Image by Steffi Reichert via Flickr
by Michael Hudson
Writer, Dandelion Salad
March 16, 2023
Geopolitical Economy Report on Mar 14, 2023
Economist Michael Hudson analyzes the collapse of Silicon Valley Bank, Silvergate, and Signature Bank, explaining the similarities to the 2008 financial crash.
He also addresses the US government bailout (which it isn’t calling a bailout), the role of the Federal Reserve and Treasury, the factor of cryptocurrency, and the danger of derivatives.
Why the Banking System is Breaking Up
by Michael Hudson
Writer, Dandelion Salad
March 16, 2023
The collapses of Silvergate and Silicon Valley Bank are like icebergs calving off from the Antarctic glacier. The financial analogy to the global warming causing this collapse is the rising temperature of interest rates, which spiked last Thursday and Friday to close at 4.60 percent for the U.S. Treasury’s two-year bonds. Bank depositors meanwhile were still being paid only 0.2 percent on their deposits. That has led to a steady withdrawal of funds from banks – and a corresponding decline in commercial bank balances with the Federal Reserve.
Most media reports reflect a prayer that the bank runs will be localized, as if there is no context or environmental cause. There is general embarrassment to explain how the breakup of banks that is now gaining momentum is the result of the way that the Obama Administration bailed out the banks in 2008. Fifteen years of Quantitative Easing has re-inflated prices for packaged bank mortgages – and with them, housing prices, stock and bond prices.
The Fed’s $9 trillion of QE (not counted as part of the budget deficit) fueled an asset-price inflation that made trillions of dollars for holders of financial assets, with a generous spillover effect for the remaining members of the top Ten Percent. The cost of home ownership soared by capitalizing mortgages at falling interest rates into more highly debt-leveraged property. The U.S. economy experienced the largest bond-market boom in history as interest rates fell below 1 percent. The economy polarized between the creditor positive-net-worth class and the rest of the economy – whose analogy to environmental pollution and global warming was debt pollution.
But in serving the banks and the financial ownership class, the Fed painted itself into a corner: What would happen if and when interest rates finally rose?
In Killing the Host I wrote about what seemed obvious enough. Rising interest rates cause the prices of bonds already issued to fall – along with real estate and stock prices. That is what has been happening under the Fed’s fight against “inflation,” its euphemism for opposing rising employment and wage levels. Prices are plunging for bonds, and also for the capitalized value of packaged mortgages and other securities in which banks hold their assets on their balance sheet to back their deposits.
The result threatens to push down bank assets below their deposit liabilities, wiping out their net worth – their stockholder equity. This is what was threatened in 2008. It is what occurred in a more extreme way with S&Ls and savings banks in the 1980s, leading to their demise. These “financial intermediaries” did not create credit as commercial banks can do, but lent deposits out in the form of long-term mortgages at fixed interest rates, often for 30 years. But in the wake of the Volcker spike in interest rates that inaugurated the 1980s, the overall level of interest rates remained higher than the interest rates that S&Ls and savings banks were receiving.
Depositors began to withdraw their money to get higher returns elsewhere, because S&Ls and savings banks could not pay their depositors higher rates out of the revenue coming in from their mortgages fixed at lower rates. So even without fraud Keating-style, the mismatch between short-term liabilities and long-term interest rates ended their business plan.
The S&Ls owed money to depositors short-term, but were locked into long-term assets at falling prices. Of course, S&L mortgages were much longer-term than was the case for commercial banks. But the effect of rising interest rates has the same effect on bank assets that it has on all financial assets. Just as the QE interest-rate decline aimed to bolster the banks, its reversal today must have the opposite effect. And if banks have made bad derivatives trades, they’re in trouble.
Any bank has a problem of keeping its asset valuations higher than its deposit liabilities. When the Fed raises interest rates sharply enough to crash bond prices, the banking system’s asset structure weakens. That is the corner into which the Fed has painted the economy by QE.
The Fed recognizes this inherent problem, of course. That is why it avoided raising interest rates for so long – until the wage-earning bottom 99 Percent began to benefit by the recovery in employment. When wages began to recover, the Fed could not resist fighting the usual class war against labor. But in doing so, its policy has turned into a war against the banking system as well.
Silvergate was the first to go, but it was a special case. It had sought to ride the cryptocurrency wave by serving as a bank for various currencies. After SBF’s vast fraud was exposed, there was a run on cryptocurrencies. Investor/gamblers jumped ship. The crypto-managers had to pay by drawing down the deposits they had at Silverlake. It went under.
Silvergate’s failure destroyed the great illusion of cryptocurrency deposits. The popular impression was that crypto provided an alternative to commercial banks and “fiat currency.” But what could crypto funds invest in to back their coin purchases, if not bank deposits and government securities or private stocks and bonds? What is crypto, ultimately, if not simply a mutual fund with secrecy of ownership to protect money launderers?
