GARY BRODE | From Deep Knowledge Investing
GARY BRODE | From Deep Knowledge Investing
Silicon Valley Bankcorp failed spectacularly in March 2023. The participants, the regulators and the media formed a circle of finger-pointing and blame. In this interview Gary explains "duration risk".
Duration risk refers to the sensitivity of a bond's price to changes in interest rates. In simple terms, duration risk is the risk that the value of a bond will decrease as interest rates rise. For a bank this risk is significant, as bonds make up a significant portion of their portfolio. If a bank doesn't manage duration risk correctly, it can result in significant losses, as was the case with Silicon Valley Bankcorp.
Gary notes that understanding duration risk is a fundamental concept in finance, and anyone in a finance-related role should know this. The Federal Reserve even contacted Silicon Valley Bankcorp last year, expressing their concern about the bank's bond portfolio. However, the bank ignored the warning, and the result was catastrophic.
As people started to withdraw their money, Silicon Valley, the problem they had where they said, oh no, we can't hold these bonds to maturity, we actually have to sell them today at a loss. And the problem that they had was if they could hold their bond portfolio until maturity, the bank would've been fine. But because they had to start selling at a loss, the bond portfolio was worth less than the amount of deposits that people were able to withdraw. And when that happens, you have a bankruptcy.
GARY'S NEWSLETTER THAT THIS CHAT WAS BASED ON
I’m writing this on a flight from NYC to Miami where I’m hoping to get through the airport quickly enough to catch my connecting flight to Managua, Nicaragua. I was supposed to make this trip a few weeks ago but was delayed.
The big news in the financial world this month related to banks, bank failures, bank regulator failures, and the repeat of almost every failure we saw in the financial system in 2008. Based on what I’m reading, there are some misunderstandings about exactly what happened, who got bailed out, and whether any of this was handled well. The short version is no, it was not. For those of you who are interested in the details (and at DKI, we’re all about the details), here’s a summary of what happened:
Silicon Valley Bancorp ($SIVB):
Silicon Valley Bancorp was the banker for many venture capital startup firms. When interest rates are zero, savers and investors become desperate to find places to get yield (income). That causes them to look for more risky investments. In addition, startup technology firms tend to have a lot of their earnings and cash flow far into the future. This makes them long-duration assets and the valuation for these kinds of firms goes up in a low interest rate environment. Those two factors meant huge amounts of capital went into these technology firms in recent years.
In exchange for credit lines unavailable at more careful banks, above-market interest rates on deposits, and special low-rate mortgages for executives, these tech. firms would keep balances of hundreds of millions or even billions at $SIVB. As billions of dollars in deposits flowed into the bank, Silicon Valley bought “safe” Treasury securities and earned a “spread”. (The spread or “net interest margin” refers to the difference between the rate on the Treasury bills the bank received and the deposit rates the bank paid.) So far, no problems – right?
Here's the issue: When interest rates rise as they have for the past year, the value of bonds, including Treasury securities, declines. Silicon Valley bought billions of dollars of these bonds at the top of the market. This isn’t a problem if you hold the bond to maturity because you get paid the expected amount.
However, when interest rates got to around 4%, even loyal SIVB depositors started looking for higher rates in other places. When these deposits left the bank, Silicon Valley had no choice but to sell its Treasury securities to raise cash to fund the departing deposits. That meant realizing massive losses in the bond portfolio caused by rising interest rates. Once people realized that SIVB had massive losses in its bond portfolio, meaning it wouldn’t be able to cover the value of all deposits heading out the door, they immediately wanted to withdraw their funds. This started an old-fashioned bank run.
The problem described above is called “duration risk”. The bank had a mismatch between deposits which could leave the bank immediately (and all at once), and its bond portfolio which didn’t have risk of loss if held to maturity but did have losses when forced to liquidate at lower current market prices. This is an almost-inconceivable error by Silicon Valley management. By January of 2022, DKI was warning subscribers that high inflation would lead the Federal Reserve to raise interest rates. By mid-2022, the Federal Reserve was warning Silicon Valley that its bond portfolio was mismatched (contained duration risk).
A bank shouldn’t have enough duration risk that its existence is threatened. Banks have portfolio managers and risk controls to prevent this exact kind of problem – at least they’re supposed to do so. In this case, there were plenty of warnings and a lot of time to react. Possible reasons the bank was unresponsive include the possibility that no one in charge at the bank understood bond math and risk management, no one wanted to realize the losses and preferred to hope for the best, and personal issues. As incredible as this sounds, the head of risk control at the bank was focused on issues of a personal nature rather than the institution-ending risk that was her responsibility to monitor and manage. In the end, no one heeded the warnings, the sales in the bond portfolio forced the bank to realize massive losses, and regulators had no choice but to shut down the bank.
