Brief
The failure of SVB Bank is quickly and drastically changing the level of economic activity in the United States. We are in a new stage of recession.
Ignore the usual calls to pull back military aid to Ukraine. Now is the best time for doubling down on US military production and aid to Ukraine for both of our sakes.
Note: for anyone who reads me only for Ukraine/Russia content: most of this article is about the current US financial mess and you can skip to the short section near the end about Ukraine support.
Recession – 1 Year In
We’ve been in a recession for about a year. I called it a recession last spring due to supply chain problems, inflation, and broad economic weakness. I was not alone in this outlook, but it was not a uniform view. Unlike recessions of the past 40 years, this recession contains supply side driven inflation, caused mostly by the bullwhip effect from covid and accelerated by Russia’s actions in the full scale invasion of Ukraine. Unlike inflation in the 70s, we are not seeing any wage/price spirals – wages are rising slower than inflation is rising and Unions do not have contracts that link pay to cost of living so there are no automatic wage increases. Europe, Japan, and the other free market companies(countries?) all have similar economic pressures, but significant divergence in how it is playing out. At risk of oversimplification, countries that depend on Russia and Ukraine for supply lines are experiencing higher inflation and worse economic outcomes, such as the Baltics and Poland.
The federal reserve has chosen to raise rates into this recession to attempt to fight inflation (discussed below). Jerome Powell has stated that “there could be some pain involved to restoring price stability". Well, Chairman, the pain is here in spades.
Digression: For the wonkish reader, here is a great paper on why we do not have any effects of wage-price spirals, and breaking down at length when the inflation pressures should subside (in short, this summer). Agreement with Professor Blanchflower’s politics, is not required to read his accurate analysis on our current economic forces:
https://bpb-us-e1.wpmucdn.com/sites.dartmouth.edu/dist/5/2216/files/2022/10/final-keynesian-inflation-paper-oct-25.pdf
The Federal Reserve: Inflation, Rates and Unemployment
The federal reserve has a dual mandate: fight inflation and keep employment high. In our current recession, both metrics are off the rails.
The broad US unemployment rate is being underestimated. The assumptions in the calculations are old and do not take into account circumstances like internet job postings (no really; they have not been updated to take into account this massive change).
When it comes to fixing the books, I like simple numbers with as few assumptions as possible. My preferred back of the napkin, to see if unemployment in America is being reported with sanity, is Labor Force Participation – a metric that is simply, how many non-institutionalized people over the age of 16 are working.
This metric shows a labor market that never recovered from Covid, and possibly never recovered from the financial crisis. The delta from 1998 to now would equate to about 5% points added to the inflation rate. Using some fun econometrics, Blanchflower estimated that the economy is short 11.9 million jobs – or about 4% more unemployment. The assumptions that have gone into the unemployment algorithm have made it a work of fiction: people assumed to have quit the employment force1 and the data on job openings, are two especially problematic numbers.
Inflation can have multiple causes: supply problems, high demand – making the economy run hot, or a combination of both. Unfortunately the fed only has one major tool: the interest rate. Here I would note, the fed also controls the money supply – normally this is just an expansion of the interest rate, but after the 08 financial crisis, the federal reserve expanded its balance sheet and now owns over 8 trillion in US government bonds. (link: https://fred.stlouisfed.org/series/WALCL)--This gives the fed a second option for reducing liquidity should it so choose.
This recent bout of inflation falls clearly on the Supply Side of the equation. The global Coronavirus pandemic massively disrupted supply chains and production of everything from Natural gas to clothing to Semiconductors. This created what is known as the Bullwhip Effect. For those who have not heard of the Bullwhip affect before, here is a brief video explanation:
As inflation pressures were really ramping up in early 2022, Russia began its full scale invasion of Ukraine. This created even more shortages of needed goods, especially food and energy, and disrupted supply chains further.
The best way to deal with supply side inflation is to try and fix the supply side itself: fixing supply chains and providing more needed goods. For instance, changing laws around NIMBYs in cities so there is housing where people want to live, drilling more oil and gas, and investing in domestic generic drug capacity.
