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Banking in uncertain times

bitsaboutmoney.com

161–170 of 378 posts

Re: Banking in uncertain times

#161
post #156

"This was complicated by some banks finding it surprisingly difficult to add numbers quickly… We have a report of Friday outflows, but it gets crunched by an ETL job which only finishes halfway through Saturday, and Cindy who understands all of this is on vacation, and… and eventually very serious people said Figure Addition The #*(%#( Out And Call Me Back Soonest" As someone who has written ETL jobs for banks, this…

I thought financial companies had regulations against bottlenecks like that? Something like, every employee has to have their access turned off for one uninterrupted week, to ensure they didn't leave something in that depends on them or they're controlling a (fraudulent) process no one else knows about?

Yes, the week (two weeks, IME) is a thing. As are contractor term limits. They reduce key man risk and keep knowledge internal. Still, it's possible to write a script to do something and then just not touch it for years. It keeps chugging away, and the mental model of how it works is lost to time or employee churn, and nothing goes wrong enough that anyone has to dig in and really understand it again.

Re: Banking in uncertain times

#162
post #82

He seems to say that the fractional reserve system is the only way society can work. But is that actually true? Quite a few banks (e.g. Brex) now allow you to keep your money in a money market fund, which invests in short term US treasuries that are protected by the full faith and credit of the US government. Importantly, in this setup, you own all the assets and the bank just acts as a custodian. And you tend to get…

A traditional bank used to take people's deposits and loan them to other for a fee. the fee would then be returned on aggregate to depositors less the cost of business and profit. this is so called fractional reserve banking. But that doesn't really provide that much interest to depositors, in this age of loose money supply. So there are more exotic functions that "investment" banks fiddle with. Ie trading on the sto…

I would disagree that Brex (and many others in the space) aren't offering banking. I can deposit money, I can withdraw it, I have a credit card, I earn interest, etc, they seem to offer everything a traditional bank would.

To your point about risky investments, like stocks, I agree that that's very sketchy. But I think even very prudent banks that don't invest in stocks etc still take on a lot of risk, like we see with the bank collapses caused by the high interest rates these days.

Re: Banking in uncertain times

#163
post #116

As a former trading desk guy I struggle to see how the system allows things to be marked-to-cost. Or rather, why is it that we allow a bank to not mark-to-market a security for which there is a liquid market? Allowing the bank to pretend it has more assets than it actually has seems to be an invitation to hide risk. If they had to MTM their underwater bonds, they would would have been pushed to raise capital earlier,…

> why is it that we allow a bank to not mark-to-market a security for which there is a liquid market? Because at maturity, the bank gets back its money. So it is perfectly valid to say "in ten years, this $100m bond is worth $100m...and I intend to hold it for ten years, so it's worth $100m [equivalent] today". The "I intend to hold it" is the relevant part of the valuation, though.

>So it is perfectly valid to say "in ten years, this $100m bond is worth $100m...and I intend to hold it for ten years, so it's worth $100m [equivalent] today".

But that valuation model is not perfectly valid. It's only partially valid under limited scenarios.

As many comments have already pointed out, the issue is the bank has customers with demand deposits. The customers can demand withdrawal of their money anytime -- without advanced notice. In other words, SVB is not a hedge fund that has the customers' deposits contractually locked up for 10 years.

Therefore, the "10 year bond held to maturity" assumption becomes invalid if the bank has to sell them prematurely at distressed discount prices -- to meet liquidity requirements of demand deposits.

You can't use value securities as "mark-to-intended-optimal-future" as an alternative to "mark-to-market" for purposes of insolvency risk calculations.

Re: Banking in uncertain times

#164

Mentioned in the article, Chart 7 from an FDIC report [1] is concerning, specifically that currently there are “unrealized losses on available–for–sale and held–to–maturity securities totaled $620 billion” — which appears to be not only a recent trend, but roughly 10x more than any point in recent history, including during 2008. Is anyone able to provide more context and clarify how significant these losses are to th…

Everyone will say they are “unrealized” losses. Some people (let’s call them “busters”) will argue this means real losses that already happened but banks are allowed to pretend it hasn’t. Other people (let’s call them “holders”) will argue these losses aren’t real and will only become real if the bank is forced to sell them, while if they manage to hold onto them for the full ten years then the losses never become real and vanish.