Along the way, two other banks failed, and First Republic received a $30 billion bailout from 11 big banks to demonstrate confidence in the system. We suspect the 11 contributing banks weren’t thrilled with the “option” to use capital to rescue a competitor, but they also know the story of the bank that didn’t participate in the Long-Term Capital Management rescue in the ‘90s only to be left to fail in 2008. It’s a club and this bailout was part of the dues.
The Regulators are a Disaster:
Everyone in this drama failed in the same ways they failed in 2008. All but one of the sell-side analysts had ratings of neutral to buy on SIVB. Moody’s had the bank rated investment grade on the day the regulators closed the bank. And it’s inexcusable for bank risk managers to not understand bond math and duration risk. The failings of the regulators here are also worth examining.
There’s a story going around that the reason this happened was due to a change to the rules allowing mid-sized banks a little extra leeway in oversight. This is partisan political nonsense. Previously, banks failed due to issues with liabilities. In 2008, banks went bankrupt because they owed massive amounts of insurance payouts relating to credit default swaps they had sold. No one was testing the banks for problems with assets, especially when those assets were 100% guaranteed Treasury securities. The higher level of regulation the biggest banks are subject to wouldn’t have changed the fact that no one was running stress tests on high-quality assets. They’re always digging in the wrong place. Even once the Fed realized there was a problem, and informed Silicon Valley, the bank refused to deal with it.
Not only have the regulators proven to be incompetent in predicting the problems we had in 2008 and the similar problems we’re seeing now in 2023, their reaction to the bank failures compounded the issues.
Conflict of Interest: The head of the San Francisco Federal Reserve was too connected to SIVB. Management has responsibility for managing the risk in its bond portfolio, but the regulators need to be a separate entity to be effective. This is like asking a 7 year-old if they’ve cleaned their room and done their homework. The answer you’re going to get is “yes” regardless of whether the work is done or not. It’s useful to check every now and then.
Not Understanding Duration Risk: In many ways, a huge contributor to this problem was created by accounting standards at the banks. Most financial institutions have to mark their books to market every day ensuring that losses can’t multiply without being obvious and acknowledged. (Mark to market simply means that you value your portfolio at current prices.) Banks can keep bonds on the books at their purchase price as long as those bonds are in the held to maturity portfolio. That’s fine if the banks can hold the bonds to maturity. When your depositors, can withdraw cash on a moment’s notice, there’s no such thing as held to maturity. These assets are held until depositors demand the return of their money. This is another way to understand duration risk.
There WAS a Bailout: Regulators tried to emphasize that investors in SIVB stock were losing their money and executives were being fired. This was an attempt to try to convince the public that we weren’t seeing 2008-style bailouts. Then, regulators decided to backstop all deposits, not just the $250k per account that is provided by FDIC insurance. Billions of dollars went to large corporations with CFOs who couldn’t manage their risk or chose not to do so.
No one did their job. No one admitted to a bailout. Furthermore, regulators tried to convince us that American taxpayers wouldn’t be paying the bill. However, we know there was a bailout because billions of dollars went to corporations that didn’t insure themselves. We can also assure you that while the losses here will be funneled through other banks, those banks will make up their losses by charging you. To make matters worse, Silicon Valley’s large depositors are huge political donors and the fact that they received billions of dollars of regulatory help despite clear FDIC rules on the matter looks terrible for the Administration.
Lack of Clarity on Who’s Covered: Treasury Secretary, Janet Yellen, has been described by our clever and funny friends at Unicus as the Marie Antoinette of our inflation. Her handling of this situation has been abysmal. She created a moral hazard by insuring the SIVB depositors instead of letting them bear the penalty for their own poor risk management decisions. Yellen then compounded the problem by creating confusion over who would be covered by this government-created largesse in the future.
There was general mumbling implying that if you were a depositor at a large “systematically important financial institution”, you’d be fine. Depositors at smaller banks might be in trouble. Yellen was unable to give any clarity on who was covered and who was at risk, which means we’re likely to see all deposits insured at some point. As someone who has been in finance for decades, Yellen should know how much the market hates uncertainty.
Moral Hazard is the Thing People Are Misunderstanding:
I’d like to address the narrative that was prevalent in the media and social media regarding the bailouts of depositors. Many people portrayed the situation as firms losing the money that they needed to make payroll. According to them, the mean government was going to put good people out of business through no fault of their own. This is nonsense for the following reasons:
Deposit Insurance is a Thing: These firms could have bought deposit insurance and protected themselves. They chose not to do so. These firms had CFOs and some had over a billion dollars at one bank. Not managing risk is a choice and not a reason to claim you’re being cheated.
Many Banks and Brokerage Firms Can Manage This Risk for You: There are financial institutions that get around the FDIC deposit insurance limit of $250k by spreading your money around multiple accounts. Some can handle over $100 million in these programs. There was no excuse for not using them. Executives at SIVB’s tech firms liked the perks they got for keeping ALL their money at one bank. They chose this risk. Here’s a short Twitter thread explaining more.