What does not help fix inflation which stems from the supply chain? Raising rates to crush aggregate demand. In other words: causing a huge recession and lots of unemployment.
Unfortunately for supply side recessions, the Fed can only control money supply and interest rates, and has no control over fiscal and industrial policy.2
Jerome Powell sees inflation, trusts the unemployment numbers and wants the Federal Reserve to appear ‘credible’ in its fight against inflation (note: credibility is not an economic measurement). On Tuesday, Mar 7, Jerome Powell said “nothing about the data suggests to me that we’ve tightened too much.” He was apparently not looking at the same data as myself, Professor Blanchflower (a former rate setter for Bank of England), and others. In 2022, the Federal Reserve raised rates into a supply side recession and massively slowed the real estate market, mortgage market, and other parts of the housing economy. Essentially he was raising rates until something in the economy broke – contrary to all rhetoric, this is the policy of a ‘hard landing’ or major recession.
SVB Bank and the C Word
On Wednesday Mar 8, Silicon Valley Bank had 42 Billion in customer Withdrawals. After trying to raise cash on Thursday but failing – on Friday, SVB Bank became the second largest US bank failure ever.
Finance has its own C word: ‘Contagion.’ When a big company goes bankrupt, especially a financial firm like a bank, there is always the risk that it causes a cascade of bankruptcies in the economy. There are 3 reasons to consider how the failure of SVB might create contagion. The immediate actions of the regulators, especially the FDIC, will determine how these play out and how many other firms will be affected.
Contagion risk of standard banking customers losing access to their money and services. SVB can really hurt a lot of tech firms and startups. It held a large number of tech founders’ wealth, in addition to a large amount of corporate accounts for the startup community. This could cause some startups to miss payday or even go under, as well as problems in San Francisco area real estate.
The FDIC insures deposits up to 250,000 per person per bank. However at Silicon Valley Bank, a whopping 88% of their deposits were over that threshold (by comparison, Bank of America only has 32% of deposits over that threshold). Tech executives and tech firms with money stuck in FDIC receivership could be waiting on their funds for a long time and are not sure if they will be paid in full. Further, some startup type firms with loans from SVB have been getting a break on their loan covenants, as they could not easily raise new capital in a weak funding environment—we do not know how many of these companies there are on the books. Enforcing the covenants of these loans could cause a wave of bankruptcies for an unknown number of startups whose futures were formerly questionable, but not yet terrible.
For a startup whose working capital was at SVB, their payroll and ability to pay rent is now stuck and they could go out of business if this is not fixed quickly. Compounding matters, there are payroll firms that banked with SVB whose clients did not have payroll go out on Friday. Some companies who never directly worked with SVB are being impacted, which further brings people to have serious contagion fears.
That letter above is the kind of stuff CFOs and CEOs have nightmares about—it is also exactly where SVB Bank could spiral into contagion fears.
Some crypto businesses tied their standard boring banking to SVB. The ‘Stablecoin’ of USDC is now priced below its $1.00 peg because it has millions of collateral stuck at SVB Bank.
The pain is not localized to the US. The UK Tech community also panicking about the SVB failure.
Contagion risk of the systemic problems at SVB, which are problems many other banks may have. SVB failed in a traditional way for banks, but the pressures its balance sheet was under, will be felt in some fashion by most vanilla US Banks. It had a lot of recent deposits and while its deposit base was very corporate in nature, many of its recent loans were against treasuries and high quality mortgage mortgage bonds.
SVB Bank had rapid deposit growth in 2022 and as a result they purchased ‘safe’ high quality mortgages against those deposits. This is standard, vanilla banking. Due to the rising rate environment, those kinds of loans lost money. When SVB sold that portfolio in its entirety to try and meet redemptions, it announced a loss of a whopping $1.8 billion. Unrealized losses in securities portfolios across all US Banks is currently estimated at $620 billion per the Wall Street Journal. So the way in which SVB lost lots of money, is a risk for many banks.
