TLDR: In June of 2007, faced with mounting margin calls Bear Stearns was forced to bail out two of its hedge funds with massive exposure to subprime mortgage CDOs. Soon after, the Fed started cutting rates. The cuts weren’t catalyzed by an economic slowdown. The Fed reacted to evidence that high interest rates were breaking stuff in the financial system. Is this what we just witnessed with SVB (and other banks)?
A sharp selloff in regional bank stocks yesterday risks pushing the Fed uncomfortably close to the one situation it desperately wants to avoid: choosing between financial stability and fighting inflation.
On Monday last week, markets were expecting a choice between a 25 bps hike and possibly a more hawkish 50 bps move in the March meeting. Mr. Powell himself earlier floated the possibility of a larger increase amid signs the economy was gaining unexpected momentum.
What a difference a week makes. This morning, any talk of 50 bps is gone and markets are pricing an almost 40% chance of the Fed pausing altogether. A pause in the face of another strong job report and evidence of rising hourly wages would be a clear concession to financial stability.
This desire to avoid having to choose explains the swift move to protect all depositors over the weekend. Various Fed governors had at times expressed confidence they had the tools - other than interest rate policy - to deal with financial stability. If the fire can be stopped, focus can switch back to the inflation battle. But the fire doesn’t seem to be stopping.
Thus far, the economy has shown few obvious side effects from the Fed’s aggressive campaign to raise rates, aside from a slowdown in housing. This is another parallel to 2007/08.
Back then, the Fed was initially reluctant to cut interest rates aggressively because some officials were worried about inflation, which was being pushed up by higher oil prices. But core inflation, which excludes volatile food and energy prices, is much higher now, posing an even stiffer potential test.
What happens if they cut rates and turn less aggressive in its inflation fight?
That was the story of 1998. Fed cut rates to address the blowup of hedge fund Long-Term Capital Management. A market melt-up followed.
We’ll find out soon which path they choose.
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A lot of friends asked us ‘Ok but what the hell exactly happened? How so fast?’.
In short, it was a classic hedge fund trade gone badly. But let’s start from the beginning.
Banks are, in essence, fixed income hedge funds. They borrow with short maturity and lend with long maturity.
Ever noticed how interest on your savings account is always lower than interest on your mortgage? Yeah. That’s bank profit for you.
Banks call it ‘Net Interest Margin’. A hedge fund would call it ‘carry’. Same stuff. Usually this is a stable trade that allows them to make money. Every once in a while, things go wrong.
For SVB the ending began in 2021. At the peak of the Tech bubble startups were receiving inordinate amounts of $$$ from VCs and stashing them in SVB. The bank had to invest this cash and decided to do so in long bonds - treasuries and mortgage backed securities.
Then inflation arrived and the Fed hiked. And hiked. Those bonds fell HARD, and the loss pulverized SVB’s equity.
Along the way, short sellers noticed. And VCs noticed. And deposits began being pulled. Things snowballed last week.
One has to give it to the regulators this time, as the management of the bank failure was flawless. Depositors were protected, equity holders were wiped out. And we went on to live another day. For those who lived Lehman, this feels much less like a headless chicken situation.
There’s a log of good stuff to read about this - we recommend Marc Rubinstein, good ole Matt Levine of FT fame (now at Bloomberg, so $$), Noah Smith and the summary at Stratechery. And of course, here’s the latest from FT Alphaville.
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