The War Between Market Stability and Chaos hots up – How will it play?

Blain’s Morning Porridge – St Patrick’s Day, March 17^h 2023: The War Between Market Stability and Chaos hots up – How will it play?

“No plan survives contact with the enemy.”

This Morning – Central Banks face a mighty challenge persuading markets and depositors the banking system is stable. The war between chaos and order in markets has turned hot. At stake is the stability and future of the global economy. Anyone for the last few choc ice?

This has been a tumultuous week for markets. A brutal war between Chaos (crashing confidence) and Order (market stability) for the soul of financial markets has broken out. It will be bloody and could still go either way. The thing is, markets are essentially chaotic – that’s what makes them work! When you to try to control them  – through distorted interest rates, financial repression and over-regulation, they tend to break down, as we are seeing now as the consequences of the last 15 years unravel.

As usual the forces of Chaos are attacking market stability through the banking system. Central Banks appear to have won the first skirmishes, acting swiftly to ensure bank liquidity through the emplacement of backstop facilities and shoring up nervous depositors with promises to make them whole in the event of a banking run. Today will see the Battle for First Republic – will General Dimon of JP Morgan leading $30 bln of deposits from Wall Street’s finest in a charge to bolster the wobbling mid-sized bank? The signs look promising.

On the Western Front, the cost has already been heavy. Two US banks collapsed, but the markets’ lines hold. An extraordinary $152 bln has been drawn from the Fed’s strategic reserve, the discount window, over the last week. An additional $12 bln has been tapped from the new Bank Term Funding Programme, which gives banks the ability to pledge Hold-to-Maturity assets at par as collateral. That is unprecedented. Most observers thought it would never be used – serving as a mere sword-waving exercise to show how serious the Fed was about providing as much liquidity as it takes.

On the Eastern Front, ECB Head Christine Lagarde cuts a confident figure. Credit Suisse may be on life support – but she ignored desperate pleas of panicked bankers to halt interest hikes, and raised Euro rates by 50 bp. Is it a sign of confidence for confidence’s sake? A fifth column within the financial commentariat believe she was scared to halt the anticipated hike lest it reveal to Chaos just how panicked the Central Bankers are. Lagarde was aware of the risks, warning market turmoil could impact credit conditions and dampen confidence – but went ahead and did it despite the clear signs that higher rates are challenging the banking sector. Courageous.. or misguided?

It’s important to define the War objectives:

• A tactical win for market stability will be defined as avoiding a systemic financial collapse.
• A strategic victory will be stabilising financial markets while addressing inflation and normalising interest rates and financial expectations.
• (But, long term stability will be achieved by letting chaos and order find their own level – largely free of interference in the function of markets!)

How will the war play out?

The central banks and regulators are confident their swift action will take the pressure off the assault on banking stability. Their strategy is to contain the damage done to bank’s capital by the rapid rise in interest rates, while building confidence in the market and among bank customers that its business as usual.

However, the underlying damage to the system has been huge: The size of the global bond market is roughly $130 trillion according to ICMA, the average maturity of outstanding bonds is now 12 years according to the OECD (much longer than I expected!), while rates have risen on average by 2.5%. Put the numbers together, and it means markets are sitting on notional mark-to-market bond losses in excess of $27 trillion. Ouch. That is a seriously big number that has to influence prices and sentiment.

A significant part of these losses sit within banks. (We will talk about the rest…. below.)

Rising rates and falling bond prices only become a banking problem if/when bank depositors start to worry about it. To remind readers of how bond portfolios have crashed, assume you bought a 10-year Government 1% bond for 100% last year. Let’s say rates were hiked and the yield on that bond rose to 5% – meaning the mark to market value of the bond had fallen to around 70%! Scale that reality up to how much banks have lost due to rising rates – and its substantial. But, it only becomes a real loss if you have to sell as the bond will still pay 100% at maturity – although its real value may be diminished by inflation.

Banks hold government and other high-grade bonds because they are highly liquid (or at least they are supposed to be), and can be sold in times of crisis to meet urgent depositor drawdowns. As Silicon Valley Bank, Signature Bank and Credit Suisse all highlight – in times of market stress any merest hint a bank is in trouble leads swiftly to depositor flight, triggering a liquidity crisis that usually kills the bank in the form of a run. That’s what did for SVB and could have ended Credit Suisse.

Therefore, the strategy of the Central Banks is to show depositors there is nothing to worry about, the mechanisms to support banks through this brief instability are robust, and if banks are well managed, then there is nothing to worry about…. Right… er?

It’s worth a quick look at the Battle of Credit Suisse earlier this week: It could have been a Chaos Strategic Win:

Global market nearly experienced apocalypse on Thursday Morning. On Wednesday Credit Suisse executives went pleading to the Swiss Regulator, the Swiss National Bank (“SNB”) for support. The bank stock price was in free fall. Depositors and banks were nervous – if the SNB hadn’t offered clear support it could (would!) have triggered an unstoppable bank run. CS, the SNB, the ECB and other central banks stared down The Barrel of Armageddon and decided not to go there.

