Sorry, No Empathy, No Bailouts And YES I MEAN IT

Guest Post by Karl Denninger

Oh but so many climate-related firms are going to fail to make payroll!  – Any one of a thousand Internet scolds.

My answer: So what?

Next up – Republic, which apparently had lines out the door (if you believe the Internet) on Saturday.  Again: So what?

Folks, bubbles attract stupidity.  Stupidity is a constant in the universe; in fact it is likely the only thing that is truly infinite (with all due respect to the late Mr. Einstein.)

The so-called “Chief Risk Officer” at SVB had a masters in….. public administration.  Anyone care to bet if she passed any form of advanced mathematics — you know, like for example Calculus or Statistics?  Do you think she understood exponents and why this graph made clear that concentration of risk and duration was stupid and likely to blow up in everyone’s face — including hers?

How about Bill Ackman and the others on the Internet screaming for a bailout?  How about the CFOs of public companies like Roku that stuck several hundred million dollars in said bank?  Was it not widespread public knowledge (and available to anyone who took 15 minutes to do research, which you’d think someone would do before putting a hundred million bucks somewhere) that this institution was chock-full of VC-funded startup companies which, historically fail 90% of the time and their debt becomes impaired or even worthless?

Where are the indictments for fiduciary malfeasance among these people?

It takes a literal five minutes with Excel to prove to yourself that if debt is rising faster than GDP no matter the interest rate eventually the interest payments on that debt will exceed all of the economy.  This of course is impossible because you cannot use over 100% of anything as its not there, but long before you reach that point you’re going to have trouble putting food on the table, fuel in the vehicle and paychecks are going to bounce.  It was for this reason that one of the first sections in my book Leverage, written after the 2008 blowup which I chronicled and laid bare upon the table featured exactly this chart.

The last bit of insanity was just 15 years ago by my math.  Did we fix it?  No.  What was featured in the stupidity of 2008?  Allowing banks to run with no reserves.  Who did that?  Ben Bernanke, who got it into the TARP bill that eventually passed and which I reported on at the time.  It accelerated that which was already going to happen because Congress is full of people who think trees grow to the moon, leverage is never bad and exponents are a suggestion.

Oh by the way, your local Realtor thinks so to as does, apparently, the former SVB “risk officer” who, it is clear, didn’t understand exponents — or didn’t care.

The simple reality is that it must always cost to borrow money in real terms.  This means the rate of interest must be positive in said real terms, which means across the curve rates must be higher than inflation — again, in real terms, not in “CPI” which has intentional distortions in it such as “Owner’s Equivalent Rent” when you’re not renting a house, you’re buying it.  Had said “CPI” actually had home prices in it then it would have shown a doubling in many markets in that section of the economy over the last three years.

In other words housing alone would have resulted in a roughly 10% per year inflation rate, plus all the other increases, which means the Fed Funds rate should have been 300bips or so beyond that all the way back to 2020 — which would put Fed Funds at about 13% for the last three years.

It isn’t of course but if it had been then all those “housing price increases” would not have happened at all.  Incidentally even today the Fed Funds rate is below inflation and thus the crazy is still on.

It’s a bit less on however, and now you see what happens when even though they’re still nuts being slightly “less” nuts means that these firms are no longer capable of operating without the wild-eyed crazy; even a slight reduction of the heroin dose caused them to fail.

Never mind the wild-eyed poor choices of executives (who signed off on all of this?) at SVB which the regulators all knew about and ignored.  The CEO?  A director of the San Francisco Federal Reserve.  Why don’t you look up a few of the other “chief” positions and what they used to do.  Bring a barf bag.  No, really.

And what did Forbes think of all this?  Why it was good for five straight years of SVB being rated one of their BEST BANKS!