Silicon Valley Bank also is in many ways a special case, given its specialized lending to IT startups. New Republic bank also has suffered a run, and it too is specialized, lending to wealthy depositors in the San Francisco and northern California area. But a bank run was being talked up last week, and financial markets were shaken up as bond prices declined when Fed Chairman Jerome Powell announced that he actually planned to raise interest rates even more than he earlier had targeted. Rising employment rates make wage earners more uppity in their demands to at least keep up with the inflation caused by the U.S. sanctions against Russian energy and food and the actions by monopolies to raise prices “to anticipate the coming inflation.” Wages have not kept pace with the resulting high inflation rates.
It looks like Silicon Valley Bank will have to liquidate its securities at a loss. Probably it will be taken over by a larger bank, but the entire financial system is being squeezed. Reuters reported on Friday that bank reserves at the Fed were plunging. That hardly is surprising, as banks are enjoying record interest rate spreads. No wonder well-to-do investors are running from the banks.
The obvious question is why the Fed doesn’t simply bail out banks in SVB’s position. The answer is that the lower prices for financial assets looks like the New Normal. For banks with negative equity, how can solvency be resolved without sharply reducing interest rates to restore the 15-year Zero Interest-Rate Policy (ZIRP)?
There is an even larger elephant in the room: derivatives. Volatility increased last Thursday and Friday. The turmoil has reached vast magnitudes beyond what characterized the 2008 crash of AIG and other speculators. Today, JP Morgan Chase and other New York banks have tens of trillions of dollar valuations of derivatives – casino bets on which way interest rates, bond prices, stock prices and other measures will change.
For every winning guess, there is a loser. When trillions of dollars are bet on, some bank trader is bound to wind up with a loss that can easily wipe out the bank’s entire net equity.
There is now a flight to “cash,” to a safe haven – something even better than cash: U.S. Treasury securities. Despite the talk of Republicans refusing to raise the debt ceiling, the Treasury can always print the money to pay its bondholders. It looks like the Treasury will become the new depository of choice for those who have the financial resources. Bank deposits will fall. And with them, bank holdings of reserves at the Fed.
So far, the stock market has resisted following the plunge in bond prices. My guess is that we will now see the Great Unwinding of the great Fictitious Capital boom of 2008-2015. So the chickens are coming hope to roost – with the “chicken” being, perhaps, the elephantine overhang of derivatives fueled by the post-2008 loosening of financial regulation and risk analysis.
Originally published March 12, 2023.
The Mechanics of a Bond Market and its Impact on the Banking Crisis
by Michael Hudson
Writer, Dandelion Salad
March 16, 2023
Why the Bank Crisis is Not Over
The crashes of Silvergate, Silicon Valley Bank, Signature Bank and the related bank insolvencies are much more serious than the 2008-09 crash. The problem at that time was crooked banks making bad mortgage loans. Debtors were unable to pay and were defaulting, and it turned out that the real estate that they had pledged as collateral was fraudulently overvalued, “mark-to-fantasy” junk mortgages made by false valuations of the property’s actual market price and the borrower’s income. Banks sold these loans to institutional buyers such as pension funds, German savings banks and other gullible buyers who had drunk Alan Greenspan’s neoliberal Kool Aid, believing that banks would not cheat them.
Silicon Valley Bank (SVB) investments had no such default risk. The Treasury always can pay, simply by printing money, and the prime long-term mortgages whose packages SVP bought also were solvent. The problem is the financial system itself, or rather, the corner into which the post-Obama Fed has painted the banking system. It cannot escape from its 13 years of Quantitative Easing without reversing the asset-price inflation and causing bonds, stocks and real estate to lower their market value.
In a nutshell, solving the illiquidity crisis of 2009 that saved the banks from losing money (at the cost of burdening the economy with enormous debts), paved away for the deeply systemic illiquidity crisis that is just now becoming clear. I cannot resist that I pointed out its basic dynamics in 2007 (Harpers) and in my 2015 book Killing the Host.
Accounting fictions vs. market reality
No risks of loan default existed for the investments in government securities or packaged long-term mortgages that SVB and other banks have bought. The problem is that the market valuation of these mortgages has fallen as a result of interest rates being jacked up. The interest yield on bonds and mortgages bought a few years ago is much lower than is available on new mortgages and new Treasury notes and bonds. When interest rates rise, these “old securities” fall in price so as to bring their yield to new buyers in line with the Fed’s rising interest rates.
A market valuation problem is not a fraud problem this time around.
The public has just discovered that the statistical picture that banks report about their assets and liabilities does not reflect market reality. Bank accountants are allowed to price their assets at “book value” based on the price that was paid to acquire them – without regard for what these investments are worth today. During the 14-year boom in prices for bonds, stocks and real estate this undervalued the actual gain that banks had made as the Fed lowered interest rates to inflate asset prices. But this Quantitative Easing (QE) ended in 2022 when the Fed began to tighten interest rates in order to slow down wage gains.