The truth is roughly that both sides are right, and the sum of their claims is much weirder than either subset.

The actual instrument in question is a little tough to get your head around. The first part is the basic bond mechanism: you give the government a thousand bucks, and ten years later they give you back that thousand dollars (guaranteed: they can print money so they will never default, only risk is they have to print so much money to pay you back that the economy explodes, and everyone has bigger problems at that point). Why would you do this? You wouldn’t, there is no upside, you only get back what you put in and it’ll be worth a little less because of inflation by then as well. Nobody does it, so right now what we have is not a real financial instrument.

So let’s make a first attempt at offering some upside: if you let them hold a thousand bucks for ten years, they’ll give you 10 bucks twice a year. Now you’ll take it - unless you think you can make more than 20 dollars out of your 1000 dollars each year by putting it somewhere else. What controls how much you can make on your 1000 dollars elsewhere? A lot of factors that all ultimately rest on the interest rate. Okay, so the government can’t just offer a flat 10 bucks twice a month, they have to offer something competitive with the current interest rate. But there’s the kicker: the current interest rate. Once you buy the bond, that amount is fixed, even if the interest rate later changes.

If the interest rates go up after you buy a bond, next years bonds will be offering higher per-year payments, so your bonds are inferior by comparison (they pay the same at the end, but less on the way, and they’ve already paid out some of the payments to you) and thus are worth a lot less. This is important because aside from holding them you can also sell them to someone else for any price you agree on, and whoever buys them from you gets the rest of the yearly payments and the final payout instead of you. They’re a hard thing to sell if interest rates have gone up, because you’re offering 20 bucks a year for five years while the government is offering 50 bucks a year for 10 years.

So: the money you get back eventually is worth less than when you handed it over because of inflation, but you’re getting small payments all along the way based on the interest rate at the time of the agreement. You care about interest and about inflation.

We have to stop for a moment and talk about interest rates and inflation. It is generally accepted that an increase in interest rates will cause a decrease in inflation a few years later. Confusingly, people will also say that interest rates move in the same direction as inflation but with a lag. It’s not that confusing though:

an increase in inflation at time t=0…

…will cause an increase in interest rates at time t=1…

…which will cause a decrease in inflation at time t=2…

(…which will cause a decrease in interest rates at time t=3…)

(…which will cause an increase in inflation at time t=4, and we’re back to step 1)

And so the cycle goes.

So in effect, you’re betting on this tension between interest and inflation resolving in your favor. In practice I believe the effect of inflation is smaller than the interest payments, so it’s also generally believed you always have a way out of the bet: just hold for the full ten years and the interest payments over that time will more than cover the inflation loss.

Except you can’t just hold on to the bet, because you’re a bank, and that thousand dollars you gave to the government is not your thousand dollars - it is some customer’s deposit, and they might want it back. So you better plan to have another thousand dollars somewhere else that you can give that customer, because the only way you can turn this bond back into money before the 10 years is up is selling it. And as mentioned before, if interest rates have recently gone up, your bond is not going to sell for anywhere close to breaking even.

That’s what that unrealized loss figure of 600 billion is: if you sold them for market value today, how much would you lose? As pointed out in the article, because interest rates were extremely low when these bonds were made, their yearly payout is very low. Because interest rates have risen rapidly, new bonds have much higher yearly payouts. And because interest rates have risen recently, we’re still in the lag period before inflation falls, so the final payout is also worth less (once again, I believe the effect of inflation differential is smaller here, and the price is I think mostly driven by the interest rate differential).

Concretely, right now, you could probably sell those bonds for no more than 75 cents on the dollar, and likely closer to 65 cents. If the Fed keeps raising interest rates like they’re doing now until the end of the current Presidential term (where someone else will get to tell the Fed what to do), we might get below 50 cents on the dollar, or even lower.

