Did The Government Bailout Of Banks Just Seal The Victory For Inflation?

To investors,

Silicon Valley Bank’s failure on Friday afternoon left the business and finance industries scrambling in uncertainty. Would depositors get their money back? What would happen to the equity and bond holders? How would so many startups meet their payroll requirements in the coming week?

I know of multiple companies who had tens or hundreds of millions of dollars stuck in the bank. They spent the weekend planning what they would do next. The options ranged from mass layoffs to taking high-interest loans from neobanks at 1% per week.

Thankfully, all of this work was for nothing.

The FDIC, Treasury, and the Fed issued a joint statement Sunday afternoon stating that they would backstop every single depositor at Silicon Valley Bank, regardless of the deposit amount. This move has been celebrated by majority of people, and it likely will help mitigate a wide-spread bank run, but there is a lot to unpack in what they just did.

First, the rescue package for Silicon Valley Bank is only for depositors. The equity and bond holders are being wiped out, which is exactly what should happen. If you take risk in the market and end up on the wrong side of a trade, it is important that you lose because it forces everyone to only take risks that they believe are worth taking in the future. If there were no losses in the market, everyone would just take as much risk as possible and then beg the government to save them when it went wrong.

Second, the government also shut down Signature Bank on Sunday and put it in receivership. It is unclear why they did this, but the joint statement ensured that all depositors of that bank would be treated the same way. All equity and bond holders would also lose in the Signature Bank situation as well.

Third, every depositor will have access to their funds starting this morning, Monday, so the risks of a bank run have been drastically reduced. This doesn’t stop customers from going to their regional banks and withdrawing all of their funds, but it will hopefully disincentivize them from doing so.

An important part of this component is that the money used to cover depositors will not come from taxpayers. The money is instead coming from a fund that banks have been paying into for the last few years for this type of emergency situation. You can think of this as a fund that was created with bank revenue or profits, but at least it does not come directly from taxpayers.

Fourth, the Fed and others are providing a massive, multi-billion dollar bailout to the entire banking industry. They won’t call it a bailout, but there is no other name for it. The government is going to allow banks to post collateral, mainly Treasuries, as collateral to borrow against, but they will be able to use the par value of the asset rather than the market value. That is insane.

This is the equivalent of you buying a house for $100, the house value falls to $70, and you go to the bank to take out a mortgage and demand they honor the original $100 value. They would laugh you out of the room. But now the government is going to let the banks do it. The logic is the bank wants to post Treasuries, which have a maturity date, and the government could hold the assets to maturity. There is no guarantee of the future and this decision introduces a significant amount of risk into the system.

We fail to ever learn our lesson.

There are a number of other details in the statement and the government’s plan, but this is the high-level details. Frankly, it is what I think matters most. The ramifications of this are worth noting as well. We have effectively proven that the $250,000 FDIC limit is just a farce. The government will step in to protect depositors of any amount. I wouldn’t bet my life savings on them doing it again in the future, but the precedent has been set now where the FDIC limit should just be raised to $5-10 million.

We must also call out that the Federal Reserve created this scenario. They held interest rates at 0% for too long and told everyone they would not aggressively raise rates by having forward guidance suggest less than 0.5% interest rates months and years out. Of course, the situation changed and the Fed increased interest rates by 4.5% and it completely screwed every bank that listened to what the Fed had originally told them.

This created a $200+ billion hole of unrealized losses on bank balance sheets. Then we get a little bank run and now we have a crisis on our hands. The belief is that the government’s plan should mitigate the bank runs from spreading, but multiple reports this morning suggest that people are lined up outside regional banks to get their money anyways.

The portion of the population that believes everything just changed is not exclusive to bank depositors. Investors across Wall Street are now predicting that the Fed will stop hiking interest rates beginning with the March meeting. If that is true, the banking system teetering on failure will have put a halt to the most aggressive interest rate hikes in history.

But there is a thread here that is worth following.

The Fed has been hiking interest rates to get inflation under control. Although they have raised rates by 4.5%, inflation has been persistently sticky. We still have CPI showing a 6.4% increase over the last 12 months and there was a 0.5% acceleration in inflation between January and February of this year. So if the Fed was to stop hiking interest rates, there is a strong argument that inflation could continue to rise again.

Add in the inflationary pressures of a multi-billion dollar bailout program for the banks and you can start to see a path towards higher inflation and a nearly guaranteed avoidance of returning to the Fed’s 2% inflation target any time soon.

Let’s talk solutions now.

First, we could move away from the fractional reserve system. I have invested in a company called Custodia, which was founded by Caitlin Long, that is trying to create a regulated financial institution that promises a very radical idea — they will take your deposits and simply hold them. They won’t gamble with your money on the back end and they won’t participate in the fractional reserve system. The Fed and other organizations have been denying various applications and they won’t let Custodia in the club. It begs the question “why?” I’ll let you pontificate on that answer for yourself.

Another solution is bitcoin. The decentralized, digital currency was created out of the ashes of the last banking crisis. It has a programmatic monetary policy and allows you to become your own bank through self-custody. There are no bitcoin holders begging the government for bailouts and you never have to cross your fingers that you can get your money out when the banks open Monday morning. If you want to learn more about bitcoin, I suggest starting by reading the Bitcoin White Paper here.

The current financial crisis is still unfolding. People are lined up outside banks right now. Bank stocks are down significantly, including regional banks which are down double-digits in pre-market trading. The overall sentiment on Twitter is a “sigh of relief,” but I don’t think we are out of the woods yet. It is imperative that you keep paying attention. Start informing yourself of the various risks you are undertaking in your deposit institution, your investment portfolio, and your overall financial life.

Self-reliance is a key theme of the 21st century. I didn’t know any of this stuff a few years ago, but I took the time to learn it. You can do the same. And it may be essential to know in the future.

Hope you all have a great day. I’ll talk to everyone tomorrow.

-Pomp

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