The First Bailout is the Cheapest….

What if …. on that infamous September week in 2008, the Fed decided to do for Lehman what the Swiss Central has announced tonight in connection with Credit Suisse, namely announce a backstop, if necessary. History probably would have been very different.

Lehman wasn’t a basket case, it had a liquidity problem deriving, among other mistakes, from a funding mismatch. If given the time, it would have probably been able to weather the storm. But at the time the Administration and the Fed decided, for multiple reasons, to look away and let them file for Chapter 11. The chaos that ensued forced the Fed and the US authorities to have to spend trillions to save the US banking system. The Fed had to cut rates to near zero and to embark on a quantitative easing program that lasted a decade.

This incredible avalanche of cheap money had soothing but also long-term negative effects by distorting the capital markets’ usual functioning and bringing rates down to negative in many countries around the world.

Negative rates adversely affected savers, gave huge headaches to insurance companies whose liability matching was made nearly impossible. It also led to super high equity markets whose valuations are also a function of the discount rate.

Then came Covid-19 and the unprecedented stimulus that President Biden bestowed upon Americans at a time when it was probably not needed anymore, at least in that magnitude. That, coupled with other exogenous factors (spike in energy costs, stressed supply chains, war…) stoked inflation to forty year highs.

To combat inflation, the Fed starting to reverse course, late, and therefore even more abruptly, with consecutive 50 and 75bps hikes that brought rates higher by nearly 500 bps in less than one year. And this is now the cause of the current crisis, the bank crisis.

Usually, banks tend to do well in times of higher interest rates because they are more efficient at managing their treasury than their clients at managing theirs. Money kept on current accounts or in low yielding deposits can be placed in loans, bonds, and deposits with other institutions at higher rates. And, in fact until just over a week ago, the banking sector seemed to be doing just fine. But under the apparent calm, another big problem was brewing, asset liability mismatching, or a reverse Lehman problem, to turn full circle.

SVB collapsed for a very simple reason. When its clients, inundated them with cash they received from tech investors and PE funds deposited their funds with SVB, the bank had to deploy this cash, and typically banks will buy safe government bonds, as a preferred part of their investment portfolio. Usually government bonds are relatively safe, except that bonds’ performance are a factor of two components, credit risk and interest rate risk. Credit risk is by definition low (or zero) for US Government bonds, but the interest rate risk component blew up in historic proportions in the last ten months. As bonds decline when prevailing interest rates rise, banks such as SVB, and many others, found that the mark to market value of their bonds had declined by possibly over ten percent. However, certain accounting rules allow banks to report the value of their bonds as they will be worth at maturity, and at maturity bonds go back to par. On the liability side of the balance sheet, as prevailing money market rates started to go up and investors time deposits rolled, SVB had to pay increasingly higher coupons to its clients, whilst being stuck with fixed rate assets now (temporarily) underwater. Once client started to smell this mismatch, they started pulling money out and created the proverbial bank run. This same scenario is playing out in many variations at lenders across the world.

One policy mistake fifteen years ago is reverberating across the markets leading to more mistakes, more corrections, more bailouts, more pain. When will it end?