Treasury Direct: Firms can have unlimited risk-free funds in Treasury securities. I know this and now you do as well. CFOs of big firms are aware of the program and again, chose not to protect themselves. If you’re curious about the program, I’ve Tweeted a guide.
These Firms Had Already Failed: As someone who’s started multiple businesses including Deep Knowledge Investing, I’m appreciative of the entrepreneurial drive to own something that succeeds. However, many of the firms banked by Silicon Valley had little revenue, no cash flow, and no hope of generating either. The plan was to build something and hope to sell it. That’s fine, but every employee took a huge risk on the unlikely success of a startup with no hope of future cash flow which required a bailout buyout. In EVERY one of these cases, they bought the lottery ticket of possible enormous riches while knowing the most likely case would be business failure. Part of the huge payout these employees wanted and thought they “deserved” was due to accepting the huge risk of total collapse.
In the end, some of them will make a fortune, and we’ll all pay “our share” of their losses. The narrative was one of sympathy for the employees, but we have sympathy for the 330 million other Americans who are now paying for others’ mistakes. Even worse, the message has now been sent that it’s ok to take irresponsible risks because the rest of us will ensure no one is ever held accountable for it. The end result will be more risk taking and less responsibility. This is the worst possible outcome for all of us, and is a close repeat of the worst decisions of 2008.
Nicaragua and a Reminder for all of us to Check our Biases:
As many of you know, I’ve spent a lot of time in Central and South America in the last two years. In places that were colonized like Nicaragua and Peru, there is justifiable anger at the Spanish invaders who colonized these countries hundreds of years ago. The Spaniards killed people, enslaved others, destroyed religious sites, and stole massive amounts of wealth. It’s understandable and reasonable for the people here to have bad feelings about that.
I’ve asked several tour guides about life before the Spaniards arrived. They’ve told me the different tribes here often went to war with each other. Mayans and Incans fought each other in addition to other inter-tribal conflicts. When I asked what happened after the wars, I’m told that many people were killed, the losers of the war were enslaved, and land and wealth were transferred to the winners. None of this excuses the atrocities committed by the Spanish invaders, but it is a helpful reminder to check our own biases and inconsistencies.
We see this behavior in investing all the time. Occasionally, a stock-picker will criticize a company for certain business practices or industry conditions, and then overlook similar characteristics in the companies they own. We all have inconsistencies and biases for and against certain things, but it’s important in investing to try to find and overcome them.
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We had a treasury secretary babbling in front of cameras stammering, literally saying, I, we might cover this. We might not. It depends where the money is at. To this day, nobody knows what is and isn't covered above $250,000. This is no way to run a banking system. It's no way to run an economy. And by the way, if you're Janet Yellen, you know you're going to get asked that question. Sort it out with your advisors before you go on camera.
G'day, and welcome back to Shares for Beginners. I'm Phil Muscatello, Multiple bank failures, bank regulator failures, and the repeat of every failure we saw 15 years ago, sparking the gfc. It's a litany of failures that we're exploring today as we welcome back Gary Broad from Deep Knowledge Investing. Hi Gary.
Gary (1m 1s):
Hey, Phil. Thanks for having me. Great to be speaking to you again.
Phil (1m 4s):
Yeah, great to have you back again. And you're talking to us today from Nicaragua. How's life going there? Yes. Is that the monastic cell that you're in now that you were talking about on Twitter?
Gary (1m 13s):
It is. And you know what's amazing? I'm a big believer in the philosophy of hedonic adjustment. I've stayed in beautiful suites and five star hotels, and it's amazing. You know, you walk in and you think, wow, this is so fantastic. And you know, three hours later you stop noticing and, you know, I walked into this. I, I basically, my room has brick floors, nothing on the walls. I have a bed, a small wooden desk and a nightstand and nothing else of, and I felt disappointed. And, you know, one day later I stopped noticing and just got comfortable. And so here I am. But the country is beautiful. I was in Granada, I'm in Maderas right now, which is right by San Juande, sir.
Gary (1m 54s):
And it's a beautiful country. The beaches here are spectacular. And I found the Nicaragua people to be very nice, very welcoming. It's been a terrific experience so far.
Phil (2m 6s):
Yeah, no, sounds very nice. So let's get back to celebrating failure. What was, is, is it still a bank? What the Silicon Valley Bankcorp is the official name, isn't it? Does it still exist?
Gary (2m 19s):
No, it was taken into rec receivership by the FDIC, basically the, the bank. It was the 16th largest bank in the United States, and it was shut down by the government before it failed on its own. So it was, it was going to fail either way, and the government took it into receivership, but it is gone. It is a zero, a bankrupt company.
Phil (2m 42s):
And I just should say, and I wanted to preface this episode, is that this is about the banking collapses and the bank failures that have been happening over the last few weeks. And while this podcast didn't cover it as it was happening, I think it's good to go back and have a little bit of hindsight, a little bit of perspective to see what, what actually went wrong, especially now that the markets seems to have stabilized. So yeah, just tell us a little bit of the story and the background of it, please.
