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Longtime Epsilon Theory readers know that I am a huge fan of Cixin Liu’s Three-Body Problem trilogy. In fact, the eponymously titled first volume – The Three-Body Problem – is the title of one of my more popular ET notes ever. But it’s the second volume in the trilogy – The Dark Forest – that is my personal fave. I think that’s because The Three-Body Problem refers to a famous physics puzzle while The Dark Forest refers to a famous game (in the game theory sense of the word), and I am a game-player at heart.
Here’s the game. You are a hunter, well armed with your trusty rifle, and you are a good shot. You are very hungry, but there is very little game to be found in these woods where you hunt. And now the sun has gone down and you find yourself in a dark forest at night. It is pitch black. You know that you are not alone in the forest, and that in fact there are other hungry hunters out there, also well armed and also good shots, and given the lack of game to be found you suspect that another hunter might want to shoot and kill you to remove a competitor. You rummage around in your pack and you feel what you know is a powerful flashlight. You pull it out.
Do you turn on the flashlight?
It’s the only way to track and find a deer or some other game to hunt, right? If you don’t turn on that flashlight, you will stay hungry. And cold. You will be miserable sitting out there in the middle of that dark forest, hoping for a sunrise that – given how crazy the physics of your world has become – you’re not sure will illuminate anything. But if you DO turn on your flashlight, then all the other hunters in the forest will know exactly where you are, and you do not trust their intentions. It is not lost on you that all of the hunters will have flashlights in their packs, and none of them have turned on their flashlights. But maybe they won’t notice you. Maybe they’re all nice hunters and won’t mind you doing a little night hunting and taking down one of the few remaining game animals in the forest. Hmm, right. On second thought maybe you’ll just sit out there, hungry and cold, waiting for a sunrise that may be a long time coming.
The equilibrium outcome of this game is that no one turns on their flashlight until they are so near death from hunger and exhaustion that they figure they’ve got nothing to lose, that in all likelihood they’re going to die anyway, so why not go for it. Flashlights are used only by the dying and the desperate. Which of course makes them even easier pickings for the other hunters, who are only to happy to dispatch a competitor for the limited food supply. In a forest full of self-interested hunters, the dark forest stays dark.
Our financial world today is a dark forest, and every big investor, every hedge fund, every bank is a hunter. We all require cash money (liquidity!) to stay warm and happy, but liquidity – which used to be oh-so plentiful in a zero interest rate world – has been harder and harder to find now that
Mother Nature the Fed has plunged the forest into the icy darkness of higher for longer interest rates after promising warm sunshine forever. Some of the hunters – the ones who need a LOT of liquidity to satisfy their insatiable balance sheet hunger, let’s call them banks with more than $100 billion in liabilities (i.e., deposits) for argument’s sake – are getting very, very hungry indeed. It’s not the biggest of these banks who are very, very hungry. No, the biggest of the banks have all been blessed by Mother Nature with all the food/liquidity they could ever eat. The biggest hunters can gorge themselves all they want, no matter how dark and forbidding the forest becomes. It’s the pretty-big banks, the ones who have gargantuan appetites to satisfy their liabilities but aren’t quite big enough to be blessed by the Fed with an infinite food supply, who are in trouble.
Silicon Valley Bank turned on their flashlight. They went looking for liquidity by selling some assets at a loss. They went looking for equity capital to make up the difference on those losses. And as soon as they turned on their flashlight, as soon as the rest of the financial world saw that they were weak and exhausted … wham! other hunters shot them dead. For some hunters, a shot is selling the stock short. For other hunters, a shot is publishing a credit downgrade. For other hunters, a shot is pulling out their deposits, encouraging others to do the same and creating a bank run. These hunters aren’t bad for doing this. It’s their nature. It’s their self-interested nature. And SVB made a lot of stupid mistakes that put them in a position of liquidity hunger and exhaustion so that they felt they had no choice but to turn on the flashlight. That was their nature, too. I’m not going through this exercise to assign blame.
I’m going through this exercise to describe what IS.
The Dark Forest is a miserable place. It is an unfair place. The hungry regional banks who are out there now aren’t evil or bad or stupid hunters, or at least not to the degree of SVB. They didn’t make liar loans and poorly underwritten sub-prime mortgage loans and all the other terrible mistakes of the years leading up to the Great Recession. They were promised warmth and sunshine for all their days by Mother Nature, and they hunted for all the good, safe stuff that Mother Nature wanted them to hunt, like Treasuries and agency MBS and munis. But in the process, the pretty-big regional banks became fat and sloppy hunters. They developed larger and larger appetites, requiring them to hunt/purchase more and more game/assets to satisfy their hunger/liabilities. As the French would say, l’appetit vient en mangeant. The appetite grows in the eating.
