F.A. Hayek’s famous quote is:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

While Hayek’s quote is most appropriately placed against government central economic planning of socialism, it applies against any government action that tries to manage the economy by going against true consumer desires by hiding market prices. Things like the minimum wage and rent control, or any other price control (e.g. subsidies) result in unintended consequences that basic economic analysis of supply and demand can predict with confidence. Yet these government manipulations only have small effect to the economy as a whole. When the government manipulates the price of money, it affects not only every transaction (since claims on money are one-half of every exchange), but also distorts the price of consuming today versus the future, and distorts the type of investments made for the future. For the latter point, the artificial lowering of interest rates not only stimulated consumption (as it was intended), but it also had the effect of steering investment toward those projects that offered higher future cash flows relative to nearer term. As we’ve noted before here at BATG, only near zero interest rates for the last decade plus would have allowed the significant shift in capital from normal businesses to all things technology that lose money year after year and are rewarded with $1B+ valuations (e.g., Uber, Lyft, Tesla, WeWork, etc in the last decade). In short, only monetary mismanagement can lead to the wholesale disruption of market economies.

Since the financial crisis, the Federal Reserve has kept interest rates near zero for most Americans. The rest of the global central bank complex was arguably much worse, with the European Central Banks and the Bank of Japan engineering negative interest rates–institutions were forced to pay the borrower (sovereigns usually) for the privilege of loaning them money. Early after the financial crisis, the Federal Reserve greatly expanded its balance sheet, but surprisingly, it did not lead to inflation, as the Fed changed its operating procedures and paid interest on reserves, effectively “sterilizing” their actions to prevent the money from entering the main street economy through the normal process of banks lending out excess reserves. But it achieved the Fed’s goals of raising asset prices, and not publicly acknowledged, bail out the banking system by buying toxic waste assets from the banks (on to the Fed’s balance sheet) and allowing them to be replaced with US Treasuries and Repos (on the bank’s balance sheets). In effect, this policy was a tax on savers to specifically bail out the banking system, but it had the effect of exacerbating income inequality and massively distorting the country’s capital structure.

Yet the Fed’s mismanagement went to new highs (lows?) with its Covid response. Few would argue that in the immediate wake of the shut down of the global economy that the Fed should have loosened. But it proceeded to add $5T to its balance sheet, with a quantitative easing program that extended until last March, almost two years after the initial Covid recession. The Fed buying made it easy for politicians of both parties to add $7T to our national debt in only two years.

Driving interest rates down to zero not only created a speculative frenzy in many asset classes, but the banking systems model of borrowing short and lending long was put in jeopardy–yes short term rates were near zero, but there were no long term assets available to compensate for the risk. Nevertheless the system had to invest all this new money somewhere, buying mortgage backed securities and treasuries with longer maturities in a vain search for some yield spread. But these asset purchases set them up for a tremendous fall. And that fall was perfectly predictable, as I wrote in Nov ’21:

Should you be in stocks, gold, bonds, bitcoin? BATG is not the place for specific financial advice (as I’m an economist and not a financial planner), but you wouldn’t catch me anywhere near bonds. If we do get the deflationary collapse in the near term, we could see yet another sharp bond rally–that indeed will be likely. But if you think that inflation is going to be higher in the long run, someday those holding bonds will be crushed. For example, bonds rallied to unprecedented lows with Covid, but then rates have risen dramatically–those investing in bonds last year have likely suffered pain. (emphasis added for this post).