Gary (3m 7s):
Sure. So Silicon Valley bankcorp, and, and by the way, I, I will tell you, deep knowledge investing, we had our own interaction with the bank. Oh, okay. Yeah, it's, we had our own near miss with them, but it was the 16th largest bank in the country. They were headquartered in San Francisco, and they were the preferred banker to many of the venture capital tech firms. They had thousands of startup firms that they were the bank for. And, you know, that was great when times were good. And I had a situation a couple of years ago when somebody who was working for me came to me and they pitched Silicon Valley Bankcorp, and, and the pitch was, okay, so you have a regular bank, but because they've done all of this financing for these tech firms, sometimes they would get small pieces of equity in the firms.
Gary (3m 58s):
And so they basically had their own venture capital fund. And there was the sense that, you know, you're buying the bank and you get the venture capital fund for free and you know, all these lottery tickets and they could be worth a fortune and, you know, wouldn't you wanna invest in the next Facebook? And I looked at this thing and realized, one, the bank was not cheap. It was expensive. It was expensive because people knew you had this venture capital portfolio. And then I, I remember saying to this very smart person who was working for me, but how do you know what the value of these venture capital firms are? Like the, the bank marks it on the books, but that doesn't mean you're gonna realize that values are private companies.
Gary (4m 37s):
There's no mark to market. We have no idea what the bank's accounting standards are. This was two years ago that I said this, and you know, the stock was hundreds of dollars at a time, and it's since gone to Zero now for a different reason. It wasn't the venture capital portfolio that failed. But the point is, there was always a question about, in my mind, at least, about the accounting at this particular place.
Phil (5m 3s):
So that's that's interesting though. It's got that kind of glamor of having the name Silicon Valley and the bank, and I'm sure that would attract a few moths to the flame.
Gary (5m 12s):
Yeah, that, I mean, they were really well known. And the thing that they did well at first, which actually led to the downfall of the bank, was they found ways to lock up the money. And so let's imagine for a minute, Phil, that you were the ceo or c f o of this venture capital startup firm. And remember, you know, when I say that, everybody imagines, you know, these tiny firms and they imagine, you know, companies like, you know, apple computer that gets started in somebody's garage, you know, or in someone's basement
Phil (5m 46s):
Boots strapping themselves up. Yeah.
Gary (5m 48s):
Yes. And, and in fairness, there were companies like that, but most of the money at Silicon Valley, Bankcorp was being held by gigantic tech firms who had multi-billion dollar valuations and had billions of dollars in cash at the bank. You know, more than 90% of the money held in that bank was from, you know, a just a dozen or two dozen accounts. And so that's where most of the money was. And what Silicon Valley would do is they wanted these firms to keep all of their money at the bank, and they would say, we will give you some extra interest, right? Or we'll give you preferred financing or in something that is particularly ominous, they would go to the executives of, of these companies and they'd say, Hey, we'll give you guys a preferred rate for your personal mortgages.
Gary (6m 39s):
Right? I mean, the conflict of interest here is horrendous. And what you had were these executives who theoretically should have known better and should have understood risk. And what they did was they acted like all of these freebies that they got had no cost. And anytime and Phil, you know this. And for everybody who's listening to this, we all know the old expression, if it looks too good to be true, it is. So if somebody calls you, if I call somebody and say, Hey, I'd like to offer you a million dollars of free cash, just show up and sign this piece of paper, don't worry, you won't owe me anything. It's free. Don't sign the paper. Right? And, and so what Silicon Valley did that was smart until it wasn't, was they would offer not only the VC firms, but the executives of those firms, all of these freebies, all of these extras in order to keep a hundred percent of their business.
Gary (7m 33s):
And you know, if you get this great offer where somebody's saying, we're going to give you extras, freebies, it's gonna be great, we'll even give you something personally under the table, you won't have to report it. Right. That there's risk associated with that. And these people all acted like they had no way to know that. And you know, I, if you're listening to this podcast, you know, you're not expected to be an attorney or a bank executive, but if you're the CFO of a multi-billion dollar firm with billions of dollars in the bank, you know about this stuff. You understand this, nothing is offered to you for free. Everything that somebody offers you will come with a cost or some associated risk.
Gary (8m 12s):
And people pretended like that wasn't the case, and it led to disaster.
Phil (8m 16s):
Okay. So it sounds like there was risk involved, and again, I should be prefacing this, that we're basing this actual conversation on your latest deep knowledge investing monthly newsletter, which we're gonna publish on the blog post for this particular episode. So listeners can have a, a good read and a deep dive into what you've actually said about this. And it's a great article. I really enjoyed reading it. And the thing that you talk about mainly is about at risk and particularly duration risk. And it's to do with their bond portfolio, isn't it?
