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A Glimmer of Hope

Updated: Jul 20, 2023

“You've never been lost until you've been lost at Mach 3.”

Paul F. Crickmore

We’re in truly unchartered territory. The Fed took interest rates from 1% to 5% in less than a year, which has literally never been done before.

Just as a car will gradually slow when a driver taps the brakes, something in that car is going to break if the driver floors the brake pedal at 120 miles per hour, which is what the Fed did to our economy. In this week’s case, it was Silicon Valley Bank, straight through the windshield.

Until last week, expectations for higher rates were hardly even up for debate, but the collapse of Silicon Valley Bank triggered a widespread and swift reassessment, with yields on two-year notes plummeting 109 basis points in the first three trading sessions of the week. Goldman Sachs Group Inc. and Barclays Plc economists changed forecasts to reflect no change by the Fed at its meeting next week, and Nomura Securities economists went even further to say the Fed would even cut rates and stop quantitative tightening. Doing so would be a complete about-face.

As Tuesday’s CPI report showed, inflation remains widespread in the US economy, so there’s a reasonable argument to be made that the Fed is unlikely to drastically reassess its radical trajectory. However, there’s also an argument that the run on SVB will drive more competition among banks for deposits and tighten lending standards, thereby effecting a tightening of financial conditions that would make inflation look much more benign in a few months than previously anticipated. As Goldman’s, Barclays’ and Nomura’s work suggests, everything changed this week.


The mechanics of a bank run work like this:

Let’s say Bank ABC has $100 million in deposits and $100 million in collateral (i.e. Treasury bonds) trading at par (face) value. As the Fed hikes rates, the value of that collateral falls to $90 million.

This is not problematic as long as customers do not simultaneously demand all $100 million in deposits. If they do, there is a collateral shortfall of $10 million to cover demands. Moreover, the bank must recognize a $10 million loss and raise new capital-- and capital raises scare investors.


The Panic of 1907, also known as the Knickerbocker Crisis, was a financial crisis that took place in the United States over a three-week period starting in mid-October during which the New York Stock Exchange fell almost 50% from its peak the previous year.

It was caused by the management at the third largest trust company in New York, the Knickerbocker Trust to be precise, ignoring all principles of risk management to corner the copper market of all things. (Imagine the hubris.) As word got out, depositors started withdrawing their deposits in significant fashion on October 18th. The trust’s board asked the president to resign, and a full-on classic run on the bank ensued on October 22nd.

The single most prominent banker in New York, J.P. Morgan, and his associates examined the books of the Knickerbocker Trust and decided it was insolvent, so they did not intervene to stop the run. (In much the same way, no bidders could be found for Silicon Valley Bank over the weekend before the bailout was announced.)

The damage was done, though, and the failure of the Knickerbocker Trust triggered runs on even healthy trusts. On the afternoon of Tuesday, October 22, the president of the Trust Company of America asked Morgan for assistance.

That evening Morgan conferred with George F. Baker, the president of First National Bank, James Stillman of the National City Bank of New York (the ancestor of Citibank), and the United States Secretary of the Treasury, George B. Cortelyou. Cortelyou said that he was ready to deposit government money in the banks to help shore up their deposits. An overnight audit of the Trust Company of America showed the institution to be sound, and Morgan declared on Wednesday afternoon, "This is the place to stop the trouble then."

A stand was made, and it strikes me as similar to the stand made by the Federal Reserve, the Treasury Department and the FDIC this week when they announced that they would make sure all depositors with accounts at SVB and Signature Bank would have access to their funds by the next day – beyond just the $250,000 guaranteed by the FDIC. Along with other actions taken, they have let it be known that there will be no runs on other banks.

And First Republic Bank (FRC) is an example of how this might look going forward. JPMorgan Chase (JPM), Citigroup (C), Bank of America (BAC), Wells Fargo (WFC), Goldman Sachs (GS), Morgan Stanley (MS) and others are involved in a $30 billion rescue package, according to a statement issued by the bank on Thursday. Of course, the stock is getting hammered on Friday morning, so now there’s new talk of FRC being acquired. Sure, yes, traders at the potential acquiring firms have been shorting FRC mercilessly this week, so they’re going to get a pretty good deal, but that’s another story… (Mercenaries, these guys, I swear. Nothing like what the brilliant Clarke and Dawe once explained to us about bankers.*)

The panic of 1907 occurred during a lengthy economic contraction, measured by the National Bureau of Economic Research as occurring between May 1907 and June 1908. But the stock market is an anticipatory animal, and it bottomed on November 15th, just a couple of weeks after the Trust Company of America rescue, and did extremely well in 1908, generating a 46% return and another 15% the year after that.

Dow Jones Industrial Average 1904–1910. The bottom of 53 was recorded November 15, 1907.

Source: National Bureau of Economic Research


Economists at Goldman Sachs this week boosted their estimated odds of a U.S. recession over the next year to 35%, up from about 25% before the collapse of Silicon Valley Bank and crisis of confidence around Credit Suisse. Meanwhile, JPMorgan Chase said regulatory scrutiny of smaller banks and a flight of deposits will slow loan growth, reducing GDP by up to a percentage point over the next year or two.

But the prevailing consensus among Wall Street reactions is that while this week’s CPI data was not super-hot, it remains hot enough to push the Fed to hike 25bps at the FOMC meeting on March 22nd. That would mean the calls by Goldman and Barclays for a pause along with Nomura's call for a 25bps rate cut will all be wrong. We don’t think they are.

Why? Because the Fed caused this problem by aggressively hiking rates which tanked banks’ collateral values. Many banks that failed to hedge their loan/bond portfolios with sufficient collateral to cover the deposits during a “bank run,” have seen enormous declines in the value of their collateral. Every hike pushes the bond losses on banks’ balance sheets ever deeper into the red.

It’s not that regulators weren’t asleep at the wheel-- they absolutely were-– but Silicon Valley Bank blew up with 10-year Treasurys on their books. This is simply what happens when the central bank pops a decade-long bubble in speculative behavior fueled by easy money and then tries to reverse it all in a single calendar year. Historically, the Fed always hikes rates until it breaks something; it has never hiked us into a soft landing.

As a person with an economic background who trades a lot of bonds and who also has a deep connection to the biotechnology start-up ecosystem, I’m probably even more appalled than most at the lack of risk management at SVB. Venture capital has been drying up for a while, and no one should be surprised that venture-backed companies’ burn rates increased significantly. It also shouldn’t have surprised anyone that rates were going to go up and that owning longer bonds as collateral was dangerous.

However, if bank regulators are interested in coming back to work after what appears to have been a multi-year hiatus, it would not make sense for them to continue inflicting these losses on banks’ collateral while simultaneously offering bailouts. We don’t think they’re going to hike rates and rescue banks simultaneously because that would be stupid. (It would also be expensive, although we know that no one in government really cares about that.)


Ultimately, we still expect the next move in the stock market to be lower, but the point of this week’s Insights is to highlight the small light that has come into view at the end of the (very long) tunnel. As we saw from the 1907-08 recession and Knickerbocker Crisis, stocks perform well in recovering economic environments; our economy does not have to be completely rehabilitated for stocks to move constructively.

Due to the government’s reaction to the Silicon Valley Bank situation, we expect the Fed to discontinue their rate hikes sooner than previously anticipated, thereby eliminating stocks’ most significant headwind. In other words, we’re still relatively defensive, but after a year of being bearish, we’re happy to write about the beginning of the end.

* Clarke and Dawe on banks

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