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Are we heading towards an new financial crisis?
Mark to market changes since 2009, combined with the recent significant interest hikes, seems to make bank balance sheets "unreliable".
Mark to market changes broadly means that banks can have certain assets on their balance sheet, and the value of the asset is set via mark to model (usually meaning its marked down as worth face value).
Banks traditionally have a ton of bonds on their balance sheet, and a lot of those are governed by mark to model and not mark to market.
Interest rates go up a lot, which leads to bonds dropping in value by a lot (20% or atm more depending on duration).
However due to mark to model, this is not reflected on the balance sheets.
So what happens next? Banks are not stupid, they know they can't trust their own numbers, and they know they can't trust anyone else's numbers.
A large bank fails, regulators are frozen and undecided what to do - they know all of the above, and that their actions / inaction might lead to a cascading effect. Obviously all the market participants also know all of this, and the conundrum the regulators are in.
Game of chicken? Banks defect and start failing, or regulators step in and backstop everything.
Is this stable in any way? Can it be stabilized? What happens to interest rates now? (the once set by central banks).
Regulators don't seem frozen to me - they pretty quickly stepped in and guaranteed deposits even beyond the current limit of $250K. There's some question how many banks are in a zombie state - zero or negative assets if properly valued, but nominally positive and in no immediate danger of default.
I suspect many of these WILL need to be bailed out, as investors read the fine print on financial statements and do the math themselves. Nobody should buy shares in or bonds issued by a bank that's under water in real terms. I kind of wonder if AI and related data-handling technology will accelerate this - as it gets easier for big (and medium) investors to verify/recalculate balance sheets, "the market" should learn faster about what's true, and the EMH gets more true.
Is it stable? No, it never has been. It's dynamic and bank failure is a normal part of things.
Around two days from when they stepped in and the announced that all depositors would be made hole, pretty sure that was not an automatic decision.
I think that is the wrong decision, but they did so in order to dampen the instability.
In the long run this likely creates more instability and uncertainty, and it looks very much like the kind of thing that leads to taking more risk (systemic), just like the mark to market / mark to model change did.
And yeah sure bank failures are a normal part of things. However this very much seems to be rooted in something that is systemic (market vs model + rising interest rates)
I guess we can disagree on whether a few days to make a non-automatic (but directionally binding) decision is "frozen and undecided".
You're right that it IS systemic. Not just the divergence between collateral/accounting and reality of value, but the basic retail banking model may be doomed. In the old days before the '80s, it was reasonable to assume that depositors are mostly stable and naive, and withdrawals were mostly uncorrelated across depositors. This made it a good model for a bank to borrow short (demand deposits) and lend long (mortgages, long-dated bonds, and other illiquid investments). EVEN THEN, if the investments lost sufficient value, the bank was insolvent and had to be taken over by the guarantor, but with naive depositors that could happen on fairly long timescales.
As banks got more sophisticated in seeking a spread between their debt service costs (account interest paid and operational costs) and their investment revenue, and as regulators added and modified rules, banks got better at hiding risk, or at least in taking on risks that don't affect regulation. This seems like it's going to have the absolute obvious effect of surprise and loss when those risks materialize.
As depositors got more sophisticated, it's a LOT easier to withdraw for almost any reason - a mild hassle to switch to another bank for payroll and such, but not as overwhelming as it used to be. AND depositors got a lot more knowledgeable about the risks of an uncertain bank future - even with guarantees, there are delays and hassles if the bank gets taken over. Which reduces the timeframes to either ride out a temporary loss, or to wind down smoothly in a full takeover.
Sorry life happened.
Anyway, there is an argument behind me saying "frozen and undecided".
Stepping in on the 10th was planned, the regulators had for sure been involved for some time, days or weeks.
This event was not a sudden thing, the things that lead to SVB failing had been in motion for some time, SVB and the regulators knew something likely had to be done.
SVB where being squeezed from two sides:
Rising interest rates leads to mounting looses on bond holdings.
A large part of their customers where money burning furnaces, and the fuel (money) that used to come from investors was drying up.
Which means well before the 10th, everyone knew something had to be done, and the thing that had to be done was that SVB need a wet signature on an agreement to provide more capital to the bank. And the deadline was for sure end of business day the 10th.
They didn't get one, and the plan proceeded to the next step, and obviously the regulators already worked all this out in the meantime, including all the possible scenarios for what would happen to depositors.
So that fact it took 2 days to decide, yeah that was indecision.
Edit:
SVB died because they where technically insolvent, and had it not been for mark to model they would have been de jure insolvent (and a long time ago).
They could keep it going because they where liquid, but they where careening towards liquidity.
Obviously banks can loan money to keep the liquid, but that pretty much always involved putting up collateral.
But in the current environment, that is somewhat problematic:
Lets say you want to borrow $100M. But the collateral (assets) are trading at lets say 80, so you need $125M book value, but it gets worse, the usual haircut in such a situation is ~20%, so now you have to put up $156M in book value (give or take, this could be less or more, depending on the assets, and how the repro partner does risk assessment).