Gary (8m 48s):
That's right. And a lot of your listeners have probably heard or read the term duration risk and thought, wait, I don't know what that is. And it sounds like this very complicated finance term. It's actually very simple. It's just finance people like to use complicated terminology, right? So duration is simply
Phil (9m 4s):
Like doctors, you know, everyone has gotta have their own jargon, their own, exactly.
Gary (9m 9s):
Yeah. Right. We, we have our own language to pretend we know things that you don't know. But the concept is really simple. And we can explain it with, you know, with a great example here, duration simply means the length of time. And what happened with Silicon Valley was there was a change in the value of bonds that they held. So in this case, what they owned were US Treasury bonds and very
Phil (9m 34s):
Safe, very safe. Everyone would expect them to be the safest things to have your money in.
Gary (9m 38s):
And in fairness, they are. If you buy a treasury bond that says you're going to get 2% interest, and let's say it's a 10 year bond, and for what it's worth, you can't get that. You, you get a higher rate right now. But this is an example, right? So if you buy a bond from the government and it's a 10 year bond at 2% interest, you will receive your 2% interest every year. And at the end of 10 years, you will receive a thousand US dollars. And so, you know, question will be, what will a thousand US dollars be worth in 10 years? But that's a whole inflation conversation, which I'd be happy to talk to you about another time. So to the extent that you will get paid, they are risk free and they're considered to be risk free.
Gary (10m 23s):
But here's the issue, Phil, that's only the case. If you hold that 10 year bond to maturity, maturity is simply a fancy word for saying for the full 10 years, if you buy a 10 year treasury bond today, and you hold it for 10 years, you will get paid what you're expected to get paid, and you will have paid the price you expected to, and that's all fine. And so the duration risk that Silicon Valley had was they were lending, sorry, they were borrowing from people at, you know, 1%, 2%, something like that. But those people could pull their money at right away. And then they were lending to the US government at maybe 3%, 4% for a longer duration.
Gary (11m 5s):
And as people started to withdraw their money, Silicon Valley, the problem they had where they said, oh no, we can't hold these bonds to maturity, we actually have to sell them today at a loss. And the problem that they had was if they could hold their bond portfolio until maturity, the bank would've been fine. But because they had to start selling at a loss, the bond portfolio was worth less than the amount of deposits that people were able to withdraw. And when that happens, you have a bankruptcy.
Phil (11m 39s):
And that's kind of like the asset backing of the bank, isn't it? That these bonds are
Gary (11m 45s):
Phil (11m 46s):
Actually where they hold their money. It's like the, the solid foundation. Well, hopefully the solid foundation on which their fiscal strength is held.
Gary (11m 55s):
Right. And that's exactly how they ended up making the error. The the bonds are risk free if you can hold them.
Phil (12m 4s):
It's a maturity. Yeah,
Gary (12m 5s):
It's a maturity, exactly. But if you have to sell them today, you might be selling at a premium, a discount, the price will be what it is. And so they had a situation where the current value of their assets they were liquidating was worth less than their liabilities. And again, when that happens and you run out of equity, it's a bankruptcy. And
Phil (12m 28s):
There, there's been a political narrative that alleges that a change to the rules, allowing mid-size banks, a little extra leeway in oversight led to this situation. What are your thoughts on that?
Gary (12m 39s):
I mean, everybody loves to blame
Phil (12m 41s):
The previous administration.
Gary (12m 43s):
Exactly. Right. In this case, that is 100% nonsense. And the reason for that is those regulations weren't the reason Silicon Valley failed. It was this duration risk. It was the fact that they, they didn't understand, or they knew and didn't care about the risk that they'd taken in their bond portfolio. And while the issues that we're talking about may sound complicated to somebody who is being introduced to bond math for the first time in some of this complicated finance terminology, if you are the CFO or the risk manager for the 16th largest bank in the country, th this is the kind of thing any first year finance student would know.
Gary (13m 27s):
These people have to know this. And, and by the way, the Federal Reserve knew it last year. The Federal Reserve called up Silicon Valley Bank, and they said, guys, we're really concerned about this. This does not look right. And the bank ignored it. Now, maybe they didn't know, maybe they didn't care. Maybe they were engaged, focused on other things, or there's always a possibility. And you know, this is an issue in my business as well with certain hedge fund managers and portfolio managers. People don't like to realize losses. A lot of times people don't wanna sell something at a loss which would've saved the bank. They wanna sit there with their fingers crossed and hope, maybe I'll get bailed out of this somehow, maybe interest rates will change, maybe we'll get the value back.
Gary (14m 8s):
And that's a very foolish way to go through life. Fingers crossed that, you know, when the house is on fire, that it'll all be fine. And so those regulations wouldn't have caught this. That really is just a political narrative because, you know, if, if you're the Democrats in Congress, blaming Donald Trump for something is, is politically popular. But this failure was not President Trump's fault. You can blame him for a lot of other things, but he did not cause the failure of Silicon Valley bankcorp.
