Brief
As the banking crisis continues, public focus has been on the flight of uninsured depositors from banks. That is important, but it is also easiest for reporters to explain. Too little press has been given to the loans and interest paying securities held by banks. It was those crappy investments that made so many depositors rightly question whether SVB, First Republic and Signature were healthy in the first place. Our banks have become black boxes – it is unclear what is in the box and what they are worth. Among the systemic approaches to fix the banking crisis, an increase in bank transparency needs to be priority number one (not 1000+ pages of legal word salad. Looking at you: Dodd Frank).
Until depositors, investors, everyone becomes more comfortable with what's under the hood of banks, the entire banking system can be tarnished with confusion. As longtime trader and economic writer, Dennis Gartman, used to say – “confusion breeds contempt.”
Three Kinds of Markings
In finance, a price at an exact time, such as end of day or month, is called a ‘mark.’ In modern finance (roughly the last 4 decades), a mark comes in three varieties: mark to market, mark to model, and what I like to call mark to near-market.
Mark to market. This is the gold standard; when there is a market price for the bond/loan/stock/etc. In a best case scenario, the item traded the same day it is being priced. In an acceptable scenario, still called mark-to-market, the stock/bond/loan did not trade, but market-makers1 provide a bid and an ask price so a firm can take the midpoint of those two prices. Mark to market is the gold standard of asset pricing because it is the transparency of the actual market and not a guess of where the market ‘might’ be.
Mark to model. Sometimes, there is no price on a stock/bond/loan. In this case, firms have to model what they believe the stock/bond/loan/derivative is worth. It goes without saying that this is where the biggest problems lie. It is almost always in the benefit of the owner of an asset to overstate its value. For example – a bank may know a struggling company is on the verge of bankruptcy, but if they paid their interest last month, the bank can pretend a loan is perfect.
Banks often must market to model because they can easily own a lot of loans that have no similar trade exposure, such as a 300+ million dollar commercial real estate loan or a loan on the bar in a 1 stoplight town. There is not an easy apples-to-apples comparison for these assets; the quality and location of the management, occupancy rates, etc. These loans all have their own peculiarities, known as idiosyncratic risk.
In the 08 Financial Crisis, marking to model was properly derided as “marking to make believe.” Subprime credit derivatives were built with the specific goal of appearing very stable in good times, ignoring any risk that housing might stop going up. When housing eventually stopped increasing, many derivatives were discovered to be worthless. The technical term is: completely full of shit.
I call in-between cases a “mark-to-near-model.” Even though an item did not trade, perhaps a similar loan/stock/bond was traded – so we see pricing on a similar asset. For instance, if there is a public purchase of a 20 million dollar loan portfolio filled with small business loans in Washington DC, the price of the whole portfolio can be a useful guide to other performing small business loans in Washington DC. It is not perfect, but it is much better than marking to make believe. Revealing price transparency in even vaguely similar assets is shown to provide create better price transparency.
For many assets, such as performing jumbo mortgages, this is a perfectly acceptable valuation technique. While there isn’t an equivalent to Mark Zuckerberg’s home loan, we can assume that it will perform similarly to all home loans made to people worth 100+ million dollars. Marking to a near-model (or mark-to-near-market) still has lots of room for bullshitting, but it's much better than having no market at all.
Held to Maturity: The Mother of All Bullshit
One of the earlier jobs of my career was confirming and sometimes finding daily and monthly markings for over 100 billion in corporate, government and distressed bonds. Firm management did not fully trust the traders to mark their own books (with reason). Part of my job was to find proper 3rd party valuations for all the less traded bonds in the book (government and major corporate bonds trade all day and have easily visible pricing; debt of small, bankrupt firms are much harder to mark).2 Investment funds mark their books daily, monthly, and yearly – it would be illegal and fraudulent for such a fund to knowingly inflate the value of their portfolios. Major funds, private and public, all have annual outside audits; it's a red flag for a large hedge fund to not use a major accounting firm to run its audit.3
Unlike Hedge funds, US Banks are NOT required to mark their assets to market. Courtesy of an accounting fiction known as ‘held to maturity,’ a bank is allowed to claim: they will hold a bond or loan to maturity and so it will pay out in full which makes the bank immune to market volatility. So even when the market price of a government bond clearly indicates that it is not worth what the bank paid for it, the bank is allowed to say ‘nope we haven’t lost a penny.’ This ‘get out of marking free’ card looks really silly if a bank is taken over by the FDIC – at that point, all the bonds and bank loans are sold off if possible and the current market price is realized. If the losses are bigger than the failed bank's capital, the FDIC (and possibly the US taxpayer) will have to pay for the problem.
The Black Box
Even worse is the black box of bank loans. Besides saying the magic words, ‘these are held to maturity,’ banks can easily hide their loan troubles and mark things as being at full value. When a bank's loans are worth less than its deposits, we say the bank is insolvent. And right now it is almost impossible to know: Are American (or European) banks solvent?