But then Mother Nature took away the warmth and sunshine. Mother Nature gave them a Dark Forest instead, where the liquidity went away as interest rates went up, and all that was left is the hunger. And a lot of hunters waiting in the night with their guns.
Mother Nature can’t solve the Dark Forest problem without making everything worse. We’ve come off a zero interest rate world for a reason – namely the world-destroyer of inflation – and if you go back to easy liquidity and lower for longer interest rates then you’re just exchanging the Dark Forest for the Burning Forest. We all lose, including those big banks blessed by the Fed, including – ultimately – the Fed itself.
There’s only one way to solve the Dark Forest problem. A group of the biggest hunters, large enough individually and as a collective so that no other group of hunters will challenge them, have to turn on their flashlights and ring the hungriest of the regional banks. They have to go hunting for the regional banks. They have to share their food, i.e. liquidity, with the regional banks. They have to protect the weak and exhausted regional banks from the other hunters who – not out of evil but out of their self-interested nature – would shoot them dead.
I think that’s exactly what today’s announcement by JP Morgan, Bank of America, Citi, Wells Fargo, Goldman Sachs, Morgan Stanley, BNY Mellon, PNC, State Street, Truist and USB did. I think that these banks’ collective deposit of $30 billion in uninsured accounts with First Republic is the first step in solving the Dark Forest problem of the American banking system.
I call it a first step because there are an awful lot of other hunters out there, and there are an awful lot of hungry, hungry regional banks. The hungry regional banks are going to have to get thinner, meaning they’re going to have to shrink their balance sheets, meaning that they’re not going to have a stock price anywhere near what it used to be. Mother Nature is going to have to be tougher on the pretty-big regional banks who got so fat and sloppy. No more unfettered appetites even when it’s all warmth and sunshine. We still have a two-tiered system of banks, where the big and pretty-big hunters get far more protection and the small hunters pay far too much for what little protection they get. The big banks who are shining their flashlights in defense of First Republic can’t stop here. And they can’t defect from each other.
It’s a tall order.
But tonight for the first time in a long time I see a way out of the Dark Forest for all of us.
Thanks for the apt metaphor. Investors need to remember the adjectives of hunger and desperation translate into rising funding costs, falling net interest margins, tightening lending standards and greater credit losses for those on the outside looking at the SIFI’s. The fundamentals in the modern banking world are worse, and particularly in Europe this was a very crowded long trade. It was just reported that INFLOWS into the US bank regional ETF, KRE, were a record in the past week. The muscle memory of how to invest in a ZIRP world with endless backstops hasn’t changed…yet.
Love a good analogy. I enjoyed the read. Banks are suffering from what every business will suffer from eventually. Inflation created the need for interest rate hikes, and as cost structures adjust to the new inflation environment and new interest rates, all is fine as long as revenue grows in line with costs. But once pricing drops due to demand hits from fighting inflation, the lagging cost structure increases wallop the business. It already happened with used vehicles. Used car dealerships got slaughtered second half of last year because their costs (cost of inventory) adjust rapidly to the market. Automakers have a slower adjustment but are about to feel it. And banks had a surge in demand for deposits with stimulus money and did well on it, but now costs are rising but revenue is not (interest income). Every industry will have its turn, and earnings will eventually reflect it. The transition from inflation to not inflation is super damaging to businesses. What seems especially pernicious about banking is the counterparty risks between industry participants. Car dealers that go bust don’t have significant financial arrangements with other car dealers. That is where a really good analogy for the industry in real life is helpful. So, yes, the hunters with ample food are trying to lead, but how much food do those hunters have? And at what point do those hunters have to turn on the other hunters in the dark forest because the big hunters are worried about their food? I especially agree with your statement that the alternative of loosening monetary policy is just burning the forest down. The Fed knows it can’t reverse because inflation could get sticky and the Fed would lose control. Great stuff Ben.
The market is grappling with how confident to be in that statement. The Fed has its political mission of keeping an eye on inflation, employment, and financial stability. It’s behind the scenes purpose is to help the banking industry. Whether that is not raising interest rates for quarters after inflation took off, not actively supervising a technically insolvent bank that had outrageous deposit growth and inadequate risk controls, or possibly blinking on the inflation mission during a bank run.
I am not highly confident that the Fed statement and press conference messaging next Wednesday can fix all of these competing narratives at once.
Taking the analogy of the ‘Dark Forest’, Ben you express the hope that you see a way out of the American Dark Forest. However, what if in this interlinked world, the American Dark Forest is possible only part of the Dark Forest? Hunters / forces from other adjacent parts of the Dark Forest (Europe?), despite the measures taken, overwhelm the place with unfortunate outcomes?