Phil (14m 36s):
Now, the other thing that seems to be happening is the discussion on whether there was or was not a bailout, was there a bailout? And who's on the hook for that money
Gary (14m 46s):
There? 100% was a bailout. And everybody who's telling you there wasn't, they're lying in a very specific way. Right? It's, it's not just they're lying in a very, very tricky way because what they're doing is they're telling you a very specific truth, right? So imagine you have a little kid in the house and you know, that little kid, you know, eats a Milky Way candy bar before dinner, and they're not supposed to. And so mom comes in and sees, you know, what's going on and chocolate on the kid's face and says, Hey, did you grab a candy bar? And the kid says, I did not have a Snickers bar.
Gary (15m 28s):
Okay, well, that's true, but you're answering the question in a very specific way. And so when, when government officials tell you that there was no bailout, here's what they're actually saying, right? They're, they're not addressing the bailout. They're saying that shareholders weren't bailed out, executives weren't bailed out. Okay, let's tell the whole truth here, Phil. That is 100% true. It's correct. The equity holders, the people who own stock in S I V B, Silicon Valley Bankcorp, they got zero, they got zeroed out. They were not rescued. The executives of the company along with all the employees of the company were fired.
Gary (16m 11s):
They all lost their jobs. And so they say, see, there was accountability, okay? But there was a bailout because there were billions of dollars in uninsured deposits that were somehow made whole. And to make things even worse, these firms were gigantic political donors. Now, you know, listen, I, again, if you're listening to this, I don't care if you're a Democrat or Republican, a libertarian, a liberal, I just, whoever you are, that's fine. That's none of my business, right? My job as a finance person is just to look for the truth in it and leave my own opinions out of it.
Gary (16m 53s):
But, you know, what happened here was these firms were gigantic donors to the Democratic Party. And it was Democratic party officials who said, okay, well they're not insured, but we're going to make them whole anyway. And again, let's go back to the beginning of this conversation. These people took on massive risk, right? And so for anybody in the United States who's ever opened up a bank account or walked into a bank, take a look at how many times you see the sign and the lettering that says F D I C insured $250,000. That's the Federal Deposit Insurance Corporation limit. You cannot walk into a bank without seeing those words in 25 places.
Gary (17m 36s):
It is on every document, it's everywhere. These people knew that. And, and we, Phil, we can talk about, I put up Twitter threads about all the ways that these executives could have insured themselves, could have saved themselves, could have saved their firms. They didn't do that. They took on that risk voluntarily, simply because they were getting all the extras, all the perks that we talked about before. They didn't wanna give that up. And so what we have are corporations who were giant political donors who took on risk and then got money that they weren't entitled to by an illegal decree, by democratic officials. Now, if somebody wants to tell me, Hey, you know, Republicans do sleazy things too, to favor the Yeah, I totally agree.
Gary (18m 20s):
It is a huge problem. Both parties do this nonsense, and it's wrong and horrible. And I'm against all of the sls in this case. These were democratic donors bailed out by democratic officials. When Republicans are in power, they do the same horrible, stupid things. So I'm not taking a political side on this, but there not only was a bailout, it's a bailout where the optics are horrendous.
Phil (18m 45s):
Is this a similar situation to what happened at Credit Suisse?
Gary (18m 49s):
In some ways it is. Credit Suisse has had issues with asset quality for a really long time. If you take a look, the value of that stock has been sliding for well over a decade. Mm. It's kind of been known in the, the finance community for a really long time that they had issues with the quality of their assets. And in the case of Credit Suisse, you're talking about, you know, your national flagship bank or one of two. And so the thing that is similar there is you've got, you know, two national flagship banks. One of them bought the other one, but they did it with a government guarantee. And so basically, like we had in the US and like we had in the US in 2008, you had a situation where if something worked out, the stockholders and executives got paid very well.
Gary (19m 42s):
If it didn't work out, people said, oh, this is a public problem, and the losses got socialized. Right? And again, you know, this is, these are different administrations, different party Republicans have done this, Democrats have done it, the Swiss have done it, the Americans have done it. This is an issue all over the place. But basically, if you have the opportunity to earn huge returns when something works, then you need to own the losses. And the moral hazard that we have just now in 2023 in the US in the banking system, or 2023 in the Swiss banking system, is the same as we had in 2008 in the US banking system, which is, you know, the profits are mine, the losses are ours, and that's not a situation that A should happen.
Gary (20m 28s):
B is consistent with any capitalist system. And
Phil (20m 32s):
It sounds like they can hold that over the heads of government by saying, well, look, if the banking system fails, we're all screwed.