Eventually you go from being technically insolvent to de jure insolvent, unless of course you can stay liquid - and SVB could not, mostly due to the customer base.
And the big problem is, pretty much all banks are in that hole right now, they are all technically insolvent. Which means, should a systemic liquidity crisis arise...nasty and quick.
I mostly agree with your model - SVB and a lot of banks (don't know about "pretty much all") are medium- to long-term insolvent. It's deeply unknown whether depositors will stay long enough for the banks to become solvent again.
"Technically" is an interesting word - it masks the important question of whether there is a path to solvency. If depositors leave money in at a significant loss (that is, getting less for it than they could at a bank with better investments), that loss is the bank's gain and at some point the bank can roll it's portfolio over into better-paying and more valuable bonds, becoming solvent.
It's certainly true that the regulators don't have a plan to "fix" this - the losses have happened, there's no turning back the clock or dropping inflation back to the insane low levels of 18 months ago. I don't know that there CAN BE any plan to fix it, just acting to minimize pain as it unwinds.
At the end of 2022 all US banks had ~2.3T Tier 1+2 capital.[1]
And at year end (2022) they had unrealized losses of $620B[2]
Is it fixable? Sure, but that won't happen, doing that would be taking the toys away from bankers, and bankers love their toys (accounting gimmicks that let them lever up to incredible heights).
If Credit Suisse blowups it will end badly, so I don't think that will happen, that's just a show to impress on all central bankers and regulators (and politicians), that this is serious and that they need to do something.
So more hiking from the FED and ECB, until ECB hits 4.5% (4.0-4.75 is my range). The problem will start here, we have the most levered banks in the world and the structure of the EU/ECB lets some countries in the EU over extend their sovereign debt.
At that point things will start to happen. Some countries will start having a lot of trouble getting founding (the usual suspects at first), also the real economy will be in recession and tax receipts will start to suffer. Banks will have liquidity problems (recession in the real economy), putting even more pressure on sovereign bond prices (higher real rates).
And then I think it will be the usual, more papering over, free money to banks, even more leeway in accounting and lower rates.
Inflation will remain high, and when it eventually goes back down we are looking at 50%-100% total since Jan 2022 (so 25% to 50% drop in purchasing power).
That's pretty much my prediction from back in August 2022 (conveniently I did not write it down, I just talked to people).
But now I did, and boy do I hope that I am wrong.
I certainly wouldn't bet against that prediction. Modern (say, since 1980) finance definitely seems to be a series of conspiracies to engineer public risks for private profit. In theory, every transaction has two parties, so if someone loses a bunch of value, someone else gained it. In the case of inflation changes, those gains went to debtors, especially to long-term debtors who didn't immediately have to refinance at higher rates. The Treasury is one of them - their long-dated bonds went way down in value, but they didn't have to give back any of the purchase price.
Unfortunately, guarantees create a ratchet effect - there's no clawback for past years' bonuses, dividends, or un-justified expenses, so the taxpayers eventually end up paying for all the value extracted.
I wish we could just do away with the guarantees - have the fed offer retail post-office-like banking services, fee based and at a loss, with strong guarantees and no profit motive nor ability to seek risk/alpha. And un-insured (or partly-insured) higher-paying investment collectives, with some spread between interest and services to depositors and return on investments.
It won't happen, of course, until the US government really comes to grip with it's debt problem, and the firehose of money to the private sector has to dry up.
Do the unrealized losses matter if every bank keeps about the same total deposits? Since when someone withdraws or spends from one huge bank, they are just transferring funds to an account usually in another huge bank, often the same one.
So the bank doesn't need to touch the bulk of it's holdings.
SVB failed on an overnight demand for 40 billion or 20 percent of its deposits. And due to their narrow user based it wasn't getting inflows from scared customers pulling out of their banks.
Yes and no, they don't matter until you need liquidity. Which as you correctly point out is what happened to SVB.
Banks do not have a lot of cash on hand (virtual or real), in fact they optimized for as little as possible.
Banks also do not exist in a vacuum, they are part of the real economy, and in fact without that they would be pointless.
Banks generally use every trick in the book to lever up as much as possible, far far beyond what a cursory reading would lead you to believe. The basic trick is to take on risk and then offset that risk, that way you don't have to provision any capital for the risk (lots of ways to do that).
Here come the problems:
The way risk is offset is not independent from the risk, they are correlated in such a way, that when systemic things start to happen, the risk offset becomes worthless and the risk taken becomes real.
Banks also suffer real losses that cant be hidden, and eventually those will start to mount, so far the real economy is ok, but eventually recession will hit (central bank are hell bent on fighting inflation, so rates will continue to go up).
That will put a strain on liquidity. Banks can handle that, they can always get cash for their assets in the form of a loan (repro, 3 party repro, discount window etc).
However the book value on a lot of their assets is way higher than market value, so that means pledging more book value than they get back in cash (a lot).