Oh that’s the risk here, for sure! Just like it was for J Pierpont Morgan in 1907 when he tried to rally his peers to prevent a rolling series of bank runs. The difference today, and I think it’s a difference that makes all the difference, is that JP Morgan didn’t have a central bank to backstop the effort in 1907 and today they certainly do.
Don’t forget fighting climate change and promoting racial justice……
Can I fast forward to the end of the game and open up my bank account with Mother Nature?
Perfect analogy! Going a step further – doesn’t the question of whether cash deposits are safe for all depositors have to be answered? If only systemic banks are “protected” then the hungry hunters are carrying muskets instead of center-fire rifles.
Hahaha! The road to CBDC is paved with good intentions …
Yes, 100%. I’d favor insurance on all deposits up to $5m. Over that, you take counterparty risk with your bank.
Yellen seemed more “deer in the headlights” vs resolute solution secured in her testimony at the Senate yesterday. This can’t stay ad hoc, they have to come up with a uniform rule or the deposit flight upstream will continue.
I enjoyed reading the piece. I could see the bank managers shivering. But you only looked at the banks’s liabilities. The problem however stems from their assets. Whether they did not hedge their rates exposure or did have too fastly growing credit portfolios. In the end it is an equity and not a liquidity problem. With credit standards tightening increasingly fast in the high volatility environment and recession risk rising, banks will suffer substantial write downs bleeding equity. Let’s wait for the weekend and whether CS will still be there on Monday, but the outlook for the banking world is grim. As the example of CS shows, even 50 BN CHF liquidity does so not provide much comfort.
Yellen is a disaster. She’s the Tony Fauci of Tim Geithners.
Honestly I don’t think that’s right. The systemic rot in the banking system today, imo, is not on the asset side (I mean, we’re really gonna get worked up about owning Treasuries and munis and agency MBS?) but on the liability side, where the fickleness and skittishness of large deposits creates existential risk for every non-GSIB bank.
There’s a name to help revive all of those GFC memories! Dimon is a scarred survivor of the gunshot weddings, and forced capital raises of that era, as are his SIFI peers. They can’t swoop in as they are already pushing deposit and market share limits. And, given the shareholder capital that was vaporized in the endless fines I doubt their boards would willingly approve. So, the game plan used last time has to be adjusted. This is problem needing solutions on the asset and liability side. The depositors are in a much better position both politically and in the cap structure.
Owning Treasuries and MBS without proper risk management creates a whole on the asset side. But you are right, without deposits fleeing, you may be able to weather this storm if the position is in a HTM book. Nevertheless when I look at balance sheets of several of the US regional banks or European peers and see that commercial real estate exposure or consumer credit books have doubled within 3 years (as there was cheap funding via deposits) imo I would be surprised if there was no reason to worry about asset quality.
Doesn’t really engender the “warm and fuzzies”.
Agree 100% on CRE and consumer credit.
The brutal verdict of the market will force a more comprehensive solution. Investors with millions of their own capital at risk won’t be satisfied with that very wishy-washy answer. Does she really think that emphasizing not just a majority, but a super-majority of FDIC/Fed bureacrats has our backs?!
Edit: I was intending to reply to Rob’s post of the Yellen video.
Watching Yellen answer questions at that Senate hearing made me suspicious that perhaps all those speaking fees she raked in over the years weren’t exclusively because people wanted to hear her share wisdom and insight.
I should add, someone on Twitter posted this sentence and I do not know if it was original to them or if it has a different origin, but it perfectly captures the discussions about what to do about fixing this kind of problem:
Today’s problems are from yesterday’s solutions.
I thought that summed it up nicely.
Treasuries and agencies, maybe not. Munis, actually yeah I think so. Munis (meaning the actual borrowers in this instance, not the asset class) are in their own Dark Forest themselves. They have also been promised eternal warmth and light and they’ve gone and added tremendous infrastructure to their balance sheets ever since the “shovel ready” stimulus days. That infrastructure has operational costs. Check out the labor cost portion of the consolidated operating margin line item and days cash on hand for your average hospital bond. The Munis are hungry…
We’re now in the dark time where that sunlight has gone away. Rates are much, much higher. Borrowing costs are much, much higher… and so are operational costs. The maintenance of that aging infrastructure is a problem. The rural areas have had a huge influx of new residents over the past 10 years, a lot of which was people fleeing high tax cities and flocking to smaller cheaper towns. Those budgets were stretched thin, but now they can’t get cute with finances and bury some of their operational costs in bond offerings and cheaply cover them over. They too can’t turn on the flashlight and do a new bond issuance or investors/rating agencies/etc will shoot them dead. A fresh look under the hood for new bond issuance at current rates could create cascading effects.