So Friday the Silicon Valley Bank was closed by the FDIC, the largest bank failure since Washington Mutual during the financial crisis. Why did they fail? It wasn’t for being exceptionally greedy and investing in all sorts of high-flying assets to make a quick buck. Nor was it financial shenanigans that cooked the books. Rather it was a bank that took deposits from primarily the venture capital world and startups as deposits, which were then invested in what the Fed policy allowed–longer maturity treasuries and mortgage backed securities. Their model was broken once the Fed engaged on its current interest rate increase policy. And this bank is likely not alone, hence the massive hit to bank stocks on Friday, and fears that Monday may lead to a contagion at other banks. As a reminder, this is precisely what happened to destroy the Savings and Loan industry in the 70s. Their whole legally required model was to invest short term deposits into long term mortgages. While the S&Ls didn’t officially fail until the 1990-91 recession, they were bankrupt as an industry to the tune of $150B in 1980 (in then year dollars) as a result of short term interest rates being much higher than the return on their long-term assets.

According to press reports I’ve read, SVB’s proportion of assets in these types (MBS, Treasuries) was much higher than other banks, but every bank that has fixed long term assets purchased over the last three years is having some level of this problem. As quoted over at National Review (from a gated article at the Telegraph):

Bonds make up 56pc of SVB’s total assets compared with 25pc at Fifth Third, and 28pc at Bank of America, after a decision to invest more $90bn of deposits into long-dated securities such as mortgage bonds and US Treasuries, according to the Financial Times. Viewed as a safe bet at the time, they are now worth $15bn less as a result of the sudden swing in interest rates.

I’ve been surprised at how long it has taken to get a big scalp from the Fed’s massive interest rate hikes, with interest rates rising faster than at any time in history. Many, many firms are struggling as their debt service costs are exploding, having greatly increased their debt (higher leverage) in the former easy money area, and there will be more shoes to drop, especially in the non-bank sector as interest rates keep rising.

EDIT Update Before Publishing! The federal government is going to bail out uninsured depositors at SVB, and another bank in NY, Signature Bank which the FDIC is also closing. I was going to write that I expected a bailout to come by Wednesday; I thought it would take more mayhem on Monday but there is entirely too much caterwauling on Wall Street and in Silicon Valley for them to wait. But don’t worry, Janet Yellen just told us this morning it won’t be a bailout. But under what legal authority can they reimburse uninsured depositors in violation of the law? That’s a pesky question someone should be asking.

Markets have been predicting a Fed reversal on their tightening for months, and I’ve thought it unlikely unless there is a big shoe(s) to drop. SVB itself isn’t big enough, but SVB may be the canary in the coal mine. We simply do not know. While I’m loathe to bail out uninsured depositors, it would really wreak havoc on small business startups and their ability to use their own money to meet payroll next week. As I tell my students in money and financial markets, when these crises hit, there is no political spine to refuse a bailout. In the second best world of bailouts, the solution is a lot more capital required. 30+% would be a nice starting point.

SVB is not alone. You know who else has long-dated assets that pay far less than the liabilities that fund them? Yes that would be the Federal Reserve. If they were a real bank the FDIC would be forced to shut them down. The bill comes due. It will be interesting to see how the authorities will try to pin the blame for this on anything but their terrible monetary policy. And I won’t hold my breath for them to ask whether we might as well repeal Dodd-Frank since it has manifestly failed to achieve its stated purpose (ending too big to fail).

EDIT Update after publishing:

Lots of discussion on whether this is a good move or not today. This CNBC article captures a whole range of perspectives. Here is the most laughable line from President Biden:

“I am firmly committed to holding those responsible for this mess fully accountable and to continuing our efforts to strengthen oversight and regulation of larger banks so that we are not in this position again,” Biden said in a statement. 

Yet everyone knows what caused SVB to go under, poor macroeconomic policy of too much spending financed by zero interest rates at the Fed. Somehow I don’t think we can count on Mr. Biden to look in the mirror.

Edit Update #2

More is coming out this morning about the poor management decisions by SVB (failure to hedge, raise equity when they could, etc). It doesn’t change my analysis on the root cause of the problem, but clearly a better run bank wouldn’t have ended up in this situation. There are also a lot of great rationales out there for why we shouldn’t have backstopped the depositors w/over $250k. We can discuss in the comments if you like.