Summary This past week was the most dramatic week in banking since the Great Financial Crisis. The Crypto space needs a robust regulatory framework. Moral hazard is as relevant as ever and needs to be taken into serious consideration by the US Government and Federal Reserve. The Story of Recent Economic History Economics is not just the study of cosmological numbers. It is the study and storytelling of excess, fear, triumph, and growth. Successful economists are able to mix equal parts data and storytelling to provide a compelling view into the black box that consistently turns similar inputs into drastically different outputs. By this point, you should all be aware that the week of March 6th, 2023 was the most dramatic week in the banking sector since the Great Financial Crisis. This week will be but another unfortunate case study in business textbooks that are published in the coming years, and although the rippling impacts are not yet fully understood, we already know what the arc of this story is. It seems like yesterday the economy was brought to its knees by the COVID-19 pandemic. In economics jargon, COVID was an exogenous shock to both supply and demand, and a rather dramatic one at that. It demanded arguably the most striking fiscal and monetary interventions in the history of the United States. After the economy is brought to a sudden halt, the swirling uncertainty and fears of an uncontrollable economic catastrophe require swift and sensational action. That action was the pumping of the economic pipes full of liquidity, causing the most rapid increase in money supply we have ever seen: Data by YCharts Essentially overnight, the total money supply in the economy more than tripled. Flooding the economy with cash is not necessarily an issue, but can lead to some interesting developments. We saw somewhat predictable outcomes; a stock market boom, a spike in personal savings, a drastic increase in bank deposits, and a subsequent surge in lending. In a vacuum, none of these should lead to catastrophic outcomes. As we know, 2022 saw a cooling of the market, a slowdown in lending volume, the fastest interest rate hike cycle in modern history, and a decreasing personal savings rate. Data by YCharts Again, none of this spells disaster. There is an increased likelihood of recession, more risk in the short-term market returns, and the return of high-yield savings accounts, but not impending doom. Irresponsibility and billions of dollars, mixed with muddled incentives, can drive irrational behavior and this week we got a taste of just how swift disaster can strike. Banking The story of Silicon Valley Bank ( SIVB ) is one of risk mismanagement. By year-end 2019, SIVB had a touch over $60B in total deposits. By year-end 2021, deposit volume ballooned to nearly $189B. Deposits are a liability for banks. At any moment, a depositor can walk into a bank branch and demand that money back. These liabilities are balanced by the core asset of a bank: loans. Banks generate profit by lending money at a higher rate than the rate they pay for deposits. In essence, while you may earn upwards of 4% in your savings account today, the bank is probably earning 5%+ on that money. For years, this dynamic was a non-factor for the risk management departments of banks. With interest rates at rock bottom, depositors didn't have a good alternative to low-yield deposit accounts. Therefore, banks could take deposits and lend or invest in marketable securities and make a healthy spread on that money, all while keeping the deposit base safe and sound. It's a win-win in this case: depositors have confidence in the safety of their money, banks can generate profits, and the economy is stimulated by fresh money creation. In the current environment though, depositors expect to be earning interest. When you can 'deposit' (in reality you are lending) money with (to) the US government and earn almost 5% interest , there's very little incentive to keep your money in a low-interest bank deposit account (other than liquidity). As a result, all banks have drastically increased the interest rate offered on high-yield deposit products to maintain relevance. Banks and fintechs alike need to offer almost 4% on savings accounts, while other products like certificates of deposits command even higher rates to compensate for their relative illiquidity. Robinhood ( HOOD ), a popular investing app, offers 4.15% on its cash sweep product, which allows users to sweep uninvested cash into a bank deposit account and earn interest instead of letting the cash sit. HSBC Bank's ( HSBC ) fully-owned US subsidiary offers 4.25% on a 12-month CD and just a touch over 3.50% on its high-yield savings account. This business model demands proper risk management. As Warren Buffett is oft quoted, there are more banks than bankers in this country. Irresponsible lending is the Achilles heel of any banking institution. The minute depositors lose faith, any bank immediately becomes an uninvestable and doomed business. Lack of faith will set in motion a bank run, in which depositors will demand their money back, and the bank will have insufficient cash on hand to meet withdrawal requests, effectively going bankrupt. This is dangerous because banks lend money out, and they can't call loans back as easily as depositors can request withdrawals. SIVB fell victim to this. As described above, banks make money by lending out deposits. This is referred to as fractional reserve banking. The reserve requirement is the percentage of total deposits that a bank must hold in cash ("cash in reserve") instead of lending. During the COVID uncertainty, the Federal Reserve dropped the reserve requirement to 0, and although this made sense at the moment, it was folly for the Fed not to increase the reserve requirement once the 2021 boom was in full effect. However, even if we had a higher reserve requirement, SIVB may still have met the same fate. SIVB had very little diversification in its lending base. Total loans more than doubled, from $32B in December 2019 to $73B in December 2022, and a significant