Further, it currently appears people will lose money held at SVB over the FDIC threshold. There is a concern that small banks, weak banks, or medium size banks with larger accounts will experience huge deposit withdrawals. Deposit levels and bank runs is something financial analysts will be watching closely in the coming weeks.
Contagion risk from derivative exposure. This is how the banking system lit on fire in 2008. Thankfully it appears so far that SVB did not have significant ‘off balance sheet exposure’ (aka derivatives) with other banks. At present, there is nothing suggesting that because of this failure, another bank is owed hundreds of millions of dollars or more which would cause that bank to be at risk.
2 out of 3 contagion risks are still open questions on the ‘find out’ part of the equation.
How does this Affect US Support for Ukraine?
Within the next week, if not the next month, I expect to hear some laypeople, politicians, and media questioning ALL foreign aid. This is a normal reaction in a recessionary environment.
For those of us calling the recession last year, we see a lack of aggregate demand in the US economy and inflation caused by supply shocks – a problem more similar to the 1970s than anything since. Given the lack of aggregate demand, robust domestic industrial production would be very helpful to our economy at present. It was the industrial buildup for World War II that finally ended the Great Depression – and on a smaller scale, increasing production of arms for Ukraine and the broader arsenal of Democracy would be very helpful to today’s economy.
For people who completely disagree with my economic analysis and say there is only so much we can afford – Never Again still means just that. We need to help the Ukrainians defend their democratic nation against genocide by an oppressive Dictator.
Thank you for reading.
Article by
Cohost and finance analyst on @MriyaReport
Addendum: SVB Recovery Estimates and Fixes
For the wonkish out there, I wanted to provide the numbers on current estimates of recovery for depositors of SVB.
As of Saturday evening, here is a balance sheet estimate by macro trader @Citrini7 twitter. Similar quick balance sheet analyses have come up with 75-86% range of recovery. I am on the low side of this estimate because I expect the loan haircuts to be larger without some form of quick intervention – I think this loan book is going to be discovered to have significant correlation and look quite toxic in a recession…
I give @citrini7 some credit because he is doing a victory lap after calling the SVB problems back in Autumn.
The recovery of assets would go better if rates came down quickly, immediately, because it could really boost the value of their Mortgage positions and likely assist in the loan book. The reverse is also true, should rates keep rising, this recovery will be on the optimistic side.
Either way, my wild guess (and in this case, also my hope) is that the FDIC prioritizes contagion risks in recovery. That would mean paying out corporate balances first so that the swath of the startup community with their capital stuck at SVB, does not go bankrupt due to missing all of their working capital, and thus missing rent and payroll.
Given that so many of the corporate assets are also tied to bank loans (and mortgages and wealth management), it may be prudent or necessary to package as much of this business together as possible and sell off the portfolio over the weekend or next week to a large bank. This would allow standard credit officers to work through the relationship issues of the loans and loan covenants while also giving the companies the possibility of success. Delaying or giving a haircut to working capital of startup firms is bound to have very negative downstream effects. Delaying working through this portfolio will start causing damage quickly, especially for anyone who misses payroll or commercial rent payments.
There is a calculated assumption that people who haven’t worked in a long enough period of time have quit the labor force. This is a longtime bugaboo of the ‘Unemployment is a bad metric’ crowd. The author used to think it was a slightly flawed but still useful metric. However, during Covid, lots of people dropped out of the labor pool for a long period of time, massively exacerbating the usual problem of recessions with this metric. As such, the flaws have gotten greater and this number should be viewed as refined horse manure.
Interestingly, at least to this writer, the Fed chose to raise rates into a recession instead of stopping the rate rise at some point and selling off the bonds it purchased in Quantitative Easing. Keeping the rate at a much lower level, say the Bagehot line of 2%, while selling off treasury bonds would have caused disruption but would not have guaranteed every bank in America losing money on its safety assets. Selling off the bond portfolio aggressively would’ve let the Fed contract the money supply very directly. While nobody knows exactly the results here, because we’re in uncharted waters with the QE portfolio, it was certainly worth trying as the alternative is our current situation which appears even less stable with systemic risks compounding across the loan books of most major banks.