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Ambrose Evans-Pritchard: Brace for a long, hot summer of financial accidents
By Ambrose Evans-Pritchard
The Telegraph, London
Tuesday, March 21, 2023
Swiss regulators have tossed nitroglycerin onto the global financial fire. They have also committed shameless expropriation. So much for the safety of Zurich.
The total wipe-out of $17 billion of Credit Suisse's tier 1 bonds renders the convertible debt market in Europe almost uninvestable. These junior bonds ought to trump equities in market hierarchy. Clearly they do not. "It means the banking crisis we've seen over the past few weeks has started a new chapter," said Russ Mould from AJ Bell.
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The Invesco AT1 capital bond fund, which pools such bank debt from the likes of Barclays or Credit Agricole, crashed by 18% as investors digested the terms of the rescue deal for Credit Suisse.
It recovered after a startled European Central Bank rushed out a reassurance that no such atrocity would happen in the eurozone. But it did in fact happen to AT1 bondholders of Spain's Banco Popular in 2017, overlooked as a minor incident at the time.
When push comes to shove, it is easier to fleece the sophisticated foreign funds that buy these instruments than to wipe out retail shareholders, in this case Swiss citizens with a political voice.
There is a reason why regulators were loath to impose haircuts on bonds at the onset of the eurozone debt crisis, even if it meant taxpayer bailouts and the stench of moral hazard. Merely to talk about write-downs risked instant contagion.
You can date the moment that the small Greek crisis turned into the larger Italian and Spanish crisis, and therefore became an existential threat to Europe's monetary union.
It was when Angela Merkel and Nicolas Sarkozy -- walking on the beach at Deauville in October 2010 -- opened the door to haircuts on sovereign debt. Investors hurried to the exits, sauve qui peut.
The justification for selling Credit Suisse at 7% of book value and vaporising its bonds is that the bank is in worse trouble than supposed. Disentangling the politics of this is tricky but the episode overall tells us that global monetary tightening has already done more systemic damage.
Regulators seem to have discovered a thicket of undisclosed losses. Capital Economics said the draconian terms of the shotgun marriage with UBS suggests that "a substantial part of Credit Suisse's $570 billion assets may be either impaired or perceived as being at risk of becoming impaired".
What is shocking is that a large and historic global bank could disintegrate in days, even if the deeper rot lies in slow-motion deposit flight over many months. Credit Suisse had larger capital buffers than most global banks. That Maginot Line so favoured by Basle regulators has proved next to useless.
"Right up until its forced sale, the bank had ample capital. Until the past few days, it also had ample liquidity. Its liquidity crunch was caused by the evaporation of trust from the market," said Clive Horwood, from the Official Monetary and Financial Institutions Forum.
It was the same lightning devastation of four US banks. Silicon Valley Bank (SVB) in California lost $42 billion of deposits in a single day on March 10.
The sequence of pre-Lehman financial tremors in 2007 -- Icelandic banks, Bear Stearns, Northern Rock -- seem almost leisurely by comparison. Our instant digital culture has accelerated the mechanisms of a modern bank-run.
The prevailing narrative is that SVB was a maverick bank with over-exposure to the US tech bubble and to interest rate risk from US Treasuries, and too reliant on large uninsured depositors. This is true as far as it goes (not far), but it evades the larger issue.
"SVB was a good bank. It did what it was supposed to do: invest in mortgages and Treasuries," said Professor Larry Kotlikoff from Boston University.
There was nothing wrong with SVB's loan book. It was not facing a wave of defaults. It chose to park excess deposits in AAA bonds for safe-keeping after stepping back from lending to Silicon Valley as the tech cycle rolled over. It had the best collateral in the world.
Yet it blew up suddenly because it had not taken out adequate hedge protection against breakneck monetary tightening by the US Federal Reserve. It was forced to crystallise paper losses that were exempt from rules on mark-to-market pricing.
That ought to give pause for thought. The Federal Deposit Insurance Corporation says US banks were $620 billion underwater on bond holdings as of December. How many others risk a bank run the moment they have to start selling any supposedly safe assets at a loss?
The fire at SVB was suppressed with an emergency guarantee of all the bank's uninsured depositors. But that begs a larger question. What about the other $8 trillion of uninsured deposits in the US banking system? Are they implicitly insured, or not?
Republic Bank also faced deposit flight and had to be rescued by a $30 billion whip round among the big banks. This has not yet done the trick. Republic's share price fell a further 30% in New York last night.
The bank is not a basket case. It passed the Dodd-Frank stress test: ergo, regulators concluded that its portfolio of mortgage loans could weather the housing slump. Prof Kotlikoff said it appeared to be "an exceptionally strong bank."
Over three days last week, the Fed increased emergency loans of different kinds from almost nothing to $318 billion.
"To put that in context, it's a far more severe liquidity crunch than at the start of the pandemic and not far off the financial crisis peak of $437.5 billion in mid-October 2008. This is a very serious crisis in the banking system," said Paul Ashworth from Capital Economics.
In parallel, the Federal Home Loan Bank tapped the US Treasury for $250 billion of liquidity to alleviate acute stress among regional and community banks.
These rescues have become necessary because the US financial system cannot withstand the pace of rate rises and quantitative tightening (QT) by the Fed.
"The current interest rate environment has had dramatic effects on the profitability and risk profile of the banks," said the FDIC's Martin Gruenberg. Well, indeed.
As long as Jerome Powell's Fed thinks its chief task is to crush inflation -- overdone in my view, since money contraction already implies that inflation will come down with a lag – the banking crisis will continue to escalate and spread.
Philip Turner, a former senior official at the Bank for International Settlements, said these bank failures are not one-off idiosyncratic upsets. The pathology is more fundamental.
"The scale, opacity, and interconnectedness of interest rate exposures remains the major systemic risk right now. This is the inevitable consequence of monetary policies pursued over the last 15 years. Central banks bought long-term assets for more than a decade in order to depress government bond yields well below sustainable market levels," he said.
"Regulators adopted rules and practices that induced banks, pension funds, and insurance companies to take on even more rate risk," said Professor Turner, writing for the journal Central Banking.
It worked marvellously at first by reinforcing QE. The nefast consequence today is that benchmark safe assets have themselves become the transmission channel for financial shocks. Ah, the implacable law of unintended consequences.
Prof Turner is not saying that QE was wrong. The error was to persist too long, and at the wrong calibration.
We are now stuck in this brave new world. Central banks have swung from frenetic money creation in 2020-21 to the monetary death march of 2023, with all key measures of the money supply flashing red warnings in America and Europe.
The best we can hope for is a controlled hard landing but that requires a circuit-breaker. At a minimum, the Fed should halt its cycle of rate rises and suspend QT until the money growth recovers. The ECB should stop beating its chest until it is clearer how much damage it has already caused.
Will either act in time? Probably not. Central bankers have yet to acknowledge that the money supply is dangerously out of kilter. So brace for a long hot summer of financial accidents until they get the message.
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