I don’t know how you ring fence the munis.
I agree with Ben’s take on raising the covered level to $5 million. And, before the gut reaction is MORE BAILOUTS! There are some things that should result if that happened.
$5m per individual, $10m for joint, $5m for corporation?
Also, if the insured amounts go up to your suggested $5m, do you remove the language that allows for uninsured depositors to be made whole in case of systemic risk as happened with SVB? Or still leave that provision in?
Oh I agree with that 100%! Still riding some of the Covid money high in a lot of communities, but a hard rain is gonna fall here, no doubt.
I think the “systemic risk” designation for SVB was purely to allow the FDIC to run a process that didn’t require them to favor bids that had zero backstop facilities.
F’n A Cotten! F’n A.
That’s pithy brilliance.
If you want to open an account these days with Mother Nature you actually …can. For a (short?) window of opportunity you can just go to a Mother Nature’s branch of SVB!
Excellent game theory metaphor yet current steps won’t solve the too many weak bank problem. Mother Nature should immediately takeover all the marginal regional banks at once while (already) backstopping depositors. No other country has thousands of regional banks. Why do we? Mostly politics. Politicians and political influencers use small banks as personal piggy banks and money laundering operations. Mother Nature after taking over the marginal banks should then outline bank consolidation across the country. Four or five primary money center banks are all we need to compete globally. Otherwise, every recession the weakest bank flashlights will come on & panic & instability will ensue. This cycle proved SVB, FRB among many others, cannot compete against money center banks without taking inordinate and essentially unsustainable risks. Buffett’s oft quoted observation comes to mind: “we find out who is swimming naked when the tide goes out.”
Lastly, my suggestions above reflects what is politically possible. Personally, I’d much prefer letting all the uninsured depositors lose those deposits and the mayhem that would ensue. The real Mother Nature, not the Fed, could solve the inefficiencies in short order. The complacency of SVB customers is the root of the problem, but God forbid we hold the public accountable. The Fed instead has stepped in earlier and more massively in each recession. ‘Moral Hazard’ is more like ‘Existential Hazard’ at this stage. Fortunately, for us in the game, the Fed, unlike Mother Nature, can just add zeros.
Once there is convergence on a single store of value, it may be that a Ponzi scheme will work.
If Charles Ponzi could have issued the medium of exchange as needed, what would the practical limit be ? Every loss of confidence can be met with new issuance.
The limit would be that the allocation of goods and services would lack competitive rationalization in a market. What is a market lacking functioning price mechanisms ?
Is the market the last McGuffin ?
Once again we have been fooled and this time by SVB customers crying wolf. I don’t think the rules could have been clearer. Your deposits are insured up to 250k after that either use a money market or another bank. Is it that hard? If SVB in their loan documents or some other fashion state that you must keep more thank 250k in their bank, get a lawyer and go to the SEC and or FDIC and say “foul”. If we keep “making whole” those who don’t deserve it the rest of us will be paying for it. Entities must fail or we all pay the cost for the gambler’s debts.
Yes, that is nearly impossible if you are running annything other than a very small business. It is hard enough to focus on growing a small business; we can’t stifle the economy by forcing every SMB to spend inordinate amounts of time trying to keep their cash safe at REGULATED institutions.
It’s not a failure of law, it’s a failure of regulation. Hold them accountable not the customers who trusted in them.
Bank risk management sits firmly at the intersection of contractual cash flows and the opaque facets of customer behavior. The buffer for uncertainty lies in levels of capital, liquidity management practices, and margin management.
Contractual cash flows do what they do, because that’s what they do. There may instances of disruptions, but over time they are pretty manageable after considering any associated optionality.
Customer behavior can be tough to fully understand and occasionally goes through periods that would make Mandelbrot proud. The key is to diversify exposures into multiple books of business that are non correlative in behavior, across many scenarios. This is not easy, but bankers need to strive to think and manage this way…
In the dark forest, you want to find your pack of ghillie-suited hunters and band together to manage through the moment. Time needs to pass to smooth customer behavior and offset contractual cash flows.
UBS goaded into backstopping CS for a nominal equity price tag. I am watching the press conference and the first three questions from the press would be charitably described as “hostile”. Early messaging is trying to describe this as “Not a Bailout”. It will be interesting to see if the CoCo’s are converted into equity and take a bath. So far, the reports indicate they are trading higher. UBS’s credit risk pricing is widening.
Edit: I see one headline that the $17 billion in CoCo’s have risen sharply and another saying they are worthless! Financial crisies are “fog of war” to navigate.