Negative real rates are never sustainable.  The insidious nature of that nonsense is that it extends duration in pre-payable debt, specifically mortgages.  Mortgages have had a roughly 7 year duration forever, despite most of them being 30 year paper nominally because people move for other than necessity reasons (e.g. “I want a bigger house”, “I want to live here rather than there” and so on.)  A huge percentage of said paper was issued at 3% and now is double that or more.  Since a mortgage is not transportable (when you sell the house you extinguish the old one and take a new one) and changing that retroactively would be both wildly illegal and ruin everyone holding said paper you can’t retroactively patch the issue — which is that now nobody with a 3% mortgage is going to prepay it and move unless they have to and so the duration is extending and will continue for the next couple of decades.  This in turn means if you have a 3% mortgage bond, the new ones are 7% and there’s 10 years left on the reasonable expectation of its life you’re now going to have to discount the face value by the difference in interest rate times the remaining duration or I won’t buy it since I can buy the new one at the higher rate!  This is not a surprise and that it would happen and accelerate was known as soon as inflation started to rise and thus force The Fed to withdraw liquidity.  The Fed cannot stop because inflation is a compound function and at the point it forces necessities to be foregone the economy collapses and, if continued beyond that point THE GOVERNMENT collapses because tax revenue wildly drops as well.  The only sound accounting move at that moment in time as a holder of said paper was to dispose of the duration or immediately discount the value of that paper to the terminal rate’s presumption and adjust as required on a monthly basis.

Nobody did this yet to not do it is fraud as these are not only expected outcomes they’re certain.

Where was the OCC on this that is supposed to prevent such mismatches from impairing bank capital?  How about The Fed itself, or the FDIC?  The San Francisco Fed was obviously polluted as the CEO was on their board (until he was quietly removed on Friday) but isn’t it interesting that all these people who were intimately involved in firms that blew up in 2008 were concentrated in one place in executive officers with direct fiduciary responsibility?

And isn’t it further quite-interesting that all the screaming you’re hearing right now is about how “terrible” it will be that “climate change” related firms will be unable to make payroll and the new upcoming VC-funded startups won’t because their favorite conduit has been disrupted?  What’s that about — the entire premise of these firms requires them to not only force their startups to bank in specific places with large amounts of money (since they don’t earn anything they have to have access to and consume tens of millions or more a year) but cash management, you know, putting all of it other than what you need to make payroll next week in 4 week bills is too much to ask?

There’s a rumor floating around (peddled by Bloomberg) that over one hundred venture and investment firms, including Sequoia, have signed a statement supporting SVB and warning of an “extinction-level event” for tech firms.  Really?  Extinction for technology or extinction for cash-furnace nonsense funded by negative real interest rates which make all manner of uneconomic things look good but require ever-expanding, exponentially-so, levels of debt issuance?

Again, that is not possible on a durable basis and once again the reason why is trivially discernable with 5 minutes and an Excel spreadsheet and graph.  It takes about an hour to do it manually using graph paper, a basic 4-function calculator or the capacity to perform basic multiplication on said paper and a pencil.

Now some basic facts on SVB specifically.

The capital structure of a bank in terms of who loses and in what order looks like this:

• Stockholders; first to go, and go they shall.  If you owned stock in this firm you have a zero.
• Bondholders, second to go.  Rumor on the street is that the bid on those bonds is about 40 cents on the dollar.
• Uninsured depositors; next up, those with over $250,000 per TIN/EIN/SSN in the bank.
• Insured depositors; those are guaranteed (if necessary) by the FDIC.

Here’s reality folks irrespective of the screaming on the Internet and elsewhere in the media: The bonds still have a bid, which means those people who do this stuff for a living, and when they’re wrong they lose a lot of money (they’re not wrong, in other words) do not believe the bank has lost all of its bond-based capital.  They’re insolvent – which just means the bond capital has been invaded.  In other words the actual loss when all is said and done for uninsured depositors is likely to be zero or close to it.  Of course this presumes we have a basic failure due to stupidity here and not fraud on top of that, which is yet to be determined with finality.  However, it may be a while before said uninsured depositors can get their money since if there was fraud then indeed some of that is gone and, if there was an interest rate being paid on it, well, it isn’t anymore.  That is, the most-likely outcome for uninsured depositors is that some of their funds have been converted into a forced-time-deposit (e.g. “CD”) paying zero interest until the bank can be either sold off or wound down and the assets disposed of.