Gary (20m 38s):
That that's right. And you know, I was having an interesting conversation on Twitter with Enrique Abida a day ago. He's somebody I really like and respect. He's a smart guy. He's a good stock picker. Really
Phil (20m 51s):
Nice. Yeah, he's, he's been on the podcast a couple of times. He's a great character. Yeah, yeah,
Gary (20m 55s):
Yeah. Love, love Enrique. And he was pointing out to me that, you know, he, he took issue with the letter, which I, you're, you know, graciously gonna make available to your subscribers. I, I hope you all read it, but, you know, Enrique took issue with it saying, Hey, you know, this really, this was a bail out of the banking system. People were worried about everybody pulling deposits out and holding cash or, you know, putting it in treasuries. They didn't want one bank run or three bank runs in this case to turn into 300 or 3000 and have a whole collapse of the system. And he pointed out that, you know, if we would've had this in another favorite industry like agriculture, where there are a lot of government subsidies, they would've done the same thing, you know?
Gary (21m 38s):
And my response to him was, Enrique, you're a hundred percent right. He is correct on that. The point that I'm making is that we had a bailout in 2008. They told us this time there's no bailout. There was a bailout. People who avoided paying for insurance or avoided doing things that would've protected them in these situations didn't do so, and somebody else got stuck with the losses. That is a bailout. So I agree with Enrique, he's right. And you are right, Phil, that this is a situation where they do hold it over people's heads. They say, well, we don't want the whole system collapse, but let me, let me remind everyone, sorry, Phil. Yep.
Phil (22m 19s):
Keep going, keep going.
Gary (22m 20s):
But let me remind everybody that the more times you do something like this, the more people realize, oh, wait a minute, I'm incentivized to engage in ridiculously risky behavior, because if it works, I will make a fortune. If it doesn't work, I'll say, well, you don't want us to fail, and we get bailed out. And so every time you do this, you send the message to the people running the system, the people running these firms go take ridiculous risks. You'll make a lot of money, or we'll cover the losses. And so when you do this again and again and again, you don't end up saving the system, you just end up with bigger and more frequent risks to the system, what they're doing.
Gary (23m 1s):
Yeah, it saved things today, just like what they did in 2008. Save things then. But if there's, if nobody is ever held accountable for failure, then what you're going to get is a lot more failure. And we'll start to see these kinds of events happening more frequently and with more money on the line. So this whole, we saved everybody narrative is complete nonsense. No, you just kicked the can down the road and put us in a position where we will be taking more failure risk later on.
Phil (23m 33s):
So let's imagine a world where there's treasury secretary Gary Broad, how would you deal with a situation? What, how would you disincentivize people? And we're just talking fantasy land here, of course.
Gary (23m 45s):
I would say three things. One, let's talk about what the regulators got, right? They closed down Silicon Valley Bancorp and two other banks. That was the right thing to do. These banks had liabilities and excessive assets, and you don't want this stuff cascading. And there was failure. And the people who were held accountable were the executives, the employees, the risk managers who we've talked about, and the shareholders. Those people all ended up either out of a job or getting zero. So the regulators got that right? And let's, you know, give 'em a round of applause for that, that was the right thing to do. What I would've done with the depositors is I would've said, you're insured for $250,000.
Gary (24m 28s):
Now, the narrative that, and this is a false narrative, the narrative that people talked about was, oh, no, no, you can't do that because you know, there's payroll and you don't want everybody losing their jobs. This will all be awful. No, right? They, they made it seem like mom and pop were going to lose their savings. Okay? First of all, I'm gonna make this point. Again, you cannot walk into a bank in the United States without seeing it 20 places. F D I C insured at $250,000. And there are lots of ways to either buy insurance or get around those limits. And if you want, again, we can talk about those. But when you're the C F O of a multi-billion dollar firm, you know about this, right? And if you are an employee, you know, if you're employee 17 at a venture capital startup, again, it's the same thing.
Gary (25m 15s):
If it works, you're going to make Facebook money, right? Or like you're going to make the kind of money that you know, PayPal money, right? You'll, you'll become immensely wealthy. Well, the other side of that is, if you work for a startup firm without much or any revenue and no free cash flow, and your fingers crossed, will get bought out for hundreds of billions of dollars, you know, years in the future, then you're taking that risk. And yeah, you could make Facebook money or PayPal money or something like that, but if it doesn't work, that's the risk that you take, right? Everybody has to be held accountable.
Gary (25m 56s):
And if you work for one of these firms and you want the upside, that lottery ticket of immense tech riches, then you need to take the risk of failure, including these CFOs who knew what they were doing. And again, there were, there were ways around that. So I would've simply said to people, you know, I'm sorry, but you knew it was $250,000 limit. Now to make things even crazier, you can buy insurance. You could have bought treasury bonds at Treasury Direct, which would've been perfectly safe if you're the C F O of these firms. Or what they could have done is they could have placed their money with multiple institutions. And there are programs to do that, that will manage it for you. I, I mean, I called somebody at a bank and within less than 10 minutes, he told me, yeah, we can cover 125 million in one account.