The assets they hold (bonds) return LESS than what the cost of funding is, that is already a reality and will only get worse (so negative cash flow).
This spiral will continue, and all the while the real economy, the one that provides a lot of liquidity to the banks is going to slow down more and more, so velocity of money slows down, that is also a big drain on liquidity.
Eventually something will blowup, and with how everything is connected, that can very well lead to a banking system Kessler syndrome moment.
So yeah sure you can ignore the issues of solvency, that is until lack of liquidity smacks you over the head and tells you that you are bankrupt.
And at any time the Fed can just lower interest rates or basically (I don't claim to understand the how) spawn more money. (Something something interest rates and fractional reserve ratios and open market operations) Since while we have all these fancy rules isn't a US dollar just kinda a crypto coin or share backed by the US government? Which means buybacks or new issues are both allowed, and as a sovereign the US government doesn't really have to obey any rule in doing so. (It has kinda a gentleman's agreement to keep it reasonable)
So they can essentially declare they have infinite money in an account, and send money to whichever bank has a liquidity issue in 1B increments if they want to.
Letting a bank fail or the system fail is a CHOICE. I thought it was in order to punish wealthy depositors who choose risky banks.
They can't lower interest rates, they are trying to bring inflation down.
You can't just keep spawning money, eventually that just leads to inflation. We have been spawning money like crazy the last 14-15 years, and this is the price.
Sure they can declare infinite money in a account and then go nuts, but that just leads to inflation.
Anyway, go read my prediction, which is essentially what you propose to some degree, and the entire cost will be pawned of onto everyday people (lots and lots of inflation).
I was just figuring they would "spot" banks with liquidity issues and get the money back later.
For example crediting a bank with 10B in treasuries with 10B liquid cash now, with a term sheet that when the 10B treasuries vest the government gets back the money.
This doesn't inject much new money or cause more than negligible inflation.
Or yeah I guess allow the bank to exchange treasuries for cash at book price. But only for banks on the edge of solvency. (Creating an incentive to be riskier next time but what can you do)
crediting a bank with 10B in treasuries with 10B liquid cash now
I have no idea what you think happens here, but that is literally 10B in new money.
It's removing the current market value of the 10B Treasury note.
Would you like to change your answer?
Where did the 10B in cash come from?
10B was given to the bank, and in exchange the bank encumbered 10B in treasuries and promised to give 10B back when they mature.
So where did the 10B come from? The treasuries are still there.
Before: 10B in treasuries
After: 10B in treasuries and 10B in cash (and 10B in the form of a promissory note).
So again, where did that 10B in cash come from?
The feds. Note the basis for my statement is that Treasury note you can think of as an exchangable paper you can barter for its face value of 7B or so.
So by the Fed giving 10 billion to the bank and taking the paper they are adding (10-7) 3B in new cash.
I may be totally wrong because I don't understand all the mechanics, derivatives, and so on that this operation actually involves.
I got my entire foundation torn down, and with it came everything else.
It all came crashing down in one giant heap of rubble.
I’ll just rebuild, I thought - not realizing you can’t build without a foundation plan.
So all I’ve ended up doing was shift through the rubble, searching for things that feel right.
Now I am back, in a very literal sense, to where I all began, so much was built, so many things destroyed and corrupted, and a major piece ended and got buried.
And all I got is “what the eff am I doing here?”
The obvious answer is “yelling at the sky demanding answers” and being utterly ignored.
I guess as per usual it is all up to me, except I don’t know how to rebuild myself……again.
F…..
Alone, wandering the endless hallways of this massive temple of healing.
Feels empty and eerily quiet, and yet I know there are 100’s of people around, most sleeping, some watching, a few dying, and close by someone being born.
Yesterday feels like ages ago, orbiting Saturn on morphine, billions of miles away from the excruciating pain that brought me here.
The daze is gone, and so is the morphine induced migraine, I feel fine, great even, and guilty.
But home I may not go, so I wander these deserted hallways, pondering the future, will it be there for my kids?
AI x-risk is convergent.
Believing otherwise is like hurling yourself at the ground, convinced you'll miss and start flying.
An idealized Oracle is equivalent to a universal Turing machine (UTM).
A self-improving Oracle approaches UTM-like behavior in the limit.
What about a (self-improving) token predictor under iteration? It appears Oracle-like, but does it tend toward UTM behavior in the limit, or is it something distinct?
Maybe, just maybe, the model does something that leads it to not be UTM like in the limit, and maybe (very much maybe) that would allow us to imbue it with some desirable properties.
/end shower thought
I recently came across a post on LinkedIn, and I have to admit the brilliance of the arguments, the coherent and frankly bulletproof ontology displayed, I was blown away and immediately had to do a major update to p(doom).
I think that the magnitude of the AI alignment problem has been ridiculously overblown & our ability to solve it widely underestimated.
I've been publicly called stupid before, but never as often as by the "AI is a significant existential risk" crowd.
That's OK, I'm used to it.
-Yann LeCun, March 20 2023