The Leveraged Sellout

Malt Liquidity 95

Yes, this is a banking crisis post. I’ll try not to be too long-winded. And… I’m back.

Credit for the post title goes to an all-time relic of banking days past, leveragedsellout.com. Damn, it felt good to be a banker.

Lynchpins

Let’s take a quick recap of the financial system:

…when boiled down to its simplest elements, the system is essentially made up of three pillars: equity, currency, and debt. Equity provides liquidity to hope. Currency provides liquidity to bargaining — our transactions have to be denominated in something. The most important pillar, and what underpins it all, is debt, which provides liquidity to trust. The systems of law and government provide a safeguard of enforcement to trust, but trust without liquidity cannot scale — there is no society without it. Connecting these pillars is the banking system, which facilitates the liquidity provision.

The capital story tells us that this system exists to allocate money efficiently to facilitate growth. But this entire system is truly a risk management framework. “Finance” is the practice of pricing and allocating risk through the movement of capital and reorganizing exposure to those movements and what it creates. It’s truly a composite field composed of all sorts of “actual” areas of study like math, law, econ, history, and philosophy, with a little psychology thrown in for good measure. As such, it’s where generalists truly shine.

I’ve talked a lot about interest rates — a lot — but I guess it’s important to know what an interest rate is, considering nobody involved in current events seems to understand it:

an interest rate is compensation for the risk on loaned capital.

Much like the intermediate value theorem, this is intuitively really simple to grasp but the implications are profound, namely that every act of lending, direct or indirect, innately contains some risk. Match this principle with the concept of systems in general:

Belief in systems can be rooted in rational thought so long as the system is constructed logically, as mathematics and legal methodology attempt to do. The belief that a set of humans will take the right course of action consistently is more along the lines of faith.

In a more practical manner, we can think of every act of depositing capital in a bank as an act of lending. This isn’t particularly insightful — the fractional reserve system necessitates this — but, as recent events have clearly shown people, if your money is in a bank, you are a stakeholder in that institution. The bank’s success is tied to your success! Whatever Bank of America pays you is compensation for the risk taken by that deposit.

Retail banking compared to investment banking is like that old prom date you sort of want to forget exists versus remembering that one time the homecoming queen got dinner with you. The glory days are over in both cases, but at least one of those memories contains a glossy veneer of feeling like Gordon Gekko. Certainly lending is one of the oldest businesses (and the basis of societal systems, as I’ve written about before) but it hasn’t been an interesting line of work since well before my existence. The most interesting line recently written about retail banking prior to this year was that Mad Men line about “executive accounts” because a lot of it is just spread collecting between what you take in and where you put it, and you’re not really sticking it in interesting places. Usually, this doesn’t amount to much, because the past two decades of monetary policy and the remarkable financialization prowess post-1980 led to much more interesting postulations and work regarding investments, trading, and debt-fueled transactions. Usually.

There’s not much to say about SVB et al’s mismanagement of interest rate risk and everything that’s happened that hasn’t been said already by everyone, including me in the plethora of phone calls, convos, and emails I’ve exchanged since then. It’s overwhelmingly clear that most people across most industries (and regulatory bodies) are finance-illiterate. Truthfully, if you’re under ~45, odds are you’ve never been in a position of seniority when rates have actually been meaningfully high. This is why thinking systemically and understanding history is useful. You’d be shocked at how many people simply don’t understand what an interest rate is or why someone would pay it. Well, now you do. Instead, this is a bit of a rant. I’m about as far from “Occupy Wall Street” as you can rationally be — I simply don’t think they’d know where to go — but this scenario and how quickly regulators did something they spent a decade post-2008 saying they wouldn’t do is deeply disturbing to me:

Europe’s financial regulators are furious at the handling of the Silicon Valley Bank collapse, privately accusing US authorities of tearing up a rule book for failed banks that they had helped to write. While the disapproval has yet to be conveyed in a formal setting, some of the region’s top policymakers are seething over the decision to cover all depositors at SVB, fearing it will undermine a globally agreed regime. One senior eurozone official described their shock at the “total and utter incompetence” of US authorities, particularly after a decade and a half of “long and boring meetings” with Americans advocating an end to bailouts. Europe’s supervisors are particularly irate at the US decision to break with its own standard of guaranteeing only the first $250,000 of deposits by invoking a “systemic risk exception” — despite claiming the California-based lender was too small to face rules aimed at preventing a rerun of the 2008 global financial crisis.

Everyone at this point understands that the people running these institutions were beyond incompetent at managing a very simple risk arising out of a scenario that anyone who paid any attention to markets was aware of — that rates were going to rise. (Seriously, I remember sitting around in discord voice channels in 2021 where teenagers and young adults were hanging on every telegraphed, mundane word in real time regarding an FOMC meeting. It’s utterly absurd how the most boring part of finance went mainstream.)

Banking is a necessity in this day and age, and we want people to have access to their capital without stuffing it under a mattress. The goal of insured deposits is to insulate people who don’t have a choice of participating in the system from that risk. 250k in liquid assets is a ton of money — 2 million in liquid assets would put you in the 99th percentile. Backstopping people below these net worths on their raw deposits makes total sense to me — it should never be an issue whether their credit union or bank is about to go under and lose their actual cash.

But the people who these banks served should have known the risks that depositing with a bank entails. That’s why they pay you the rate! Look, a JP Morgan isn’t even going to sniff at a client below $50 million and they’ll restrict their services accordingly. I have a severe dislike of Michael Lewis and the Big Short, but the “meeting” in the lobby scene is generally how small funds and companies are treated. It’s not worth their time. Unless you’re making Indonesia-GDP-sized bets on green tea and paying 8 figures in premium a trade or your company is the star of a big issuance roadshow, you’re going to be ignored by the big boys. Of course, this is what market competition for clients brings — a smaller institution can offer higher interest rates and more personalized service to try and draw these clients away, which is what these banks did by financing wineries, lending against equity and crypto, and lending to companies that wouldn’t pass scrutiny in most institutions (cough, Silvergate.) This strategy makes sense in a rising rates environment, you can make much more on spread-collecting because there’s actually a spread — but this naturally implies that, well, you should be aware of what to do when the rates actually rise.

Look, I’m not saying everyone should have been blown out on their deposits with SVB and such. But the FDIC is not supposed to be invoked, ever, when it comes to backstopping these types of depositors. The Fed and the Treasury are supposed to assess banking risk and provide liquidity (and maybe “big stick” a few mergers while they’re at it a la CS.) The natural order of things would have been for the market to bid for the book. The issue with all of these books was duration risk, not default risk — it’s the only way you can blow up on treasuries. A massive chunk of Americans don’t understand interest rates, and I guess the sector most narratively attached to the US growth story didn’t understand it either. To me, this is administrative overreach — the definition of socializing losses and privatizing gains. The only possibility that troubles me as much as the risk-free rate no longer being risk-free is the reality where defaulting isn’t even allowed.

The original core delusion of modern America was that the post-60s boom was sustainable and that was how things should be rather than the greatest confluence of circumstances to create a once-in-a-lifetime boom that fueled the growth story until 2008. Now, we add one more core delusion to the mix, for this generation — that the mentality surrounding money that we grew accustomed to in the ZIRP era is how things work, rather than an unprecedented step to fuel economic recovery. You know what they say about addiction — that mentality never goes away.