I imagine being counterparty to CS and facing a doomsday scenario helped encourage the management of UBS to swallow that pill.
It saves the “American banking system”, but doesn’t it zombify First Republic & the regional banks? Maybe that’s the intention, dragging their death out over time as to stave off the panic, prevent the bank run, but they are effectively dead to shareholders. If your management at any of these banks, you’re trying to find a way to exit ASAP. And don’t they need to come out with the zombie prop fund for every other regional bank by 7am tomorrow morning?
Now a tiff between European and Swiss bank regulators about how the AT1 (CoCo) bonds were treated in the backstop/bailout of CS. This is a $275 billion market that grew out of the capital needs of the European banking system post-GFC. Most would expect equity to be first loss before bonds, tell that to the $17 billion CS holders. How does an investor price the remainder of the market when the local gang meted out its decree to protect its national champion. Another security where they decide how it works when things get real.
This looks to me like the very definition of losing the meta game. Zero out the AT1 people, sure, that’s the risk they signed up for. But bypassing them to give equity holders anything other than zero is pretty egregious and absolutely murders the market for CoCos for years to come. So now any bank that needs to go get additional funding via a CoCo is going to find the terms the market will accept to be untenable. This was a short term solution that creates a gigantic problem like five minutes later.
Agreed, bailing out the equity holders is… wild!
The corollary to your earlier admonition that Today’s problems are from yesterday’s solutions.
I loved Groundhog Day, and the Superbowl commercial spoofing it. It is tiresome regarding global bank backstops without consequences.
Speaking of munis, looks like FRC had 60% of its securities portfolio in munis …
First Republic had just $11bn eligible for Fed’s new facility
The bank held nearly $20bn of municipal bonds, representing over 60% of its securities portfolio
That explains the need for $30BB in deposits from other institutions.
Honestly I think this was the functional equivalent of zeroing out the equity, basically the same thing as $2/share for Bear. Only difference is that I’m sure they’ve papered this well enough so that it doesn’t end up being $10.
On the CoCos … I remember when this was launched it seemed like such a strange place in the stack. My sense is that the stress right now is contained to the Snr/Sub spreads, which is fine? ish? But we’ll see.
My working theory… JP Morgan would like to buy First Republic especially their advisory business as it would fit in with their own advisory business.
They face two issues… 1) last time they bought (were forced to buy) a firm (WAMU) they got a good price but were sued several years later for the sins of WAMU and 2) unlikely regulators would approve a merger with First Republic.
What to do? 1) Keep First Republic alive so the asset remains intact and 2) work the back channels to get a fair price and no resistance to the merger.
Failing that they put themselves in a position to buy just the advisory business in a liquidation.
Leave it to Bloomberg’s Matt Levine to make other critical points about Modern Banking. I pasted the important parts of today’s column. For those bored with the basic idea that banks f#cked up, regulators weren’t watching, executives kept gains anyway, and the public stepped in…Again; unfortunately, there is more!
Main points are that laws that theoretically govern large banks are more “suggestions”, the suggestions get changed in unpredictable ways during a “crisis”, and actors with no economic interest in the securities you own tell you when it is a crisis. All of those involved in the ecosystem will bald face lie to your face when they need to with no consequences. And, yet investors still line up to buy bank stocks…
Rule of law
An uncontrolled bank failure is very bad for everyone. Banks are not generally constructed in such a way that they could withstand all their money fleeing at once: If there is a run and all the depositors take their money out at once, the bank will be forced to sell everything hastily and will probably end up without enough money to pay back the depositors, leaving other creditors and shareholders with nothing. At a big international bank that is active in the capital markets, this problem is probably worse: Derivatives counterparties and overnight lenders will flee, traders will bet against the bank’s positions, markets will be stressed and the bank will probably collapse rapidly and in a way that leaves too little value for everyone.
If you are a national bank regulator and one of your biggest banks seems to be teetering on the edge of an uncontrolled failure, here are some things that are generally true:
This is all a pretty standard playbook for, you know, once-a-decade-or-two banking crises, but it is not really written down anywhere, except eventually in the memoirs of central bankers and regulators. Mostly for good reasons, there will not be a law saying, like, “if the national bank regulator is worried about a 20% probability of an uncontrolled bank failure, she can pick a different bank and force it to buy the struggling bank over a weekend, and name her own price.” It’s just, if you are the regulator, you kind of know you can do that, and you know that you should, and you know that the relevant bankers also know it.
And so if you meet with the chief executive officer of the struggling bank on Thursday and say “hey your biggest rival is gonna buy you this weekend at a 90% discount to your closing stock price tomorrow,” and he says “what, no, what gives you the right to do that,” you can just sort of stare at him for a minute and he’ll say “oh right” and agree to the deal.