portion of these loans was in the tech industry. Tech, particularly micro-cap tech, saw the deepest pits of the 2022 bear market. With an overwhelming majority of its lending base belonging to the industry suffering the most, SIVB became a ticking time bomb. That timer was set to March 10th, when SIVB went "poof" overnight. As deposits were drastically increasing, SIVB bought a low-yield, unhedged bond portfolio in 2021 to keep that money working. In and of itself, this isn't a major issue. The issues began when the Fed began rapidly increasing rates to tame inflation. SIVB management had the decision to make: either keep the money earning ~2% in this bond portfolio or sell at a loss and put the money in US T-bills earning ~5%. They decided to sell at a ~$2B loss and buffer this loss with a stock offering of comparable size. This offering would have covered the loss but would have also diluted current owners by nearly 20%. The stock tanked on Thursday, March 9th in response to this news. Even on the morning of March 10th, it was not entirely clear whether SIVB would fail or not. There was a chance to shore up liquidity with the stock offering. Then, the stock offering fell through, and the stock price tanked even further. A dramatic stock price decrease does not shutter a bank in and of itself, but this stock freefall caused something much more dangerous to happen: SIVB depositors lost faith in their deposits. Overnight, withdrawal requests started piling up, and the liquidity crisis ensued. Here we are today: the FDIC effectively owns SIVB, and depositors are unsure whether they will get their deposits above $250k back. This is causing ripple effects through the California wine industry, VC space, tech-startup industry, and the crypto space. I cannot shed light on what will happen next (if I could, I wouldn't be writing this article, I'd be scraping together every penny I could find to profit off my superior foresight!), but now I'd like to shift the discussion onto crypto. Bitcoin Earlier this week, Silvergate Capital Corporation ( SI ), closed its doors one last time. What started in the mid-2010s as an expansion of the business into the crypto space by offering bank accounts to companies involved in Bitcoin services, rapidly devolved into what would cause its demise. Following the historic fraud and crash of FTX, Silvergate started feeling pressure on its deposits. The crypto space was suffering before the FTX fiasco, and this obviously hurts the banks that offer services to companies in this space. Withdrawal requests exceeded $8B , and Silvergate felt the pressure of a bank run . The company had a fire-sale of some assets, which caused another significant loss to be realized. Once they delayed the release of their annual report, depositors lost faith. As with SIVB, the end of this bank was the moment the depositors lost faith in the liquidity of their deposits. Aside from Silvergate causing concerns in crypto, SIVB is now stirring up some additional pressure in this space. Circle , the company that offers USD Coin ( USDC-USD ), has $3.3B of its $40B of USDC reserves with SIVB. This caused USDC, which should trade 1:1 with the US Dollar, to drop as low as $0.84 on the dollar on March 11th. At the time of writing, USDC has stabilized a bit to $0.94, But when a product that is designed to trade 1:1 is trading at 0.94:1, its legitimacy is in serious question. If USDC becomes entirely illegitimate, the wider crypto space will face increased pressure, on top of what has already been a dramatic bear market. At age 99, we should be used to Charlie Munger being right about things, as he so commonly has been. The investing titan of Berkshire recently called "crypto-crap" a worthless market and said anyone who disagrees is an idiot. Shortly thereafter, one of the foremost crypto-related banking institutions collapsed and now the legitimacy of Stablecoins is in question. Bitcoin maximalists believe Bitcoin transcends crypto, though. They see a decentralized finance future that uses Bitcoin as the universal currency. Fanatical claims of " Bitcoin to $1 million " have become commonplace. Even institutional investors, namely Cathie Wood, have bought into the Bitcoin hype. These maximalists also believe that Bitcoin, with its fixed supply, fixes the risks of fractional reserve banking and the fiat money system (which effectively has an unlimited supply). Bitcoin is missing a few really important aspects that the US dollar has, though. First, the US dollar has the full faith and backing of the most powerful military and largest economy in the history of the world. Second, the US dollar has an extensive taxation and regulatory framework. Third, the US Dollar has the ability to become a Central Bank Digital Currency, which is something that could destroy the utility value of Bitcoin. The one thing Bitcoin has that the US Dollar will never have is full anonymity, decentralization (except for the pesky risk that some billionaire buys up most of the available Bitcoin and refuses to ever sell it), and utilization of a blockchain network. Let's face it, if the US refuses to construct taxation and regulatory frameworks for Bitcoin, it has no future as the universal currency. At the risk of enflaming the Bitcoin maximalists, I'll even mention that all major 'milestones' of Bitcoin are denominated in USD. The milestone of "Bitcoin to $1 million" still has one very important feature: it's compared to the US dollar. The value of a Bitcoin is currently only referenced relative to how many US Dollars it's worth. Further, it has very minimal transactional value. I can't go to my local gas station and pay in Bitcoin yet. The Lightning Network makes this somewhat more feasible, but it's still in the very early stages of adoption. Anyone based in reality should not believe that Bitcoin will become the universal currency in the near future, and certainly should not invest with that expectation. If you want to use Bitcoin as a hedging tool against a deflationary fiat crisis in the US dollar, fine. But becoming the universal currency