Why This Isn’t A Credit Crunch Like 2008
With Deutsche Bank under attack it means that another week has been lost to speculation and uncertainty around the plumbing that makes the economy function - the banking system.
This isn't great and as the weeks pile up, raise some even bigger, more systemic questions than "is bank X or Y in real trouble or just trouble."
Unsurprisingly given this importance, we had a lot of great mail and feedback from the last two editions. Please feel free to always reach out at contact@pebble.finance or on one of our many social media channels.
Judging from our inbox it would seem that the initial shock of the bank runs and implosion is dissipating, people are instead taking stock of what the future may hold.
Overall, people appear to be worried. Along these lines, one of the better points was simply:
Won't this result in a severe credit crunch (like 2008)? What bank has made a loan in the last 2 weeks?! Why will this change going forward?
Good question(s)!
This is, in many ways, a very natural response to some serious problems in the developed world's banks. Silvergate Capital, Signature Bank, Silicon Valley Bank (side note: what's with all the "S's"?!) Credit Suisse, First Republic and the list may go on, are clear evidence that the problems are neither isolated nor minor in the current banking system.
These are real (big) banks with very real and big problems.
And as we tried to argue last week, the consequences of these problems will be both serious and are important to follow but the systemic risk of a severe credit crunch still seem low.
There are a few reasons for this:
The first is we know a lot more about the working of the credit system than we did before the 2008 crisis. We have successfully deployed some of the tools and rescue mechanisms we developed then.
The second is there is remarkably little panic, in markets or otherwise.
One of the least discussed aspects of the current banking crisis is that the catalyst of Silicon Valley Bank's problems (to which it was unusually though not uniquely exposed) - government bonds - has significantly risen in price since then and directly thanks to the bank's demise.
As usual, let us deal with each in turn:
For the first point:
We made mention of this two weeks ago in our piece on "Contagion Risk:"
We have procedures and policies in place to deal with exactly this outcome. Furthermore, overall the banking system is both very well capitalized and this should not spiral into a Lehman-type credit crunch.
Worrying about "another Lehman" is a classic case of worrying about the last crisis. That isn't generally how crises work. The crisis you need to worry about is one you haven't properly prepared for, like Covid-19 or a bank with an unexpected large influx of deposits, dealt with poorly.
Further, the issue with 2008 was, as you may recall, the tremendous uncertainty around the location of "toxic" asset backed securities in the form of subprime US mortgages. No one knew who owned what or just how low these heavily securitized asset prices would go (many went to zero, of course). The issue was not just the underlying (bad) mortgages but the very complex way that they had been packaged together and sold.
This meant not just financial losses but also a tremendous amount of fear and a lack of trust which led to a lack of lending that quickly led the economy to completely stall. Hence the "credit crunch."
That isn't the case this time around. In fact, we know exactly what the problem is and what the losses could be. Banking is a highly regulated sector and the problematic assets are, rather amusingly, the US government bonds and mortgages that are supposed to be ultra-safe and liquid. This makes them not just safer but also more predictable.
Now that transparency can be a problem. The problem for SVB was we knew exactly how many deposits were uninsured and how much capital they might have to raise. That proved fatal.
But overall, the current crisis is the result of some deposit mismatches leading to very unbalanced banks. It is absolutely the case that if panic around those banks were allowed to spread that people could begin clamoring for their money back from perfectly good banks and the contagion would spread.
But besides the fact that that hasn't happened (in several weeks now) there is also the fact that everyone can see and understand what the problem is.
We also learned valuable lessons about the banking system and innovated. Now, we are successfully deploying some of those emergency tools or even just the threat of them to make sure the system can continue functioning smoothly.
For instance we have allowed banks to borrow money from the Federal Reserve's discount window cheaply and easily. They have done to the tune of nearly $400 billion.
See here:
This has undone some of the work the end of quantitative easing has accomplished over the last year but so what? It allows banks access to ready capital in return for good collateral and that will keep them able to supply any depositors who ask for their savings back.
Side note: What the Federal Reserve is doing isn't quantitative easing. QE is buying bonds. These are (cheap) loans to the banking system.
Lastly, it is also worth keeping in mind that the amount of firepower represented above is essentially unlimited.
On the second point:
Stocks are up. Which is a bit weird for a crisis.
In fact, they even ended up on Friday, the day that concerns about Deutsche Bank took hold.
And yes, they were up sharply this week before falling again but even over the last month US equities are basically flat overall. That is a bit underwhelming for a major crisis in the magnitude of 2008.
Here is an example of the S&P 500 vs the Financials Sector over the last month:
A bad time to be a bank stock but there is very limited contagion to the rest of the economy.
And yes, markets can be wrong. They frequently are and we have made a very happy habit about picking when we think they are right and/or wrong but it does seem more than a bit strange that serious banks are failing and the stock market is not panicking. These are very liquid and secure securities, not complex financial derivatives.
As we discovered with First Republic and SVB, whether you are a deposit holder or an investor, if you want to sell up and move your money you can do it from the comfort of your smartphone. People could dump stocks or move deposits from the chairlift, or the lounge chair or commuting or just about anything.
The speed of Silicon Valley Bank's demise and the different nature of banking and investing in the 21st century would suggest that similar speed could occur if the economy was truly in trouble.
On the last point....
It is very difficult to imagine a credit crisis if the value of the asset that is causing the problems - US government bonds and US mortgages - is rising in price as the crisis unfolds.
Typically, it is the other way around, of course. That was the issue in 2008:
A few borrowers default on their mortgages -> which cause the mortgage bonds to fall in price -> which cause the derivatives to start collapsing -> which hurts the ability of banks to lend -> which causes more economic distress ->and more mortgages holders to default.
Fun, Fun.
As we wrote about last week, the irony of the present situation is that SVB's demise has removed the very cause of their crisis. Thanks to the banking crisis US Bond prices have risen (and yields have declined) a lot over the last month. This has been true for mortgages as well.
See here the collapse in the US 2 year bond (yields down, prices up) over the last 2 months.
So, banks that had experienced large losses on their portfolio of government bonds and mortgages have seen that reverse over the last 3 weeks as those prices have appreciated, even as the Federal Reserve raised more rates.
Furthermore, if the crisis deepens then the expectation would be for this trend only to accelerate in the same direction. Mortgage and bond prices would only rise as the expectation of a true crisis grows.
That doesn't have to be an automatic dis-qualifier. If the weeks pile up and the credit market stays constrained then that will eventually add up but while investors remain on edge, the combination of banks taking advantage of rescue windows and rising ultra safe asset prices will help them.
And yes, indeed, lending standards may tighten further, which will hit credit growth but cheaper mortgage rates are still, well, cheaper. There is no reason that this won't quickly lead to the housing market thawing, at least a little bit.
For now, the big trend is less of a credit crunch and more of a deposit flow from banks to money market mutual funds. That will continue and could be something you should look into because, as we have highlighted half a dozen times, you can get almost 100x in money market funds that own US Treasuries rather in your "high yield" savings account.
Here are money market inflows:
~4.20% vs perhaps ~0.04% is quite the difference and they have the benefit of being backed by the full faith and credit of the US government with no FDIC cap.
Banking is changing and perhaps not for the better. It is a bad time to be a bank or own bank stocks but that isn't alone either.
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