He is a banker and his counterpart is a banker and you are a bank regulator and you all know the unwritten rules, but not everyone does. The struggling bank’s shareholders, for instance, might get angry about being forced to sell their shares at a 90% discount. “This is illegal, we have rights,” they might say. And your response might reasonably be “well, no, if we hadn’t done this deal over the weekend, the bank would have gone into uncontrolled failure, which would have had many very bad consequences, the least consequential of which is that your shares would be worth zero, so be happy you got something.”
But their response might reasonably be: “What? Prove it. I don’t know that the bank would have gone to zero over the weekend, and in fact on Wednesday you were saying that its capital position was great and there was nothing to worry about. Now you are telling me it’s a zero, but I don’t believe you.”
And for various reasons, it will be hard for you to prove that the bank was going to zero. For one thing, you did keep saying everything was fine. And there is a general fog of war and quantum uncertainty of bank assets. And it is hard to prove the counterfactual: The stuff you did to stabilize the system over the weekend might have made the struggling bank solvent. Also, though, you might be wrong? Like, if you thought there was a 30% chance of an uncontrolled failure, you probably took decisive steps to end it over the weekend, which means there was a 70% chance you were wrong. Not a risk you wanted to take, as a bank regulator, but maybe one the shareholders would have been willing to take.
Or politicians might say “what gave you the right to do this bank merger over the weekend, put thousands of bankers out of work, and promise tons of taxpayer money to backstop the combined bank?” And you will mutter a legal answer — you do have lawyers, and they can make creative use of the written rules in an emergency — but the real deep intuitive answer is that bank rescues follow an unwritten and ad hoc playbook and you did what you thought you had to. But nobody wants to hear that answer and you will save it for your memoir.
The Financial Times has a particularly brisk and brutal account of how the Swiss “trinity” — the Swiss National Bank, the Financial Markets Supervisory Authority and the minister of finance — forced UBS Group AG to buy Credit Suisse Group AG over the weekend. All the elements are there. There’s the worry about an uncontrolled failure due to bank run:
There is the peremptory order to the struggling bank:
Note that this was the meeting last week at which Finma and the SNB announced a liquidity backstop for Credit Suisse; the announcement said “FINMA confirms that Credit Suisse meets the higher capital and liquidity requirements applicable to systemically important banks” and that “there are no indications of a direct risk of contagion for Swiss institutions due to the current turmoil in the US banking market.” Even as the regulators were telling the market that everything was fine and Credit Suisse was not in trouble, they were telling Credit Suisse that it was all over.
There is the peremptory order to UBS, which understood that uncontrolled failure of Credit Suisse would be a catastrophe for UBS as well:
There was some pushback from Credit Suisse:
But it had no real leverage:
But the shareholders also complained:
One difference is that the Swiss regulators did not bring the chairmen of Credit Suisse and UBS to a hotel and torture them until they agreed to the deal. (This is in part because the chairmen of Credit Suisse and UBS are experienced bankers who know how this is supposed to go, though also for other reasons.) Still I mean you can see their point. Bloomberg’s Hugo Miller and Dylan Griffiths write:
I guess. One can always find fault with these rescues, in part due to fog-of-war and hard-to-prove-the-counterfactual reasons and in part because, you know, why wouldn’t people panic in a crisis. But to me, the Credit Suisse rescue looks more or less like the standard playbook. Which doesn’t mean that it followed the rules and upheld the rule of law. That’s not how these things generally go.
For example, I wrote yesterday about how Credit Suisse’s additional tier 1 capital securities were zeroed by this deal, even as Credit Suisse’s shareholders got something (though not much). There are about 16 billion Swiss francs of AT1s outstanding, and their holders are very upset about this treatment and contemplating suing. The AT1s are, nominally, senior in the capital structure to the common stock, so it is weird for them to get nothing when the common gets something.
The AT1s are basically bonds that pay interest, but there is a provision in the bonds saying that they get written down to zero if (1) Credit Suisse’s common equity tier 1 capital falls below 7% or (2) the Swiss regulators decide that zeroing them is necessary to keep Credit Suisse solvent.
My point yesterday was that the first trigger — the 7% capital ratio trigger — necessarily means that the AT1s are sometimes junior to the common stock: If the common equity capital ratio falls to 5%, then (1) there is value remaining for the equity (5% of risk-weighted assets!) but (2) the AT1s get triggered and written down to zero.
But I conceded that that is not exactly what happened to Credit Suisse’s AT1s: Credit Suisse did not make a determination that its capital ratio fell below 7% and then deliver that notice to the holders in accordance with the terms to force a writedown. Part of the reason it did not do this was urgency, fog of war, etc.