Credit Suisse was given a Chf 50 billion liquidity backstop. It helped and created stability. Instead of shuttering the doors, the bank’s stock jumped 30% Thursday morning – although doubts as to its future value quickly emerged. If the SNB had not intervened… it would have been a financial catastrophe to match the collapse of Lehman Brothers in 2008.

I’ve warned many times how the seeds of the next financial crisis are planted in the solutions to the last one. After 2008 came the conflabulation of Contingent Capital Bonds which pay a nice rate of interest, but unlike any other bond, they get hit before equity on the subordination ladder. If a bank’s core capital ratio tumbles below a certain level (usually 8%), the bonds immediately convert into what will be worthless equity or are written off.

Credit Suisse had a CET1 Core capital ratio over 14%, but had it been forced to sell bonds to meet a run by depositors, that capital ratio would have tumbled, triggering the CoCo write off. That, in itself, would have created immediate systemic contagion, hitting other European banks, and raising the very real prospect they too would face a capital hit and broken capital levels. And, Credit Suisse would still be buried in the crisis! Nothing solved.

It would have gotten worse. The banking losses would have been exacerbated by derivative exposures around the sector. French banks, in particular, are very, very good at derivatives, but with the downside they will suffer most in the event of disruptive chaos. The yield on less liquid bonds would have surged higher, resulting in even higher notional losses on hold-to-maturity bonds, while there would have been a feeding frenzy to buy the safest available-for-sale government bonds, which would have been countered by banks selling to refund depositor. Messy.

Had Credit Suisse been forced to trigger its CoCos, or gone bust, the reputational damage would have been irrecoverable. It would have triggered a tsunami of systemic crisis across European banking – banks would have fallen like dominoes, forcing bailouts.

The good news is, it was just another tactical skirmish the central banks and regulators won because the SNB offered the backstop line to the bank.

It was, apparently, a near run thing – as the Duke of Wellington once said..

The Bank War could get worse

Stemming the collapse of First Republic and Credit Suisse does not mean the battle for banking is yet won. Across Europe and the US, rising rates have impacted banks because of the mark to market effect on bond portfolios. These portfolios are safe – they will pay back at 100% when they mature, but because rates have risen their immediate value is less. In normal markets, that does not matter: Banks manage the risk, demonstrate their competency, and thus depositors don’t worry. In times of stress – they worry a lot.

As I wrote earlier this week, there is never just one cockroach. You can bet other banks are going to experience crisis. Central banks will rush in reinforcing backstops, and provide critical support. How much more will Jamie Dimon’s US Financial Cavalry offer to shore up weaker lenders? Successive waves of uncertainty will wash against the banking sector.. We are in for a period of acute fire-fighting and repeated skirmish and crisis – may even a pitched battle or two. Fatigue will set it.

There is always a risk it could get worse if a large credit loss or fraud is revealed. Maybe another bank will still crash on an outright solvency event.

What if the Battle for Banking is just Maskirovka?

Maskirovka is the Russian strategy of distracting the enemy by getting them to look in the wrong direction as the main assault is made elsewhere. What if banks are the distraction.. and asset managers are the real targets?

One of the major consequences of the 2008 financial crisis was to address and constrain the risk-taking culture within banks via new capital and risk regulations. You can’t destroy risk – you can only transform and transfer it. Most of the risk that once lay within banks pre-2008 now resides in the Investment Management Sector.

Much of the asset management real-money sector; pension funds and insurance companies, mirror banks in terms of their regulatory oversight and requirements on their asset liability management systems. These real money accounts are largely invested in bonds – largely longer duration – to match their future liabilities. Although they will be holding long-dated bond assets to maturity, the mark-to-market valuations on their portfolios will have been impacted just as were banks.

Both banks are asset managers are going to struggle to substantially de-risk ahead of further expected interest rate rises. Their notional bond losses will mount. It will not be a surprise to discover Asset Managers are under even bigger stress than banks – and we’ve never faced a situation when a whole raft of investment firms could be at risk of systemic failure.  If one crashes, then the rest will experience similar collapses in their asset marks. If it happens, it’s unclear how the regulators will manage it, unless the central banks step in to boost prices and liquidity by reopening the QE spigot, effectively distorting markets again.

The waters may appear calm on the surface, but underneath there is some frantic paddling going on, and its possible things could get much worse as phase 2 kicks in – stresses in asset management. No government can afford to allow a crash that will consume voter pensions and insurance!

Phase 3 will then follow..

As banks and asset managers struggle, who is going to lend? Already lenders are pulling out the market, waiting for more stable conditions. Bond markets will dry up, while banks are increasingly unwilling to lend. That will push corporate funding rates higher, perhaps forcing government intervention or triggering recession..

Who knows… but for now… all eyes on the Battle of First Republic..

No time for five things this morning…

Out of time, back to the day job, and have a great weekend…

Bill Blain
Strategist – Shard Capital