Taking Stock: a trail of broken things

The bank crisis may have subsided. But other leveraged investments are likely to come unstuck, as a result of rapid interest rate hikes over the last year. Meanwhile, the crisis has left a legacy of breakages that carry their own costs.

Credit Suisse rests in the arms of UBS, SVB with First Citizens, First Republic has been given a $30bn loan from fellow banks. Deutsche Bank shares rose 9.1% yesterday (Monday). The S&P500 has had three positive sessions in a row.

All is right with the world. The fear of a re-run of the global financial crisis is changing into an interpretation of the current crisis to being a series of idiosyncratic failings that lack a commonality that might lead to a systemic bank crisis.

The heads of the Fed, ECB and the Bank of England have all said that they believe mechanisms are in place to prevent a broader, systemic, shock to the banking system. They will deal with any further bank failures on a case by case basis.

Interest rate expectations are changing. 2yr Treasury yields, sensitive to rate changes, are back over 4%. The certainty that rates have peaked and that the Fed will start cutting them in September is fading.

Things have been broken

But all is not right with the world. Things have broken that will be difficult to repair and more may yet brake.

Ten days ago, the Swiss government passed an ordinance that wrote down CHF 17bn of contingent convertible – to nothing – in order to ease its merger with UBS. This has alarmed holders of the so-called CoCo bonds, who believed that they would convert to equity during times of bank stress (isn’t that what the word ‘convertible’ refers to?). CoCos are broken.

European banks have issued a lot of CoCo debt since the global financial crisis, but they may find it difficult to continue to do so if the rules governing them can change so quickly. The consequence may be that capital becomes more expensive for European banks, which will reduce lending and economic growth.

It is a world turned upside down when it is the Swiss who tear up the rules governing an important piece of bank capital. So much for Swiss stability and sound regulation. Broken.

And then we have the regulators. Depositors at SVB have been rescued by the FDIC expanding its insurance coverage, despite the bulk being held by tech companies and venture capital funds. Where is moral hazard? Broken.

The Fed has ripped up the convention that it lends cash against quality assets during times of bank stress, by accepting Treasuries at par value rather than their current market price. So, what is the true price of a 10yr Treasury? Answer: it depends on who owns it. Price transparency: broken

The solution? Perhaps a return to the separation of investment and retail banks and limits on the size of banks so that none are too big to fail. And not only in the U.S.

European countries have longed to build champions that can take on the U.S. banks, at the least when competing for European business. They have encouraged their regulators to oblige. The newly enlarged UBS may emerge as a serious European rival to the large American banks, but at a huge price. Its balance sheet is now equivalent to 520% of Switzerland’s GDP, its failure is inconceivable.

What else might break?

Some commentators have observed that a better comparison to the recent crisis is not 2008/9, but to the 1998 collapse of the highly leveraged and massive Long Term Capital Management (LTMC).

Then it was idiosyncratic management failing that led to the fund’s undoing. The fund strayed from its area of expertise (bond spreads), into riskier stocks and currencies, all the while using leverage to boost returns. The collapse of LTMC created a mini-financial crisis.

Where might we see similar overconfidence and excess leverage today? Real estate investment vehicles, private equity and hedge funds are the most commonly cited examples.

Should we see these start to buckle under the pressure of high interest rates, we are unlikely to see to the Fed, the FDIC and other regulatory bodies come to the rescue. The private sector will be expected to look after itself, with losses falling in a way that asserts moral hazard.

That is the theory.

But don’t underestimate the ability of the aforementioned industries to lobby for the socialisation of losses, or for the macroeconomic implications of any large failures to be so large that the Fed is forced to respond by modifying its monetary policy.

We can hope that the crisis fades away, but investors should prepare themselves for more things breaking. Both in terms of investment/ financial companies and assumptions regarding regulations and how losses are shared out.

Implications for interest rates

As we have suggested in previous notes, it is a reasonable assumption that despite protestations to the contrary, central banks will take a softer approach to tackling stubborn core inflation until macroeconomic risks subside. This may mean interest rates peak at lower levels than markets were expecting a month ago, but it also surely means that both inflation and interest rates in the U.S., Europe and Japan will be higher for longer in the medium term.


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