It hardly seems fair, but then again this system wasn't built for us all to be dealt the same cards. 

4. I don't believe in fear-mongering, cynicism or divisiveness - but I do believe in honesty. 

That being said, it is hard to speak about things transparently without scaring people, especially when so many unsuspecting and hardworking individuals have been hurt in recent years. It is no small statement to claim that 3-4% (and that is a conservative estimate) of Americans may lose their jobs in coming years - and that this might be a necessary step in reversing the course of inflation. How is a single mother with young children supposed to digest that news? How are young people just getting started in their careers supposed to be optimistic about their futures? How are people who lost their homes in '08, still in recovery from that crisis, supposed to move forward with the news that we might be headed into another? These are questions I don't have the answer to. But it seems to me that U.S. citizens are better armed to deal with economic downturns and crises when they are prepared with the information that will allow them to plan and navigate the landscape accordingly. I think that begins with transparency and honesty - but there are plenty of incentives not to do so. 

5. Why not tell the truth? Well, the way I see it, this whole system depends on controlling sentiment. And if you let too many people in on what's really going on on the inside, you risk a complete collapse. 

Ignorance is bliss, and bliss is what gets consumers to spend their hard-earned money. The run on SVB should serve as an example of what happens when you lose control of sentiment. One withdrawal turns into another, which turns into a social media post, which turns into a frenzy, which turns into a collapsed financial institution. Of course, the initial source of speculation around the bank was their poorly hedged bond portfolio and significant cash shortfall. However once a snowball gets rolling, you don't need to push it anymore - you just let the hill do the work. The same snowball exposed the fraud at FTX, and is what caused significant volatility in regional banks across the United States (and other GSIBs abroad, like Credit Suisse, UBS, and Deustche). When you lose control of sentiment, you risk exposing the underbelly of the system, which unfortunately is riddled with holes and rotten flesh. Let me be clear (as Obama would say) - I do believe in honesty. My point is simply that confidence is what holds this (financial and political) system up, not the underlying fundamentals. Therefore, it is in the best interest of Washington and the Street to keep confidence high, and the easiest way to do that is to gloss over the truth (and all too often, to lie). 

6. While I do believe the general public deserves the truth, it would be naive to believe that everyone wants to hear it. 

People want to hear the version of the truth that aligns with what they already believe. Being a truth-seeker does not mean tuning into your favorite host on [insert polarized TV station and/or social media platform] every night as they "break down what is really going on". It means going against the grain, finding information for yourself and reckoning with its implications, even if it makes you uncomfortable, even if it takes you down a road you weren't expecting to go down. We are incentivized to do the opposite, however, and in truth, how many of us really want to? And even for those of us that do, how successful can we really be? How can we know who to trust, or who really provides unbiased reporting and opinions? I don't have the answers to most of these questions. What I do know, however, is that everyone has a bias. The second we begin to recognize that all information is disseminated through other human beings with their own beliefs and flaws, the closer we will get to "the truth". 

7. Any time there is turmoil in the financial sector, the 'Big Bad Bankers' narrative returns to the headlines. 

The narrative usually goes something like this, "Bankers got greedy with people's money and lost it, and now Washington is bailing out Wall Street like they always do". Then there is an added line, usually to the effect of "we need increased regulation and oversight over these institutions which continue to act recklessly with the money of hard-working Americans". The biggest banks in the United States are certainly guilty of greed, mismanagement, manipulation, fraud, and likely a host of other crimes that the general public may never learn of. That being said, some of the commentary that I have heard around recent banking turmoil makes me question if people understand how banking actually works. There seems to be a general misconception that banks hold all of our money in a big vault underground and give it back to us when we ask for it. I wonder how many people realize that when we deposit our money in the bank, the bank keeps a small amount on hand, and then turns around and invests the rest. After all, how do you think your savings account grows year after year without depositing money in it? 

8. Because the banks invest our money in order to produce returns (for themselves and for us), it is important that there are strict regulations in place and complete oversight of operations. 