When interest rates rise and bond prices fall, stock prices tend to follow. But banks don’t have to mark down the market price of their assets to reflect this decline if they simply hold on to their bonds or packaged mortgages. They only have to reveal the loss in market value if depositors on balance withdraw their money and the bank actually has to sell these assets to raise the cash to pay their depositors.
That is what happened at Silicon Valley Bank. In fact, it has been a problem for the entire U.S. banking system. This chart comes from Naked Capitalism, which has been following the banking crisis daily.
How SVP’s short-termism failed to see where the financial sector is heading
During the years of low interest rates, the U.S. banking system found that its monopoly power was too strong. It only had to pay depositors 0.1 or 0.2 percent on deposits. That was all that the Treasury was paying on short-term risk-free Treasury bills. So depositors had little alternative, but banks were charging much higher rates for their loans, mortgages and credit cards. And when the Covid crisis hit in 2020, corporations held back on new investments and flooded the banks with money that they were not spending.
The banks were able to make an arbitrage gain – obtaining higher rates from investments than they were paying for deposits – by buying longer-term securities. SVB bought long-term Treasury bonds. The margin wasn’t large – less than 2 percentage points. But it was the only safe “free money” around.
Last year Federal Reserve Chairman Powell announced that the central bank was going to raise interest rates in order to slow the wage growth that developed as the economy began to recover. That led most investors to realize that higher interest rates would lower the price of bonds – most steeply for the longest-term bonds. Most money managers avoided such price declines by moving their money into short-term Treasury bills or money-market funds, while real estate, bond and stock prices fell.
For some reason SVB did not make this obvious move. They kept their assets concentrated in long-term Treasury bonds and similar securities. As long as the bank did not have any net deposit withdrawals, it did not have to report this decline in the market value of its assets.
However, it was left holding the bag when Mr. Powell announced that not enough American workers were unemployed to hold down their wage gains, so he planned to raise interest rates even more than he had expected. He said that a serious recession was needed to keep wages low enough to keep U.S. corporate profits high, and hence their stock price.
This reversed the Obama bailout’s Quantitative Easing that steadily inflated asset prices for real estate, stocks and bonds. But the Fed has painted itself into a corner: If it restores the era of “normal” interest rates, that will reversed the 15-year run-up of asset-price gains for the FIRE sector.
This sudden shift on March 11-12 left SVB “sitting on an unrealized loss of close to $163bn – more than its equity base. Deposit outflows then started to crystallize this into a realized loss.” SVB was not alone. Banks across the country were losing deposits.
This was not a “run on the banks” resulting from fears of insolvency. It was because banks were strong enough monopolies to avoid sharing their rising earnings with their depositors. They were making soaring profits on the rates they charge borrowers and the rates yielded by their investments. But they continued to pay depositors only about 0.2%.
The U.S. Treasury was paying much more, and on Thursday, March 11, the 2-year Treasury note was yielding almost 5 percent. The widening gap between what investors can earn by buying risk-free Treasury securities and the pittance that banks were paying their depositors led the more well-to-do depositors to withdraw their money to earn a fairer market return elsewhere.
It would be wrong to think of this as a “bank run” – much less as a panic. The depositors were not irrational or falling subject to “the madness of crowds” in withdrawing their money. The banks simply were too selfish. And as customers withdrew their deposits, banks had to sell off their portfolio of securities – including the long-term securities held by SVB.
All this is part of the unwinding of the Obama bank bailouts and Quantitative Easing. The result of trying to return to more normal historic interest-rate levels is that on March 14, Moody’s rating agency cut the outlook for the U.S. banking system from stable to negative, citing the “rapidly changing operating environment.” What they are referring to is the plunge in the ability of bank reserves to cover what they owed to their depositors, who were withdrawing their money and forcing the banks to sell securities at a loss.
President Biden’s deceptive cover-up
President Biden is trying to confuse voters by assuring them that the “rescue” of uninsured wealthy SVB depositors is not a bailout. But of course it is a bailout. What he meant was that bank stockholders were not bailed out. But its large uninsured depositors who were saved from losing a single penny, despite the fact that they did not qualify for safety, and in fact had jointly talked among themselves and decided to jump ship and cause the bank collapse.
What Biden really meant was that this is not a taxpayer bailout. It does not involve money creation or a budget deficit, any more than the Fed’s $9 trillion in Quantitative Easing for the banks since 2008 has been money creation or increased the budget deficit. It is a balance-sheet exercise – technically a kind of “swap” with offsets of good Federal Reserve credit for “bad” bank securities pledged as collateral – way above current market pricing, to be sure. That is precisely what “rescued” the banks after 2009. Federal credit was created without taxation.
