Over the past few days, the pound plunged, including with a flash-crash on Monday that briefly took it to record lows against the US dollar. Prices of long-dated bonds went into a death spiral, with the 10-year yield spiking by 130 basis points in four trading days to 4.63% early today, and by 275 basis points in seven weeks ago (up from 1.88% in early August).

The bond market reaction represents a colossal and sudden degree of “tightening” of the financial conditions, before the Bank of England’s QT had even started. QT is designed to bring up long-term yields, but they already exploded due to chaos.

It was the market’s backlash against the new government’s reckless plan to cut taxes for the rich and for corporations, funded by new debt, while piling on spending to subsidize energy costs, also funded by new debt, thereby requiring the issuance of large amounts of new debt, even as inflation has already reached to 10%.

The Bank of England, which is in charge of maintaining financial stability, now has a slew of problems to deal with: inflation spiraling out of control, currency plunging, bond market in chaos, financial stability at risk, and spreading contagion. And some of them require the response that the others require.

There is much speculation that at least one major bank is not fine and could create the next Lehman Brothers moment. ABC Australia, quoting ‘a credible source’, reported that a major investment bank is on the brink. Morgan Stanley have said that the surging US dollar is setting the stage for “something to break” in the financial system.

The two which are in the worst shape are Deutsche Bank (heavily exposed to the energy crisis) and Credit Suisse. Both are already trading at distressed valuation but I’ll focus on Credit Suisse in this post.

“But this time, notice that the Fed is not helping"

42:48 And we’re into uncharted territory, like I say. So to summarize all this, the banks are all bankrupt right now.

In the first week, the Federal Reserve handed out more than $300 billion in loans through its newly created Bank Term Funding Program (BTFP).

According to a Washington Post report, banks would face unprecedented losses if they were forced to liquidate their bond portfolios as SVB did.

According to the Post, the total capital buffer in the US banking system totals $2.2 trillion. Meanwhile, total unrealized losses in the system based on a pair of academic papers is between $1.7 and $2 trillion.

In other words, if banks were suddenly forced to liquidate their bond and loan portfolios, the losses would erase between 77 percent and 91 percent of their combined capital cushion. It follows that large numbers of banks are terrifyingly fragile.”

 

A second report by the Wall Street Journal cites a study from Stanford and Columbia Universities that found 186 US banks are in distress.

As economist Peter St. Onge put it, “In other words, we were already right up against the edge.”

This is precisely why the Fed had to create a way for banks to borrow against their devalued bond portfolio. If banks were put in a position where they had to sell those bonds to raise capital, they would have fallen like dominoes.

The Fed bailout may have plugged that hole in the dam, but there will almost certainly be more cracks in the future.

So, how did we get into this situation?

Peter Schiff summed it up during an interview with Liz Claman.

It’s because of the government that Silicon Valley Bank was in the position that it was. The reason it owned so many long-term, low-yielding US Treasuries and mortgage-backed securities was because the Fed kept interest rates at zero for so long. And the reason that it chose those assets was because bank regulators kind of pushed banks into Treasuries and mortgage-backed securities because they give them favorable accounting treatment. They don’t have to take any haircuts. They don’t have to mark them to market. So, the government created the problem.”

 

St. Onge went into more detail in an article published by the Mises Wire.

In short, while tech bros and loose bankers hog the headlines, what drives hundreds of banks to the edge is our crony banking system.

 

In this case, rapid Fed rate hikes crashed into a banking system that fractional reserve banking and the Fed’s “Lender of Last Resort” (LOLR) permanent bailout have driven to permanently drive as fast as possible, as close to the edge of the cliff as possible.

 

Together, the moral hazard has given a green light to those reckless tech bros, to those loose bankers who hand out millions—it turns out hundreds of billions. And it drives the entire banking industry to use opaque accounting tricks to hustle sleepy regulators and innocent taxpayers and dollar-holders who get stuck with the bill. The bankers themselves sleep like babies because they know you’ll cover their losses, but they keep their wins.

 

What turned this rigged casino into a crisis is in the past year the Fed hiked rates at the fastest pace in 50 years, from 0 percent last March to 4.5 percent to 4.75 percent today. They did this in a desperate bid to cancel the inflation they caused by financing $7 trillion in deficit spending and Covid lockdowns. Indeed, those of us who wondered why voters stood by meekly had only to look at the flood of money going out the door.

 

These reckless hikes savaged long bond prices, by far the most popular asset in bank vaults: Across the board, long bonds fell 20 percent, feeding an estimated 10 percent plunge in all bank asset values. In essence, the bank thought it had a dollar in the vault, but turns out it only had 90 or 80 cents. In the case of high-flyers like Silicon Valley and potentially hundreds more, it was more like 60 cents. Few banks can survive that.

 

So, what’s next?

In the euphoric atmosphere generated by easy credit and a soaring asset valuations, some of the easy credit sloshes into marginal investments (farmland that is only briefly productive if it rains enough, for example), high-risk speculative ventures based on sizzle rather than actual steak and outright frauds passed off as legitimate "sure-fire opportunities."

The price people are willing to pay for all these assets soars as the demand created by easy credit increases. And why does credit continue increasing? The assets rising in value create more collateral which then supports more credit.

This self-reinforcing feedback appears highly virtuous in the expansion phase: the grazing land bought to put under the plow just doubled in value, so the owners can borrow more and use the cash to expand their purchase of more grazing land. The same mechanism is at work in every asset: homes, commercial real estate, stocks and bonds: the more the asset gains in value, the more collateral becomes available to support more credit.

Since there's plenty of collateral to back up the new loans, both borrowers and lenders see the profitable expansion of credit as "safe."

This safety is illusory, as it's resting on an unstable pile of sand: bubble valuations driven by easy credit. We all know that price is set by what somebody will pay for the asset. What attracts less attention is price is also set by how much somebody can borrow to buy the asset.

Once the borrower has maxed out their ability to borrow (their income and assets-owned cannot support more debt) or credit conditions tighten, then those who might have paid even higher prices for assets had they been able to borrow more money can no longer borrow enough to bid the asset higher.

Since price is set on the margin (i.e. by the last sales), the normal churn of selling is enough to push valuations down. At first the euphoria is undented by the decline, but as credit tightens (interest rates rise and lending standards tighten, cutting off marginal buyers and ventures) then buyers become scarce and skittish sellers proliferate.

The deception of the past decade is that central banks have been “printing money” via quantitative easing. This may have helped boost confidence in the real economy that it was safe to borrow once more. But other than the printing of the tiny volumes of cash, which account for less than two percent of transactions, central banks have no means of directly creating currency.

What QE actually did was to create a desperate search for yield, in which financial institutions and big investors sought assets which would give higher rates of return. And so, in the course of the decade between the Crash and the Covid, they helped to inflate the financial “everything bubble,” in which unproductive assets – which are excluded from official inflation measures – across the economy inflated in price at an astronomical rate.

Not that investors fare particularly well, since there is no means of realising the theoretical value of the assets themselves, because the institutions which own them are the only ones who could realistically buy them. In a sense, they are trading real returns for the illusion of appreciating assets… we have plenty of examples of what happens when shareholders seek to sell at the same time, or when bank depositors all try to withdraw their cash… it isn’t pretty.