MORAL HAZARDS.

One reason macroeconomists of the Keynesian sort don't get too upset about deficit spending (at least in times of recession) or accumulating Federal debt is that the bonds the Treasury sells to finance that deficit spending serve as assets on the balance sheets of banks.  Because the Treasury's promise to make good on those bonds when they come due has so far always been kept, a bank that owes money to depositors (its liabilities) is almost always sound because there is a market for those government bonds.

There is one complication, though.  When older treasuries offer a lower interest rate than current treasuries, those older bonds can be sold, albeit at a discount relative to current bonds bearing a higher interest rate.  Think about it this way: a one-year promise to pay a dollar used to sell for 99 cents; these days that promise might sell for 95 cents.  The calculations get more convoluted than I'm in the mood to get into when we're talking about thirty year bonds, but the intuition is the same.

Now comes that Silicon Valley Bank that was holding a lot of those thirty year Treasuries as assets, and thanks to the Federal Reserve's attempts to roll back the money printing of the past few years, those holdings suddenly lost value.  Immediately the finger-pointing commences.  "President Trump and congressional Republicans' decision to roll back Dodd-Frank's 'too big to fail' rules for banks like SVB—reducing both oversight and capital requirements—contributed to a costly collapse," said Sen. Elizabeth Warren.  Consider the source. that's Jake Johnson at Common Dreams helping the communist wing of the Democrats excommunicate senators Manchin, Tester, and Warren.  That same article also notes that Useful Idiots in information technology had a lot of their money in that bank.

The American Prospect's David Dayen noted that "because the depositors holding the bag at SVB are Very Important People, there's going to be intense pressure for a bailout."

"Hedge fund titan Bill Ackman is already calling for one," Dayen observed. "Larry Summers told Bloomberg that the financial system should be fine, as long as depositors get every penny of their money back, which would be a $150 billion bailout."

Depends on how you conduct the "bailout." The usual stratagem in situations where a bank doesn't hedge its holdings properly is for it to be combined with some larger bank, which works until you run out of larger banks with more robust balance sheets.  Marginal Revolution's Tyler Cowen explains that.

The failure and closure of Silicon Valley Bank (SVB) raise immediate issues as to how policymakers should react. I’d like to step back and consider what this implies for banking regulation more generally in the longer run. The main lesson is that successful bank regulation is an ongoing, dynamic problem, unintended secondary consequences are rife, and neither more regulation or less regulation can be guaranteed to succeed.

If you think of the FDIC/Fed/Treasury as a consolidated entity, the broader question is how many financial institution liabilities they should guarantee, whether explicitly or implicitly. Let us consider why in fact the government felt compelled to guarantee all of the deposits.

An unwillingness to guarantee all the deposits would satisfy the desire to penalize businesses and banks for their mistakes, limit moral hazard, and limit the fiscal liabilities of the public sector. Those are common goals in these debates. Nonetheless unintended secondary consequences kick in, and the final results of that policy may not be as intended.

Once depositors are allowed to take losses, both individuals and institutions will adjust their deposit behavior, and they probably would do so relatively quickly. Smaller banks would receive many fewer deposits, and the giant “too big to fail” banks, such as JP Morgan, would receive many more deposits. Many people know that if depositors at an institution such as JP Morgan were allowed to take losses above 250k, the economy would come crashing down. The federal government would in some manner intervene – whether we like it or not – and depositors at the biggest banks would be protected.

In essence, we would end up centralizing much of our American and foreign capital in our “too big to fail” banks. That would make them all the more too big to fail. It also might boost financial sector concentration in undesirable ways.

To see the perversity of the actual result, we started off wanting to punish banks and depositors for their mistakes. We end up in a world where it is much harder to punish banks and depositors for their mistakes.

Another unintended secondary consequence is that lots of funds would flow out of the banking system and into U.S. Treasuries. In other words, our private businesses would find it harder to borrow and our government would find it easier to borrow and thus government would command more resources. That hardly seems like a desirable outcome for a policy decision that had some initially libertarian motives.