Banks bought 2 trillion dollars of an asset and right now that asset is only worth 1.4 trillion. That is, objectively, a huge loss. Point to the busters.

…But if we just hold the asset long enough, it is worth about 2 trillion again. Point to the holders, and this is why we call them “unrealized” losses.

…But if we can’t hold the asset (because, say, everyone withdraws at the same time), we have to sell at the current market rate, and those losses are forced to be realized. Point once more to the busters.

…But if we can rely on the FDIC or the government or other banks to step in and cover our withdrawals, we aren’t forced to sell - we can hold until the value returns, and pay back the FDIC or the government or the other banks then. Point once more to the holders.

And so it goes, back and forth between the busters and the holders. Who is right? In aggregate it’s both and neither, but at specific times for specific banks it could very visibly be one or the other. No wonder it’s so confusing!

There’s a lot more of these back and forths at every level that further complicate things. The government is jacking up interest rates so they’re causing the pressure… but banks know this dynamic exists and didn’t prepare for it so they made themselves vulnerable to this pressure… but the government regulations make these investments much more attractive to banks (very roughly: regulations say you only have to put up 0-20% of the value of these investments as collateral, for other investments it could be 100% or even 400% collateral) so the government pushed the banks in this direction… and so this cycle goes, too.

The fundamental dynamic is these bonds were an easy investment that turned into a giant Sword of Damocles over your head that’s growing by the day. In ten years you can step out from under the Sword, but any day now your depositors might panic and drop it on you, but if they do drop it the government might catch it before it kills you.

Thus, finally, some insight into the title of the post: very uncertain times indeed.

Re: Banking in uncertain times

#165
post #116

As a former trading desk guy I struggle to see how the system allows things to be marked-to-cost. Or rather, why is it that we allow a bank to not mark-to-market a security for which there is a liquid market? Allowing the bank to pretend it has more assets than it actually has seems to be an invitation to hide risk. If they had to MTM their underwater bonds, they would would have been pushed to raise capital earlier,…

> why is it that we allow a bank to not mark-to-market a security for which there is a liquid market? Because at maturity, the bank gets back its money. So it is perfectly valid to say "in ten years, this $100m bond is worth $100m...and I intend to hold it for ten years, so it's worth $100m [equivalent] today". The "I intend to hold it" is the relevant part of the valuation, though.

Welcome to a non-zero interest rate environment. "$100m equivalent today" is not $100m -- the term to search for is "net present value". These considerations are precisely what marking to market captures

Re: Banking in uncertain times

#166
post #112

Earlier quoted context omitted.

I just don't get this about the system in the US. If you keep creating money out of thin air — which as per my admittedly naive understanding is equivalent to just printing money without giving back anything in return — wouldn't it ultimately lead to a collapse or a hyper inflation? Like it did in Venezuela a few years ago (???). Why is the US seemingly immune to this kind of thing?

>Why is the US seemingly immune to this kind of thing? See https://en.wikipedia.org/wiki/List_of_countries_by_military_... Not trying to be a low-effort reply but any Economy 101 textbook will theorize that it's impossible. Practically, the world is too dependent on the USD in one way or another. If they try to break loose, they might get confronted with those military expenditures which is a good enough incentive to…

No, really, this argument is even worse ignorance than the gold standard stuff, because it isn't true even as an oversimplification or historical detail.

The difference between Venezuela and any relatively stable country (the US is one of many, some of which have tiny armies and pacifist foreign policies) isn't military spending or reserve currency status, it's that the money in the country with the stable currency is created as a debt which the borrower and bank has to be repay in future (with the central bank also intervening if it thinks too many borrowers and banks are taking on debts) whereas the money in places like Venezuela is being created to pay off debts.

