The Instability Of Wealth, Banks and Capitalism
Plus, asset allocation updates
A week ago, I had never heard of SVB bank.
Thursday night, I couldn’t sleep. Was the system about to seize up? I went through each position I owned and wondered how it was linked to SVB. Again and again.
Today, I can sleep again. The authorities did the right thing. By allowing depositors to get their money out, policymakers short-circuited a panic. But in the wake of the news of SVB’s collapse, investors also bought a ton of bonds. Now the market is once again off kilter, this time betting the Federal Reserve will cut rates when inflation is high.
Providing money to depositors is different than providing money to the economy as a whole. I don’t think the Fed cuts. In fact, I think they hike, unless another financial institution goes belly up soon, driven more by self-reinforcing perceived panic than a true liquidity shortage.
I hate worrying about money. Hate it. Truly, when I retired from Bridgwater my hope was to adjust my portfolio once a quarter and crank out more books and podcasts. Readers enjoy both Master, Minion and Raising a Thief and I have another book on the way. But I can’t not look when there is this much turbulence.
A few things seem clear:
a) SVB had terrible risk management. Shareholders will be (appropriately) wiped out but depositors (appropriately) saved,
b) the Federal Reserve is creating virtually unlimited liquidity for depositors, so the banking system is safe,
c) BUT this liquidity is targeted because inflation, while it is coming down, is still too high and the central bank can not yet cut interest rates for the economy overall and
d) higher interest rates (to fight inflation) crush those with weak liquidity.
To understand what is going on, you need to hold two things in your mind at once—money for depositors, but not easy money overall.
Here is the broader context:
Capitalism, particularly American-style capitalism is a fantastic vehicle for wealth creation … in aggregate. In the specific, it is wildly risky and full of vicious pitfalls that are easy to see in retrospect but hard in the moment. One day a bank is a paragon of the community, contributing to Little League (or, in Silicon Valley, something more crunchy) and the next day Federal Deposit Insurance Corporation officials are standing outside the doors, telling clients the bank has been taken over by the government.
This instability is inherent to how the system runs, which is why the wealth creation machine is periodically interrupted by rolling crises that stretch back as far as there has been money. For traders, these dates are stamped on the inside of your brain: ‘20 (Covid), ‘12 (Europe debt), ‘08 (credit), ‘00 (tech), ‘98 (Asian FX), ‘94 (bonds), late 80s (Savings and Loan Crisis), ‘82 (Volcker tightening), ‘73 (Bretton Woods), ‘29 (Great Depression), ‘23 (German hyperinflation), etc. All these crises stem from two fundamental puzzles—no one ever, anywhere, has figured out a) how much money to print or b) how tightly to regulate commerce.
If you print too little money, you get a Depression. If you print too much, you get inflation. If you over-regulate, you get the Soviet Union, if you under regulate you get gangster Capitalism.
The economy is complex, and ever-changing due to technological innovation so figuring out how to properly calculate how much money should be printed and what rules to apply is difficult. The people setting the rules and overseeing the financial system make lots of mistakes, as do the people who are running the companies both inside and outside the financial system. That’s not pleasant, but it is reality. Knowing this, I watch my money like a hawk because that is what gives me freedom and I know asset values can shift very, very fast.
What’s a Bank and Why Do They Blow Up So Much?
In a Capitalistic system, the central bank is the heart and the banks are the arteries. The banks are designed to distribute the blood. To get them to do this, they are incentivized to take risk.
The simplest way to think of this is that if you give a bank $1 they are allowed to lend out 90 cents of this. The actual rules regarding collateral and lending are intricate but this is a useful over-simplification. The moment your money is deposited at a bank, the incentives (and risks) kick in.
To make money, the bank needs to lend out the funds because a loan, like a mortgage, pays the bank more money than buying a government bond (which is another form of lending). The riskier the loan, the higher the yield, the better the bank profit, as long as the bank gets repaid.
Put yourself in the position of the CEO. He reports to the board and shareholders. They both want to see profits and will fire the CEO if they fail to produce. This set of incentives pumps money into the economy and has allowed a huge increase in overall quality of life. We live longer and more comfortably than ever before…BUT.
But, a bank always has a structural vulnerability. It is levered 10 to 1. If the collateral (say the homes it is lending against) decline by 10%, bank capital is wiped out. That’s what happened in 2008. They also have a problem when loan demand weakens. What do they do with the extra cash piling up?
Having watched this firsthand when I was a banker, I can tell you.