I do not disagree with that notion and I completely support making the big dogs play by the same rules and the little ones. The problem with that narrative in this most recent crisis is that it wasn't a lack of regulatory oversight on the GSIBs that caused this crisis, it was the relaxed regulations for the smaller regional and community banks the led to the collapse of Silicon Valley Bank and the impending instability of others. The United States has more banks than any other country in the world, all of which play an important role in fueling our economy. Until recently, it seems, these smaller banks have been not viewed as "systemically important", as they would say. Clearly, however, as the US government stepped in overnight to rescue the entire financial system after SVB failed, it would seem that these regional banks pose a greater systemic risk to the economy than we have accounted for. If the smaller banks are "too big to fail" just like the Big 4 (5 or 6), then wouldn't that make them systemically important? And what does that say about the fragility of our financial system? If a run on a regional bank like First Republic, which typically has lower reserve requirements than the big banks, is just as dangerous as a run on JPMorgan Chase or Wells Fargo, how solid is the ground we are standing on? And wouldn't that call for increased oversight on these smaller banks? It certainly would seem that way. 

9. It seems that the primary reason why universal regulatory standards have not been implemented across the banking sector is that, simply put, the smaller banks cannot afford to meet the same requirements as the larger banks. 

Not only are the financial commitments more of a burden to the regionals; so are the increased reserve requirements (which some would argue are not high enough even for the GSIBs). Smaller banks have to be able to lend a greater percentage of their deposits. This is what makes them profitable, but also what makes them more vulnerable to systemic (and non-systemic) risk. Therefore, a one-size-fits-all approach won't work when addressing this issue. That is not, however, an excuse to place all the blame on the larger banks without making any significant changes to how the federal government and the FDIC oversees the smaller banks. The past month has been a lesson to this country, and to the world, that when you ignore the little guys, it comes back to bite you. 

10. Disinflation is still the primary objective, and it should be. 

Perhaps after reading my comments thus far, you'd think I was in the camp that was calling for a pause at the last FOMC meeting, or even a rate cut. I am not; truthfully, I believe that even with the landscape being as shaky as it currently is, this is not the time to take a dovish stance on inflation. In the long run, rampant inflation poses are larger threat to the people in this country than a high interest rate environment targeted at disinflation (slowing inflation) and eventually deflation (reducing prices). We will all have to pay a price for achieving this goal, and it will involve pain on many levels, from the bottom-up. "The truth" as I see it pertaining to this situation is this; this is a correction, a bill that has come due, and now we have to pay it. Like it or not, the unemployment rate that we have seen for the past few years is well below average. Businesses have been hiring at a clip that is well above average, especially in the tech sector (and we have seen them beginning to reverse course already). If you know anything about statistics and averages, it is that given enough time, trends will revert to the mean. We've manipulated the economy to avoid this reversion - we've pumped money into the economy, propped up corporate profits, insured companies from losses, used tools to finance public and private debt, and promoted growth when we should have been promoting a more conservative approach to venture capital, credit, employment, and employee payroll. We've been riding a high, and now it's time to come back down to Earth. Will it be a soft landing for some? Maybe. Will it be a hard landing for those who are most vulnerable? Undoubtedly. This is coming, whether we deal with it now or kick the can down the road. Just like a bank run, this crisis can work like a snowball. The longer we let it run down the hill without taking the blow, the more it will gain steam. It's time to face this now, and do the best we can to brace for the impact. 

+1. A quick comment on the crypto space. 

If I am a newcomer to the broader financial system, then I am an infant when it comes to the cryptocurrency landscape. Quite honestly, I don't really know how Bitcoin or Dogecoin or any of the other coins are actually valued, nor do I truly comprehend how any of it is legal. Some people, especially those in my generation, believe that digital-based currency is the currency of the future. Crypto advocates swear by it and claim that it is as revolutionary as it is misunderstood. While I am sure that it has the potential to be as revolutionary as its pundits claim, in its current form, I can't say that I want to come anywhere near it. The crypto space has always been volatile and has been characterized by fraud and manipulation since its inception. I was recently reminded of Bitconnect, which ended up turning into a meme and a complete scam involving over $10 billion dollars. Since then, plenty of platforms promoting digital currencies have risen and fallen, and along with them a number of people have gone to jail (for a very long time). Perhaps this is the natural progression of something revolutionary being born (sometimes failure is a part of the road to success), and I'm missing out on a star being born. This could certainly be true; but when the downside risk is losing all of my investments with little to no recourse for realized losses, I struggle to find the appetite for jumping in, regardless of toted rewards. I will continue to comment on current events in crypto, but I doubt I will have any skin in the game for the foreseeable future.