Re: Banking in uncertain times

#167
post #159

As a former trading desk guy I struggle to see how the system allows things to be marked-to-cost. Or rather, why is it that we allow a bank to not mark-to-market a security for which there is a liquid market? Allowing the bank to pretend it has more assets than it actually has seems to be an invitation to hide risk. If they had to MTM their underwater bonds, they would would have been pushed to raise capital earlier,…

There are liquidity, jurisdiction and tax considerations that go into bond accounting. Under both US GAAP and IFRS you can't flip between held to maturity, available for sale and m2m asset classification advantageously. I think this is ok -- it's impractical and misleading for a bank to value every liability and asset by rebaselining value constantly. How would you determine fair value for a bespoke security anyway?…

Many types of institutions have to mark to market on a ~constant basis, so it's not impossible. Yes there are certain asset classes (private companies, for example) that don't have easy or reliable marks (but people still do it anyway!). But at least for SVB the issue was not determining the market value, but that the market value was bad.

Re: Banking in uncertain times

#168
post #54

Earlier quoted context omitted.

The bailout to the banks is two fold. First the direct bailout in form loan guarantees. The moral hazard on those are limited by the time limit on when the assets had to have been bought (in the past) and on how long they can be used (a year). The second is a third or fourth order bailout of banks. By moving the goal posts on depositors responsibilities to “none if you are a powerful lobby”, risky banks no longer hav…

I don't think it's a big change. I think very few people are qualified to do due diligence on their banks. It's a bit like expecting people to inspect bridges before they drive over them. It's a piece of financial infrastructure that we expect to just work. It would be a big change to not have that expectation, and would likely result in the collapse of the regional banking system as people flock to the Big Four "sys…

> I don’t think it’s a big change

This is a big part of the problem in tech apparently. It _is_ a big change and in other industries it is very common for large cash holders to do normal due diligence on their banks and to have technology and procedures to mitigate the counterparty risk.

The flocking concern was literally cited as one of the problems with “too big to fail” in 2008 and it happened! Lots of corporate & governmental treasurers took that as a clue to move to larger banks.

Bank runs start because someone notices and publishes that a bank is insolvent, not the other way around. In this case it was because a bunch of supposedly sophisticated actors realized it too late.

Re: Banking in uncertain times

#169
post #163
post #116

Earlier quoted context omitted.

> why is it that we allow a bank to not mark-to-market a security for which there is a liquid market? Because at maturity, the bank gets back its money. So it is perfectly valid to say "in ten years, this $100m bond is worth $100m...and I intend to hold it for ten years, so it's worth $100m [equivalent] today". The "I intend to hold it" is the relevant part of the valuation, though.

>So it is perfectly valid to say "in ten years, this $100m bond is worth $100m...and I intend to hold it for ten years, so it's worth $100m [equivalent] today". But that valuation model is not perfectly valid. It's only partially valid under limited scenarios. As many comments have already pointed out, the issue is the bank has customers with demand deposits . The customers can demand withdrawal of their money anytim…

> But that valuation model is not perfectly valid. It’s only partially valid under limited scenarios.

Its valid under the applicable regulations. However, it is one case where having adequate capital under those rules was not backstopped by available liquidity measures from the Fed.

One thing that seems to be generating less commentary is that, in the wake of the SVB collapse, and virtually simultaneously to the announcement of the systemic risk exception for SVB by the FDIC/Treasury/Fed, the Federal Reserve also announced a generally-available liquidity backstop program for this kind of hold-to-maturity assets.

> You can’t use value securities as “mark-to-intended-optimal-future” as an alternative to “mark-to-market” for purposes of insolvency risk calculations.

To the extent that refers to valuing the class of assets at issue at their par value, and to the extent that that was true last week, its not now.

Re: Banking in uncertain times

#170
post #165
post #116

Earlier quoted context omitted.

> why is it that we allow a bank to not mark-to-market a security for which there is a liquid market? Because at maturity, the bank gets back its money. So it is perfectly valid to say "in ten years, this $100m bond is worth $100m...and I intend to hold it for ten years, so it's worth $100m [equivalent] today". The "I intend to hold it" is the relevant part of the valuation, though.

Welcome to a non-zero interest rate environment. "$100m equivalent today" is not $100m -- the term to search for is "net present value". These considerations are precisely what marking to market captures

If those assets are in your hold to maturity portfolio, they are still worth $100m. This return is guaranteed unless the Federal Bank defaults on those treasuries.
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