The banking system’s inherent tunnel vision
One may echo Queen Elizabeth II and ask, “Did nobody see this coming?” Where was the Federal Home Loan Bank that was supposed to regulate SVB? Where were the Federal Reserve examiners?
To answer that, one should look at just who the bank regulators and examiners are. They are vetted by the banks themselves, chosen for their denial that there is any inherently structural problem in our financial system. They are “true believers” that financial markets are self-correcting by “automatic stabilizers” and “common sense.”
Deregulatory corruption played a role in carefully selecting such tunnel-visioned regulators and examiners. SVB was overseen by the Federal Home Loan Bank (FHLB). The FHLB is notorious for regulatory capture by the banks who choose to operate under its supervision. Yet SVB’s business is not home-mortgage lending. It is lending to high-tech private equity entities being prepared for IPOs – to be issued at high prices, talked up, and then often left to fall in a pump and dump game. Bank officials or examiners who recognize this problem are disqualified from employment by being “over-qualified.”
Another political consideration is that Silicon Valley is a Democratic Party stronghold and rich source of campaign financing. The Biden Administration was not going to kill the goose that lays the golden eggs of campaign contributions. Of course it was going to bail out the bank and its private-capital customers. The financial sector is the core of Democratic Party support, and the party leadership is loyal to its supporters. As President Obama told the bankers who worried that he might follow through on his campaign promises to write down mortgage debts to realistic market valuations in order to enable exploited junk-mortgage clients to remain in their homes, “I’m the only one between you [the bankers visiting the White House] and the mob with the pitchforks,” that is, his characterization of voters who believed his “hope and change” patter talk.
The Fed gets frightened and rolls back interest rates
On March 14 stock and bond prices soared. Margin buyers made a killing as they saw that the Administration’s plan is the usual one: to kick the bank problem down the road, flood the economy with bailouts (for the bankers, not for student debtors) until election day in November 2024.
The great question is thus whether interest rates can ever get back to a historic “normal” without turning the entire banking system into something like SVB. If the Fed really raises interest rates back to normal levels to slow wage growth, there must be a financial crash. To avoid this, the Fed must create an exponentially rising flow of Quantitative Easing.
The underlying problem is that interest-bearing debt grows exponentially, but the economy follows an S-curve and then turns down. And when the economy turns down – or is deliberately slowed down when labor’s wage rates tend to catch up with the price inflation caused by monopoly prices and U.S. anti-Russian sanctions that raise energy and food prices, the magnitude of financial claims on the economy exceeds the ability to pay.
That is the real financial crisis that the economy faces. It goes beyond banking. The entire economy is saddled with debt deflation, even in the face of Federal Reserve-backed asset-price inflation. So the great question – literally the “bottom line” – is how can the Fed maneuver its way out of the low-interest Quantitative Easing corner in which it has painted the U.S. economy? The longer it and whichever party is in power continues to save FIRE sector investors from taking a loss, the more violent the ultimate resolution must be.
Michael Hudson is President of The Institute for the Study of Long-Term Economic Trends (ISLET), a Wall Street Financial Analyst, Distinguished Research Professor of Economics at the University of Missouri, Kansas City and author of A Philosophy for a Fair Society (2022), The Destiny of Civilization (2022), …and forgive them their debts (2018), J is for Junk Economics (2017), Killing the Host (2015), The Bubble and Beyond (2012), Super Imperialism: The Economic Strategy of American Empire (1968 & 2003 & 3rd Edition 2021), Trade, Development and Foreign Debt: A History of Theories of Polarization v. Convergence in the World Economy (1992 & 2009) and The Myth of Aid (1971), amongst many others. Support his work via Patreon. He can be reached via his website Michael Hudson, mh@michael-hudson.com. Originally published March 15, 2023.
See also:
Silicon Valley Bank Collapses, The Bailout Has Begun, by Gary Wilson
From the archives:
Michael Hudson and Radhika Desai: Since Money is Political
Michael Hudson and Radhika Desai: What Causes Inflation?
Central Banks Are A Symptom, Capitalism Is The Cause, by Pete Dolack
Michael Hudson and Ralph Nader: The Real Purpose of The Federal Reserve
Your Life Savings Could Be Wiped Out In A Massive Derivatives Collapse by Ellen Brown
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We’re in completely uncharted financial territory and it’s time to seriously consider some radical solutions – like nationalizing any financial institution that gets in trouble, and creating a publicly owned and run banking utility. We should also dissolve the Fed and return all monetary functions to direct control of the Treasury.
These are really not all that radical. We once had rudimentary financial services available through the post office in very wee berg, and there was no Fed until the early 20th century when lazy Congress punted their oversight role and put us all at risk of predation by sleazy banksters!
I so agree, Cliff.
Socialism for the rich and worsening of poverty for the poor.
Exactly.