Do You Smell Smoke?

On August 12, 2007, I posted an analysis (Financial Markets Running on Empty) of an odd statistical blip within financial markets that seemed to be overlooked (purposely ignored?) at the time but proved ominous in hindsight. The Dow had dropped 279 points on Monday, August 6, then jumped back 469 points by Thursday, August 9 only to drop 381 points on Friday, August 10. A discussion of the factors causing those jitters on the PBS NewsHour struck me as odd at the time. Two notable figures in economics explained away the wild oscillations as a perfectly logical result from a sudden shift in the "risk spread" between the cost of "safe" money versus the cost of achieving higher returns as markets realized the risks taken to earn those higher returns were in fact much larger than previously understood.

Ah, makes perfect sense, I said at the time. Nothing to see here, move along…

Except that discussion happened to mention a dollar figure involved with the funds "injected" by the Federal Reserve into financial institutions on Friday, August 10 to stabilize the markets. $38 billion dollars. That struck me as a rather large number. I did some digging to compare normal daily Federal Reserve "injections" with the $38 billion dollar figure and came away dumbstruck, leading to one key rhetorical question… Did the events of August 10, 2007 feel like the events of September 11, 2001? The Fed's intervention on August 10 dwarfed that of the interventions after September 11, 2001 despite market uncertainties after 9/11 that were obviously astronomically high. That raised another critical question… Assuming the Fed doesn't commit tens of billions of dollars for nothing, what risks were seen on August 10, 2007 that were WORSE than those after markets re-opened after September 11, 2001?

More disconcerting than the basic dollar amounts involved was another subtle change in Federal Reserve strategy undertaken with the intervention on August 10, 2007. On that day, the Fed not only initiated purchases of Treasure bills -- normally viewed as near-zero risk for all parties involved -- they began buying up corporate bonds and mortgage backed securities, the very investments underlying the crash that -- in hindsight -- was essentially beginning that day on August 10, 2007 and cumulated in the 2008 meltdown.

The key point of that analysis was that ANY time the Federal Reserve is required to inject RECORD amounts of cash to provide liquidity between banks as they settle their books each night, bad things are afoot. When the Federal Reserve also has to devise new mechanisms for stuffing cash into the pockets of banks never previously used or contemplated, really bad things are afoot.


Fast forward to the events of the week of March 13, 2023.

The public was already spooked by the failure of Silicon Valley Bank on March 10, 2023 triggered by its narrow focus on providing merchant services (payroll / accounts payable) services to bubble-funded startups and its incompetent strategies for hedging risk from interest rate fluctuations. That failure was bookended by the failure of two other institutions, Silvergate and Signature Bank, which had exposure to risks in crypto markets and firms betting on crypto assets. After Silicon Valley slipped under the water, markets began looking for other institutions that might be similarly challenged by swings in long term interest rates and a new victim was found -- First Republic Bank. Analysis of the bank's depositor profile showed 68% of accounts over the FDIC's limit of $250,000. The bank's credit rating was downgraded on March 15 by Fitch's and Moodys.

As the stock price of First Republic continued falling the week of 3/13 in response to these disclosures, private discussions between regulators, the Fed and initially JPMorgan Chase concluded "something must be done." A collection of uber-banks (the TBTFs) and wanna-be-uber banks (the "tbtf" regionals) organized a plan to inject $30 billion dollars into First Republic by transferring balances of their depositors over to First Republic. At the same time, the Fed devised a new means for floating money to banks. In an attempt to even out short term panics triggering fluctuating valuations for Treasuries prior to maturity, the Fed will now loan dollars to banks by holding Treasuries owned by the bank for 12 months in exchange for the cash value the bank paid for the Treasuries, even if the current market price on that T-bill is LESS. This avoids the impact of having to raise cash by selling Treasuries prior to maturity and taking exaggerated losses -- the sequence of events that tanked Silicon Valley Bank.

Receiving far less attention was the fact that the events of the week of March 13, 2023 generated another wave of massive liquidity intervention on the part of the Federal Reserve. How massive? Larger than the interventions at the peak of the 2008 meltdown.

In addition to $11.9 billion being lent in the first week of the Fed's new one-year lending program, overnight lending via the Fed's "discount window" to banks settling their books each night skyrocketed. In the week ending March 10, discount window lending totaled $4.5 billion. For the week ending 3/17/2023, discount window lending totalled $152 billion dollars. In comparison, discount window lending in the worst week of the 2008 crisis totaled $110 billion dollars. Inflation from 2008 to 2023 totaled about 29.6% so in 2023 dollars, the 2008 lending peak would be $142 billion.

Again, the question must be asked. Do the events surrounding the failure of three banks in 2023 appear to be anywhere near as consequential as the meltdowns in 2008 triggered by years of fraud with mortgage backed securities and credit default swaps and retail mortgage origination fraud?

As was the case in 2007, perhaps the insiders talking their book by telling Average Joe and Jane to sit tight and leave their money where it is know something -- or many things -- the public does not. It's not like there are shortages of risks facing financial systems worldwide:

  • Credit Suisse undergoing a pre-emptive merger into UBS at the urging of the Swiss Central Bank and Swiss regulators, concerned its tanking equity might trigger a failure similar to Silicon Valley Bank or the fate just dodged by Republic One in the US.
  • Massive strikes in France related to imposed changes in retirement ages driven by massive increases in costs due to declining birth rates and longer lives, all of which could ripple into France's financial system.
  • Looming debt ceiling charades in the United States that have technically already put the Treasury beyond the current debt ceiling, only to be delayed by manipulations of accounts across the federal government -- manipulations whose incremental freed cash could vanish in an instant if the Treasury has to respond to another banking crisis.