Banks need a lot of leverage to make money borrowing 2-3% below where they lend it; on average, US banks use a 12X leverage ratio.4 This is why banks only want to lend to people who have money and why banks require down payments on a home loan; if a bank leveraged 12 and times loses 8% of its money, it's busto. Caput. Done.
Safe ain’t what it used to be
For ‘safe’ government bonds, savvy investors can ballpark how much money banks have lost as rates rose. Even this exercise is not perfect as banks do not publish enough information for investors to know the details of what banks have invested in or how they are doing. Compounding this problem of opacity, rumors that a bank has a problem can lead to a run on the bank. In the specific case of SVB, uninsured depositors, led by Peter Thiel, realized that SVB Bank had a huge problem and pulled all of their money from the bank.5
When interest rates go up fast, bank loan books generally lose a ton, even in their ‘safe’ government bonds. If rates had gone up 2% in a year that would be considered a significant rise in bank rates, and historically quite rough. From 2022 to now, we have more than doubled that: rates increased from 0 to 5.25% from March 2022 to May 2023. It has been the fastest extended rate increase in four decades and it occurred starting at a zero percent interest rate.
Most US Regional Banks can be assumed to be entirely unhedged (they have no protection against interest rates going up) – only 6% of US Bank assets are hedged to begin with and that is not evenly spread across banks. Losing money when interest rates rise, known as interest rate risk, is what doomed SVB bank. As it expanded aggressively into startups, founders and VC firms, SVB picked up far more deposits than it made in loans. It invested those deposits in medium duration US treasury bonds (5-10 years until they are due) that SVB claimed it was holding until maturity – that claim becomes a blatant lie when a run on the bank forces them to sell everything. When those bonds were sold, they revealed massive losses.
Transparency and Accountants
There are reasons that bank regulators have allowed the accounting fictions of ‘held to maturity’ to persist alongside an incredibly lax approach to enforcing regular assessment of loan valuation to banks. I find them all to be VERY lacking. Allowing banks to become opaque black boxes of unmarked bonds and loans backed by government guaranteed deposits is a terrible idea.
At the SEC creation in the 1930s, one of the key requirements was that all companies, including banks, would need to be transparent going forward. Transparency allows market participants (lenders, borrowers, and investors) to properly assess risk. Markets cannot exert discipline when they have no transparency into assets. Allowing banks to define bonds and loans as ‘held to maturity’ is no small part of our current crisis.
Banks need better rules around impairment of large loans, and it needs to go all the way to the accounting standards. An accounting firm legally gave a kosher designation to the ‘toxic waste’ of Signature Bank in 2022 which has become the US taxpayers problem. Instead of allowing major auditors to play the ‘held to maturity’ chicanery with banks, regulators should require that banks to mark their books to market and auditors to audit pricing methodology on illiquid loans.
There are a number of policy responses that would help us get out of this mess. First and foremost, banks have to come clean about what they own. Transparency is needed – the time to find out what’s inside the black box is not when it explodes.
Thank you for reading.
Addendum
This is my second article about public policy. The first was:
Rooting Out Corruption: Public Land Registries, Apr 23, 2023
Earlier Articles on the Banking crisis:
Article 1: US is in a recession + SVB Failure
Article 2: Signature Bank Failure
Article 3: Credit Suisse Failure
Article 4: First Republic Failure
Article by Finance Substack
Editing by @J_prettybuds
The old fashioned job of trading desks was to provide a market. This means coming up, at all times, with a willingness to buy at one price and sell at a slightly higher price. This is called making a market and the people who do it are market-makers. The difference between the prices is called the spread.
I was excellent at this job, and while the head of the distressed desk and I had a great relationship, he found my monthly book markings highly annoying. So he nicknamed me “Mark” and proceeded to call me that henceforth.
Bernie Madoff’s scam was empowered by using a tiny shop called Friehling & Horowitz that nobody knew for anybody else and, as it turned out, didn’t even conduct audits.
At the start of 2022, Silicon Valley’s T1 leverage ratio was 7.96 percent and Signature’s was 8.79 percent. Leverage of 12.5 and 11.3 respectively. There are other ways to calculate leverage ratios but the basic one gets the job done.
Illiquid and Insolvent are fancy words that both mean a bank is bankrupt. Illiquid means that all the assets (loans, real estate, etc) are not worth enough to pay back all the depositors. Illiquidity means when there is a temporary cash crunch usually due to a run on the bank, Mary Poppins style–it is possible for a run on the bank to cause a solvent bank to go bankrupt. Banks tend to get pushed into bankruptcy due to being illiquid. In all US cases in 2023 so far, SVB, First Republic, and Signature Bank, the failed banks have been both illiquid and insolvent. The FDIC has had to take a loss on sorting out all three banks due to their loans and bonds having lost a ton of money.