Gary (26m 45s):
F D I C insured, I called a client of mine. I, I'm not allowed to use his name, but he, he's at L P L I think they can cover by spreading deposits around something like $150 million by right? And all of its insured, they didn't do that because they wanted the perks of having all their money at Silicon Valley Bank. So this narrative that mom and pop were going to lose their savings and it wasn't fair is, is complete nonsense. These were large firms with risk managers who took risk and were never held accountable. And then the third thing that I would've done had I been treasury secretary would've been to be clear on who was and wasn't covered.
Gary (27m 28s):
And the current treasury secretary, Janet Yellen, made a mess of the whole situation. And she has this horrible deer in the headlights look when she's asked about this, and basically, you know, was saying, well, we might cover your deposits. We might not. If you're at a systematically important bank, if your, if your deposits are at a big bank, we might cover it. We probably would. If you're at a small bank, we might not. And there's all of this uncertainty. And for, again, for anyone who's listening to this one, the market needs clarity. Two, if you have money in the bank, shouldn't you know if you're insured or not?
Gary (28m 8s):
Shouldn't you know at what limit you're insured? Shouldn't bank executives and executives of companies, and mom and pop and everybody listening to this, who has money in the bank, shouldn't you know what is and isn't covered? We had a treasury secretary babbling in front of cameras stammering, literally saying, I, we might cover this. We might not. It depends where the money is. Like at, to this day, nobody knows what is and isn't covered above $250,000. This is no way to run a banking system. It's no way to run an economy. And by the way, if you're Janet Yellen, you know you're going to get asked that question, sort it out with your advisors before you go on camera.
Gary (28m 54s):
Right? It wasn't like somebody knocked on her door at three in the morning with a a TV camera and said, you know, secretary Yellen, we need an answer on this. What's going on? Yeah, what's going on? Right? No, she, she got dressed, you know, put her shoes on, walked into a room where she knew there were gonna be cameras. Like she had to know that question was coming. Her parent advance, give people clarity. And how do you get to be a, a senior executive for the US government for decades without knowing that you need to give people clarity without knowing that when the cameras are on, you need to explain to people, this is our policy.
Gary (29m 34s):
And there even was like a two day period where the Treasury Department was saying one thing, the Federal Reserve was saying something else. Nobody was saying anything clear answers were shifting. And, you know, listen, if, if you wanna cover everything, I, I will disagree with that decision, but then people should know this is what we're on the hook for. And so if somebody of a bank goes under and they say, okay, you're covered and your insurance company doesn't have the money to cover it, that's a scam. If the government prints money to cover it and steals from the rest of us in order to cover it, that's a scam. Again, this is no way to run a, a banking system,
Phil (30m 13s):
Which brings us neatly to the topic of inflation and back to the real world where Janet Yellen is the Treasury Secretary, not Gary Broad. And why do you call Janet Yellen the Marie Antoinette of our inflation?
Gary (30m 26s):
Well, first, Phil, let's, that's a hilarious line, but let's give credit that one comes from Lakshmi Ganapathi, from Unicus Research. Laks is a phenomenal researcher, really smart person. She has a great sense of humor. The best thing I can tell you about her is she is subversive. When you talk to her, you think she's going in one direction and she gets you teed up. But you know, when she delivers, it's not going where you think it is. And so she was the one who coined the line. We always give her credit when we use it. But the reason it's a phenomenal line is because Janet Yellen was saying her biggest regret in her previous role was that we didn't get more inflation again, for everybody listening to this.
Gary (31m 11s):
Yeah. How does that help you if things cost more, if the loaf of bread that costs you $2, you know, you go to the, the store next year and it costs you 2.20 or 2.50, how does that make your life better? Higher prices do not improve your life. And you know, if anybody wants to raise their hand and say, no, no, no, I want higher prices. I wanna pay more. Send me an email. I can't wait to hear from you because that will be a great interaction. Or, you know, call Phil, you should be the, the next guest on the show. So to go from the back to a little history, but you know, Marie Antoinette, the, the wife of Louis 16th of France, you know, when she heard the peasants were revolting because they didn't have bread, they didn't have food, her answer was let them eat cake.
Gary (31m 53s):
She refused to see the problem and, and acted like they're suffering, you know, was so irrelevant that, well, if you don't have bread, you might as well eat cake. Right? If you don't have a shack to live in, go live in a mansion, right? You know, if, if your car doesn't work, what? Get a yacht and sale there. And it's a ridiculous way to behave. And it's a ridiculous way to talk about something that makes people's lives worse. And so when Locke says she's the Maria Antoinette of our inflation, when you have a treasury secretary saying, we need more inflation, and my regret is not creating more inflation, it is incredibly insensitive. It's foolish, it's stupid. It's bad policy and bad politics.
Phil (32m 35s):
Okay, Gary, well thanks very much for joining me to explain this. And like I said, we're going to be linking your blog post, or actually will publish your blog post in this blog post for this episode so people can see the, the full story behind it. But Gary, as always, enjoy Nicaragua and great to talk to you again.
Gary (32m 53s):
Thanks Phil. It's been a pleasure. I appreciate it.
Chloe (32m 55s):
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