But part of the reason is that Credit Suisse’s capital ratio never fell below 7%. A week ago, Credit Suisse reported that its common equity tier 1 capital ratio, as of the end of 2022, was 14.1%. Last Wednesday, as I mentioned above, the Swiss regulators affirmed “that Credit Suisse meets the higher capital and liquidity requirements applicable to systemically important banks,” as of Wednesday; those requirements included a 10% common equity tier 1 capital ratio.
And then Credit Suisse sold for about CHF 3 billion to UBS over the weekend. On the one hand, an equity value of CHF 3 billion is quite small, roughly 0.6% of its total book assets as of the end of 2022, and about 1.2% of risk-weighted assets, suggesting that the actual value of Credit Suisse’s equity was well below 7%. On the other hand, that’s not how capital accounting works, and it seems like for accounting purposes UBS is allowed to treat Credit Suisse as though it was solvent and well capitalized and its assets were worth far more than its liabilities. UBS’s investor presentation notes that it got CHF 56 billion of badwill from the deal, meaning that for accounting purposes it bought CHF 59 billion worth of equity for CHF 3 billion, and CHF 59 billion of equity would leave Credit Suisse quite well capitalized.
So as a matter of rough justice, the AT1s going to zero while the common stock went almost-but-not-quite to zero seems very fair and expected to me. On the other hand, as a legal reading of the documents, this argument doesn’t really work.
Instead, the AT1s got zeroed through a more ad hoc regulatory determination that it was necessary to zero them to save the bank. And the problem there is (1) you can second-guess that determination and (2) you can argue that, if it was necessary to zero the AT1s, then it was also necessary to zero the common stock, so preserving value for the common undermines the case for zeroing the AT1s.
I am not super-sympathetic to those arguments, but they are not trivial, and they are the sort of arguments that come out of an ad hoc desperate weekend rescue of a big bank. And in particular, the Swiss regulators’ insistence that Credit Suisse was well capitalized both last week (when they were trying to calm markets) and this week (when they don’t want to leave UBS with a giant capital hole) makes it harder for them to argue that the AT1s needed to be triggered. There is a real tension between the standard regulatory responses of (1) insisting that everything is fine and also (2) taking drastic emergency actions.
Anyway, this isn’t over. Bloomberg reports:
That’s basically a bet that you can get someone (a court, a government) to second-guess the Swiss authorities’ decision to zero the AT1. The market odds on that bet are between 20-to-1 and 50-to-1, so a long shot but not utterly hopeless.
One charming thing about Credit Suisse in recent years is that it had a habit of paying its employees with its weirdest assets. It was happy to give its managing directors bonuses consisting of, like, toxic mortgage assets, or derivatives counterparty credit exposure. The idea was that, if Credit Suisse had stuff on its books that looked bad for regulatory capital, and that the market didn’t want, but that Credit Suisse thought was good, then it would give that stuff to its employees. This was clever both as a matter of aligning incentives (bankers would be more careful if they had to eat their own cooking in their personal accounts) and as a matter of dis-aligning incentives (the bankers, after all, were picking which bits of their cooking got jammed into their PAs, and might have picked the good bits).
But eventually this got a bit more standardized, so that instead of paying employees in whatever weird exposures it had lying around, Credit Suisse started paying part of their bonuses in one particular weird exposure. It was … oh no … it was additional tier 1 contingent capital securities! The things that got zeroed this weekend! Bad choice.
Except that the bonuses weren’t exactly paid in the AT1 bonds that were publicly traded and were zeroed this weekend. Instead, they got paid “Contingent Capital Awards” with very similar terms, including that the awards would go to zero if capital fell too low or to prevent insolvency or a public rescue. So did they get zeroed over the weekend along with the public AT1 bonds, or not? I don’t know! Maybe not? Bloomberg’s Harry Wilson and Marion Halftermeyer report:
Yeah look, if I were the regulator (or UBS), I might prefer to zero the public-market AT1s but not the employee ones: The employee ones are fairly small, so zeroing them doesn’t conserve much capital, and the employees are going to be pretty demoralized right now, so giving them something seems helpful for the long-term future of the business. On the other hand, the holders of the public AT1s are already threatening legal action because they got zeroed while the shareholders got something, and they are going to be furious if Credit Suisse pays out the more-or-less identical employee AT1s and not them. Any banking rescue is going to involve some arbitrary distinctions, but that one seems tough.