In a longer Bloomberg report that also engages the Washington finger-pointing, we note exactly how that failure to the hedge came about.

In their private discussions with officials, big bank executives have also pointed to moves by the Fed, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation in 2019 - when they allowed banks with less than $700 billion in assets to opt out of recognizing swings in so-called accumulated other comprehensive income in their regulatory capital.

That was meant to make key capital ratios less volatile, but may have helped make smaller lenders more comfortable taking risk in their bond portfolios, since losses there would be less likely to immediately endanger stock buybacks and dividends.

That certainly played out at SVB. In late 2020, the firm’s asset-liability committee received an internal recommendation to buy shorter-term bonds as more deposits flowed in, according to documents viewed by Bloomberg. That shift would reduce the risk of sizable losses if interest rates quickly rose. But it would have a cost: an estimated $18 million reduction in earnings, with a $36 million hit going forward from there.

Executives balked. Instead, the company continued to plow cash into higher-yielding assets. That helped profit jump 52% to a record in 2021 and helped the firm’s valuation soar past $40 billion. But as rates soared in 2022, the firm racked up more than $16 billion of unrealized losses on its bond holdings.

Throughout last year, some employees pleaded to reposition the company’s balance sheet into shorter duration bonds. The asks were repeatedly rejected, according to a person familiar with the conversations. The firm did start to put on some hedges and sell assets late last year, but the moves proved too late.

Now it might be that a Wise Regulator could tell a bank whose risk-managers were getting exposed to the wrong sort of interest rate risk to act differently, but the employees who were taking what proved to be the wrong sort of risks had every opportunity to see it.  John "Grumpy Economist" Cochrane has the gory details.  "The Silicon Valley Bank failure strikes me as a colossal failure of bank regulation, and instructive on how rotten the whole edifice is."  It's so much easier for Fauxahontas and the like to blame Donald Trump or the remaining sensible Senate Democrats, rather than to consider how simple and avoidable the error was.

In sum, you have "duration mismatch" plus run-prone uninsured depositors. We teach this in the first week of an MBA or undergraduate banking class. This isn't crypto or derivatives or special purpose vehicles or anything fancy.

Where were the regulators? The Dodd Frank act added hundreds of thousands of pages of regulations, and an army of hundreds of regulators. The Fed enacts "stress tests" in case regular regulation fails. How can this massive architecture fail to spot basic duration mismatch and a massive run-prone deposit base? It's not hard to fix, either. Banks can quickly enter swap contracts to cheaply alter their exposure to interest rate risk without selling the whole asset portfolio.

But as early as the summer of 2022, it was obvious how much more exposed Silicon Valley were to that interest rate risk than comparable sized banks.  "Perhaps the rules are at fault? If a regulator allows "hold to maturity" accounting, then, as above, they might think the bank is fine. But are regulators really so blind? Are the hundreds of thousands of pages of rules stopping them from making basic duration calculations that you can do in an afternoon? If so, a bonfire is in order."  There's a lot more at the link, some of it technical, most of it intuitive.

But, perhaps because rent-seekers, or was it connected Democrat donors, squawked, we have a moral hazard problem that the most Solomonic of regulation cannot put right.

And then, once the management of Silicon Valley Bank and Signature screwed up badly enough, the federal government decided, “Never mind. We’re going to protect every amount for every bank customer.” The Biden administration may not like people calling that a bailout, but that is indeed a bailout.

As our Phil Klein writes, “In practice, it has created a huge moral hazard by signaling that the $250,000 FDIC limit on deposit insurance does not exist in practice. The clear signal it sends is that when financial institutions make poor decisions, the government will swoop in to clean up the mess.”

And it does little for our confidence when any spokesman for the Jarrett regency comes on television and says "to be clear."  Doesn't matter whether it's Buckwheat or Yenta or Dementia Joe himself, they're going to obfuscate, and they'll take care of their campaign contributors.