If you’re a company and have a huge amount of money there under these conditions obtaining a short-term line to cover that for operating purposes within days should be no big deal — unless, of course, you are a money-losing operation and can’t subordinate those deposits to secure the line because you have loan covenants that make that impossible or worse, you can’t borrow or bank anywhere else without violating your other covenants such as, for example, with said venture fund that, along with SVB, loaned you the money you’re operating on.  If you did that then yeah, you’re screwed (and so are your employees) but that’s not a function of the bank going out of business its your own fault because you were stupid and were operating an unproved, money-losing outfit funded by the leverage games that were created by said negative rate environment.  If you’re in that position or employed by someone in that position what you deserve is nothing because you were stealing from the public at-large via these machinations and your bet that you could grow out of it proved false.  That this was “legal” does not change the essential character of what you were either doing or living on.  You gambled and lost so shut up.

Folks, you may personally think the “bubble” side of such things is great.  You may even have a job as a result of it.  You might be a “coder” even though you can’t really code as you don’t understand assembler or even how a computer actually works and thus you rely on some other piece of nonsense (like “Android Studio” or some other “abstraction” layer) to keep your software from blowing up. You might be a “Chief Risk Officer” who has a Masters in Public Administration and, it appears, never managed to pass a math class requiring the understanding of statistics or, for that matter, even exponents.  You might be one of the 90% plus who makes their living extracting funds from others in the medical system but never provides a single second of care to a single person and thus, when you get down to it, your job is to steal rather than heal.  And you might be one of those so-called property owners who thinks AirBNB is great with not a care in the world that the bartender in the local tourist establishment has nowhere to live because on that salary they can’t pay $500,000 for your one or two-bedroom cabin with no closet space.

I think I want to update Einstein’s observation on stupidity being infinite to include insanity, which, it appears, is in danger of exceeding stupidity in terms of prevalence.

You learned nothing from what happened 15 years ago and you demanded nothing change either.

Now there are people screaming that The Fed has “caved” and is bailing people out. Nope.  Here’s their term sheet for the “Bank Term Funding Program” (Bring The Frapping Punch!).

You’ll note a few things.

First, the collateral has to be good.  The list of things you can pledge is found here under 201.108(b); it includes Treasuries, Fannie, Freddie, Ginnies and similar.  Note that FHA insured loans are not eligible because it is not an unconditional guarantee.  This is important.

Second, yes, they are allowing them to be pledged at “par” rather than with a haircut, but there’s a price to that, which is that the lending against it is at a penalty rate and the advances are made with recourse, so if there is fraud (for example) and the collateral is not actually good the bank that does it is boned.  Second, since you must pay interest on the advance (and that ain’t zero anymore!) you are digging a bigger hole and had better have a way to get out of it.

In short all this does is stop the predatory circumstance that people like Ackman were trying to incite over the weekend.  The basic problem, which is that OCC and the banking system generally, along with the ratings agencies, have sat on their hands with a known duration extending event, that is basically locking people in 3% mortgages that will not prepay as usual except under extreme duress, and on top of it with an interest rate mismatch that have a lower cash flow than current note issues of the same type and character which means their current value, if sold, is less.

But if not sold, while their face value is “good” in that they have unconditional guarantees you still get a much smaller coupon, which is what you’re operating the institution on and with which you’d like to pay interest on your deposits, than you have with more-current paper issued at a higher rate.

There is no way to fix that, it was certain to happen and was not speculative thus not including that in your “models” is fraud as is ignoring it if you’re a bank executive or regulator and it is for that reason that the OCC and Fed should have, six-plus months ago when it was clear inflation was not “transitory” and disappearing in a few weeks forced disgorgement and roll-down into the short end of the curve so as to prevent this from becoming an issue.  Yes, that would have hit earnings and of course the ever-sacred “buybacks” and thus stock prices in those firms would go down.

Well, guess what?  Stanching the predatory behavior of jackasses like Ackman does nothing to resolve the fundamental problem in that the monetary heroin cannot be restarted and as a direct result now, the time is for all this crap of the last fifteen years, and the entire reason this blog exists, to come back out of the system.

One of the best definitions of insanity I’ve ever heard is doing the same thing over and over again but expecting a different result.

Welcome to 2008, part deux.

Let me know when you’re ready to force those who did it last time and now have done it again off the public policy playing field.  They won’t go willingly; tyrants, thieves, brigands and other malefactors never do.

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