When we last talked about the proposed First Boston carveout, good lord, six days ago, I said that it “might be the most conflicted transaction I have ever seen. I just admire it?” It was an amazing piece of work, for Klein to be a Credit Suisse board member, to be put in charge of deciding what to do with the investment banking business, to decide the answer was to sell it to himself and also to buy his existing investment banking boutique, and for him to get Credit Suisse to agree that that was all fine.
And now it is apparently falling apart for reasons that have nothing to do with its own audacity. Oh, I mean. It is possible that there is some characteristic of Credit Suisse that made it unusually likely to (1) do this First Boston deal, (2) have the Archegos, Greensill, tuna-bond, garden-party-spying, etc. scandals and (3) ultimately fail and be sold to UBS. Possibly the problem is that the overall level of audacity at Credit Suisse was too high, and eventually that caught up to it.
Patrick, all that information deserved a thread/article of its own! So much information packed in there!
It could. I think it is more powerful in this thread. There is enough similar fodder in the world of finance to keep Matt busy writing a DAILY column of similar density, length, and head shaking revelations. We all need to be reminded that the darkness pervades many levels.
I have empathy for managers who have to navigate the minefield of public business models that populate the indexes clients measure them against.
Levine is great, and always a must-read.
Regarding First Republic, I think it all comes back to the client base.
FRC clients are generally wealthy and financially sophisticated individuals, and they are the core of both sides of the balance sheet. The company has built one helluva brand catering to them (“It’s a privilege to serve you”), and they know it. Potential buyers see this too, but not in a good way right now.
On the deposit side of the balance sheet, these clients have been slowly departing over recent quarters for the greener pastures of money market accounts and T-bills. They already know savings interest rates are inadequate, but they for now are a bit stickier because they have a loyalty to the bank. That said, recent events have them seriously questioning any excess over $250k.
But back to loyalty. First Republic clients have this loyalty partially because of service, and partially because FRC likely refinanced their first mortgage at 2.5%, and maybe they sold them a second home mortgage at 3.0%. These loans are almost entirely jumbo mortgages that the bank carries on its balance sheet. Sure, the loans are performing, and the clients remain in strong financial positions, but the mortgages are still worth a lot less now than they were due to rates.
So you are now Jamie Dimon, and you might want to buy the bank. First Republic looks mint on paper: great, mostly loyal, customers, big balances. But you know their depositors are already looking to greener interest pastures, and their mortgages are not worth par at today’s rates. If you tried to hold on to these fleeing deposits by selling 3 month CDs at the T-bill rate, you would be paying your clients more than you are earning from their 30-year mortgages. Do you really want to own this bank? Your best move is to stabilize the bank, not own it, which is why Dimon did what he did last week.
I am a client of FRC. I became one five years ago when J.p. morgan, after a 20 year relationship, decided they didn’t want my business. So the idea that JPM wants FRC for the client base is not one I buy into.
I agree - I think Dimon would prefer the ‘stickier’ deposits of corporate accounts and middle income savers over the more financially aware HNW base at First Republic.
Since this is a public thread on the internet, several people have inquired privately as to why JP Morgan would not want a client’s business…let me summarize it as:
Our account was not large enough and were not buying enough cross sell at JP Morgan to make it worth their while.
For our fund business which was large enough, the reason given was that we were not doing AML with one of their big four approved providers. It didn’t matter to them that our administrators were Northern Trust and SS&C. It also didn’t matter to them that they had done full KYC on us and knew perfectly well after a 20 year relationship who was in our fund since most of them were their clients as well.
Basically, we were not interesting enough to JP Morgan and were not generating enough fees. Plus Big Four loves Big Four. That is how the 'polies form.
And thank you to all who inquired privately, that was considerate and unexpected in a very positive way. I have no issues sharing the reasons publicly. The one who ought to be embarrased at their treatment of their clients is JP Morgan. They got no shame though.
More calming words (/s) from the Treasury Secretary:
WATCH LIVE: Yellen testifies on budget in Senate hearing amid questions about banking system - YouTube (at 17:15)
Re: extending deposit guarantees beyond $250K:
So not a single (senior) person at Treasury, the Fed or the FDIC has had a conversation…
The potential bank rescuers (JPow and Yellen) seem overconfident to investors who aren’t sure what the rules of the road look like for a substantail swath of the US banking sector. Pretty simple tell is KRE (regional bank ETF) up, markets calm. Today, it slumped 4% in the aftermath of both missionaries speaking.
What time did she say that cause I think it was her comments that tanked the markets.
The financial missionaries are saying it was rate increase , of course the DOW up a couple hundred points after that announcement.
This has been an absolute banger of a week for the comms teams of the Fed and Treasury. If you had told them to be more confusing and unprofessional a la Brewster’s Millions what would they have done differently?
Continue the discussion at the Epsilon Theory Forum