soon? Please live in reality. The 2nd largest economy in the world has already imposed an outright ban on crypto. And the largest economy will not so freely give up its status as the reserve currency of the world to a few lines of computer code. I could be wrong. There could be a decentralized finance revolution, which could make Bitcoin the universal currency of the future world. The extent of my exposure to Bitcoin will be an investment in Block, Inc. ( SQ ), though. (Mis)Behavior Finally, to tie together the two preceding discussions, let's move on to a discussion of behavioral economics and game theory. The title of this section is in reference to a book I recently began reading, Benoit Mandelbrot's The (Mis)Behavior of Markets . In his seminal application of fractal geometry on financial markets, Mandelbrot's thesis is that risk management is drastically misunderstood in modern financial theory. The foundation of modern finance theory is the assumption that variance and standard deviation are the primary components of market risk. Further, one of the main pillars is that market events follow a standard normal distribution or a 'bell curve'. In this light, modern financial theory acknowledges 'tail risk' but drastically underestimates its likelihood. For example, Mandelbrot mentions October 19th, 1987, popularized as ' Black Monday ' which saw a crash of unprecedented levels. A crash of this level should, according to a standard normal distribution, have such an infinitesimally small likelihood as to be functionally equivalent to 0%. This misbehavior, as Mandelbrot calls it, is caused ultimately by a misunderstanding and mismanagement of risk. This threat is amplified in the modern era of high-frequency trading and algorithmic trading, in which computers are making decisions in real time based on assumptions written into their programming. With a fundamental misunderstanding of risk, a historic rise in money supply coupled with rock-bottom interest rates, we finally arrive at the common thread of this story: moral hazard and misguided expectations. Something the US government has allowed to become pervasive throughout the financial industry. Moral hazard began as a fringe concept in game theory. Game theory is the study of how individuals and entities interact with each other, primarily in a market setting. Moral hazard states that there is a lack of incentive to guard against risk when one is protected from its consequences. This is best characterized by irresponsible bank lending and became a point of serious contention in 2008 when the Treasury bailed out banks with TARP (Troubled Asset Relief Program). By 2008, big banks had been giving irresponsible mortgage loans for years, bundling those loans into mortgage-backed securities, using those securities as collateral in collateralized debt obligations, and then taking credit default swap insurance policies out on those debt obligations. In what became the nightmare we are all familiar with today, we learned that you cannot seek to drive riskless profit on the foundation of a junk asset. However, when "everyone else is doing it" in a capitalist system that requires businesses to keep up or die, human irrationality quickly takes over. This irrationality mixed with billions of dollars brought the entire global financial system to its knees. Ultimately, the US taxpayer bailed out these irresponsible bankers who quite reprehensibly received very little punishment relative to the harm they caused. Thus, moral hazard becomes a very serious risk to the modern economy. If banks believe they are 'systemically important' and believe they'll be bailed out in a crisis, even if they caused that crisis, then why concern themselves with pesky and complicated risk management? Although the concept of moral hazard doesn't fit perfectly with the retail investor purchasing crypto, it certainly fits the trend of famous investors touting the benefits of crypto and related services. When you are renowned and well-respected, people trust what you say. When people trust what you say, they are willing to put hard-earned money to work in an asset you advertise. When you advertise a speculative asset because you are being paid for it, you are irresponsible at best. Certainly, this should not distract us from the true criminal Sam Bankman-Fried, but Mr. Wonderful's actions were irresponsible, greedy, and reprehensible. And yet, he's shielded from the consequences. To be fair to Kevin O'Leary, it is not his fault and should not be construed as such. However, it is a good characterization of moral hazard because I doubt he would have advertised for FTX if he was to be held liable for all potential losses of the people that invested as a result of his sponsorship. After 40 years of globalization-driven low inflation and rapid corporate earnings growth, the economy has become drunk on liquidity, low rates, and misguided expectations. The banking industry could be facing its second major crisis in a 20-year span, and many retail investors have dumped significant amounts of money into digital assets with no transactional or utility value. All of this is based on a few core beliefs: the US taxpayer will bail out irresponsible banks, the Fed will return to easy money policies, and the bulls will rampage through markets again, and soon. Moral hazard has led to irresponsible asset allocation across both corporate and personal balance sheets which could cause a financial reckoning of unprecedented levels. In 2023, the US government needs to restore rapidly deteriorating faith in the banking sector and construct a robust regulatory framework for crypto, all while bringing inflation back into balance. 2023 is a year that will be characterized by imbalanced markets and uncertainty. I cannot tell you what the optimal asset allocation currently is, but I can implore you to diversify across asset classes, cash included, and be responsible with debt. I am fascinated with economics and the markets and truly believe we are currently living through one of the most interesting periods in human history.
