History Repeats
One thing I read this week was this analysis from famed investor John Hempton.
While reading it, it’s easy to forget that it was written in 2007 and not last month.
Interestingly, although correctly identifying the problems in the subprime mortage market, he states his opinion at the time that there is no reason to believe there will be contagion into other areas of lending (prime mortgages, for example), that the big banks will likely make it through unscathed while some regional banks concentrated in California or Florida with outsized exposure to subprime mortgages might not, and that the bigger risk for the banking sector to his mind was interest rate risk, not credit risk.
Of course, a year later we were in the throws of the Global Financial Crisis and it was credit risk at the center of it, not interest rate risk.
Today, 15 years later, Hempton is finally right, and it is interest rate risk that is causing stress on the banks (to be fair, he does mention in his post that the problem with betting on these things in markets is that you can ultimately be right and still lose a lot of money because sometimes events take decades to play out).
One key idea that he dissects is the separation of loan origination from lending (i.e. credit underwriting) which was made possible by the invention of loan securitization. The most common form of loan securitization is the cash flow from a pool of mortgages being packaged into a portfolio and having tranches sold off as mortgage backed securities or MBS, but various other forms of asset backed securities or ABS exist, including credit card loans, toll roads, record royalties…anything with a cash flow attached. Of course, MBS were the instruments that were at the heart of the GFC in 2008-09.
At the heart of the instruments that were at the heart of the financial crisis was a misalignment of incentives. When the act of loan origination was separated from the act of lending, the loan originators, who were commonly regional banks, became incentivized to simply originate as many loans as they could because that’s what they got paid for. They were no longer concerned with the ability of the borrower to pay back the loan, that would become someone else’s problem.
The change in dynamic is captured nicely in the following observation: “Borrowers used to dress in a suit to visit the branch manager. Now the banker dresses in a suit to visit the borrower.”
The thing about risk though is it cannot be erased, only transformed and reallocated, usually to someone who doesn’t understand it and ends up holding the bag.
So, predictably, the credit quality of new loans kept on deteriorating until the whole edifice collapsed. The lenders, who were now large pools of foreign capital instead of the regional banks, managed their credit risk by slicing and dicing the mortgage portfolios into tranches of high and low credit and interest rate risk. For example, in a portfolio of 1,000 mortages, certain lenders would get paid back out of the first 500 borrowers to make their payments and that tranche would have low credit risk, and other lenders would get paid out of everyone that made their payments beyond the first 500 to make their payments, and that tranche would have higher credit risk.
So instead of anyone actually underwriting the credit quality of any of the loans, the credit risk was managed by statistical models. And the thing about models is they work until they don’t.
The takeaways are 1) always be on high alert for and highly suspicious of any situation in which there are misaligned incentives and 2) economic reality eventually asserts itself.
Economic Reality Eventually Asserts Itself
Fast forward to today, and economic reality is asserting itself on banks that took too much interest rate risk, the very risk Hempton identified in 2007.
You can hide losses in HTM securities on the balance sheet for awhile, but when you have to sell those securities to meet deposit outflows it doesn’t matter what you have them marked at on the balance sheet, it matters what you can actually sell them for.
Where else is economic reality eventually going to assert itself?
On VC and PE funds, who thus far have avoided marking their portfolios to market.
On office real estate investors, who in the last three years have been hit with two cataclysmic events in first covid and then interest rates being hiked from 0% to 5% in a year. Offices are empty and as soon as leases expire and/or buildings need to be refinanced, watch out below.
Because economic reality eventually asserts itself, why don’t our accounting rules attempt to reflect the economic reality of businesses? Again, you cannot erase risk, you can only transform and reallocate it, often to unsuspecting bagholders.
In the case of Silicon Valley Bank, those unsuspecting bagholders were about to be despositors before the FDIC bailed them out. Now the unsuspecting bagholders are the slice of the American (and, really, global) public that do not own financial assets (typically the poor and the young among us), and eventually the slice of the global public that owns U.S. treasuries, because the losses are getting socialized in the money.
A Country is Not Its Government
I’ve been rather critical of our government lately so I want to make one thing clear. These thoughts are borrowed from one of my favorite twitter follows, but I think they’re important to share.
A country is not its government. You can love a country and be critical of, or even despise, its current government. Governments and regimes come and go over the centuries, but the people and the country persist.
Germany is not, and never was, equivalent to the Nazi regime. Spain has been governed by monarchs, dictators, and democracies, and through it all, it is Spain.
In fact, it is often under the cloak of patriotism that terrible leaders are allowed to do terrible things. Like, for example, the Patriot Act. And more pressingly, the Restrict Act (TikTok ban bill) that I mentioned last week.
I love America and I think the people here are wonderful.
I also think the current regime is teetering on the edge of belligerence and overreach.
And when it’s gone, America will still be America, and it’s people will still be lovely.
The Case for $1 million BTC
Doug Clinton of Deepwater Asset Management (formerly Loup Ventures) articulates the case for $1 million BTC in 90 days on his Substack The Deload, as Balaji Srinivasan has now famously bet will happen.
He makes the point:
No chance was my initial reaction to BTC at $1 million in 90 days, but it’s always valuable to consider what conditions would make the unlikely happen. That’s the basis of extraordinary investment opportunities through contrarian thinking — finding the unlikely thing that actually happens.
He goes on to reason that while imminent hyperinflation and $1 million BTC is highly unlikely, there does exist a plausible scenario that could conspire to push the price of BTC up dramatically in a short period of time.
Paradoxically, if the U.S. Government continues to choke off access points to crypto as it has already boldly been doing, it could result in low liquidity for the asset class which is actually a more favorable environment for wild price swings:
As we’ve said here before, market prices are not set by aggregate demand but by the marginal buyer and seller, meaning the most bullish buyer willing to pay the most and the most bearish seller willing to accept the least. Restricting access probably means two things: The most bullish buyers will still find a way to buy Bitcoin and the most bearish sellers will exit before they get trapped.
Bullish buyers and sellers trapped in a hard-to-access marketplace creates the possibility of a demand vacuum where only buyers willing to pay a high price find access, but the ecosystem is only filled with bullish owners hesitant to sell. The net result may be enhanced scarcity that drives up prices, perhaps aggressively.
Limited access to crypto seems the most reasonable spark that propels BTC to crazy prices in 90 days, and it doesn’t depend on hyperinflation to happen.
Combine this with the powerful narrative of “they’re blocking the exits, they don’t want you to own crypto” that has arisen and would only grow more prevalent in such a scenario, and you could have a recipe for the elusive God Candle crypto traders have been waiting for.
In Case You Missed It
Politico has more:
Big Government and Big Banks working hand in hand to throttle an innovative, nascent industry that at its core is about increasing access to the financial system for all and devolving power from the hands of centralized authorities and actors to the people.
Scourge of crypto? More like the scourge of our country.
I sincerely hope this gambit backfires in the biggest imaginable way: her losing her seat and Boston becoming a crypto hub.
On models:
"In buying longer-term investments that paid more interest, SVB had fallen out of compliance with a key risk metric. An internal model showed that higher interest rates could have a devastating impact on the bank’s future earnings, according to two former employees familiar with the modeling who spoke on the condition of anonymity to describe confidential deliberations.
Instead of heeding that warning — and over the concerns of some staffers — SVB executives simply changed the model’s assumptions, according to the former employees and securities filings. The tweaks, which have not been previously reported, initially predicted that rising interest rates would have minimal impact."
https://www.washingtonpost.com/business/2023/04/02/svb-collapse-risk-model/