March 2023
Zombie Banks
Steven McClurg, Chief Investment Officer of Valkyrie Investments Inc.
For educational and illustrative purposes only. This is not a solicitation to buy or offer cryptocurrency or securities. Investments may be speculative, illiquid and there is a total risk of loss of principal. There is no guarantee that any specific outcome will be achieved. Past performance is not indicative of future results.
After the last financial crisis, interest rates went from 5.25% to near 0%, allowing bad companies to survive by borrowing money at low rates. Companies like Sears and Blackberry, who produced or sold items that no one really wanted, continued to exist. Eventually, companies like this do see a rebound in buyers of their products, thanks to a large reduction in prices. As goods and services are dumped into markets at low prices, enough cash is generated for the companies to pay their debt service, and amend and extend debt at low rates. Dumping of goods artificially kept inflation low for a period of time despite QE and increased money supply. But cheap goods and wage stagnation can only last so long in an environment with an infinite money supply. As we saw in the last three years, inflation has caught up to us after 12 years of easy policy.
When debt is cheap, companies don’t have to innovate or pivot. The innovation part is important, because technological innovation is deflationary…
What does this have to do with banks? When interest rates were low for too long, banks started taking bigger risks: lack of depository base diversification and reaching for yield in MBS and venture debt.
Bank Economics
Banks make money by taking in deposits and lending those deposits out. The greater the spread between the cost of gathering deposit dollars to the rate of return by lending those dollars is the gross profit margin of a bank. Plain and simple. Riskier banks will gather deposits from riskier counterparties due to the lower cost of acquisition and issue venture debt or buy risky bonds at higher yields to increase that spread.
Structured debt
To be clear, MBS may not seem risky on the surface, as most is government agency secured (Agency MBS) and has little risk of loss of principal, but bonds have other types of risks. One is duration risk, which is the magnitude that price drops when interest rates rise.
Duration is calculated by several factors; the less a bond coupon, the higher the duration, the longer the expected life of a bond, the higher the duration. A year ago, 30 year US Treasuries, with a long expected life and low coupon had very high duration, and fell in price 30%. Agency MBS, since it is secured by Fannie or Freddie, has a lower risk, therefore lower coupon (remember, higher duration) and long maturities (30-year mortgages), even though the Weighted Average Life is closer to 7 years. Banks expect mortgages to refinance frequently, much sooner than their maturity, and therefore be ok with taking duration risk.
Risk to Banks
I explained the bank risk to my portfolio management team at Valkyrie back in June:
to which a more junior team member, who previously worked in tradfi answered:
We saw what happened. When your single-sector deposit base (tech companies) draw down money (predictable by the mass layoffs in tech like Twitter, Meta, Amazon) then the bank is forced to sell liquid investments, like mutual bonds and treasuries, and at a discount to par (because bond math works like this: yields up, price down).
Fed and Treasury Bailout
Finally, the Fed stepped in to prevent a run on the banks. Let’s be clear about bank runs. When you pull money out of a bank, where do you move it? Well, other banks, of course. The real issue is not a system-wide bank run, because money would have been simply shifted around. The real issue was loss of deposits for SVB and other similar banks that service VCs, PEs, and tech companies. Who would have been the real loser then? Pension Funds with large Venture and PE investments, and of course the politically powerful tech companies.
The statement from the Fed was that this bailout would cost the taxpayers nothing. All $300 billion in loans to support the deposit bases would be absorbed on the Fed’s balance sheet. To put it in perspective, the Fed has unwound $600 billion of its balance sheet in the last year to “fight inflation”. Adding $300 billion back is the equivalent of adding 2% in annual CPI. Therefore, the taxpayers were indeed taxed, across the board. And lower income brackets hit the hardest.
“Inflation is taxation without legislation.”
-Milton Friedman
We now enter the era of zombie banks.
Back to the important calculation of how banks make money. Since there is now an infinite insurance on bank deposits, there is no reason for banks to take on more risky clients and a non-diversified deposit base.
Bank investments will be as risky as they want to be, so we will likely see a reach for yield in assets in order to increase the spread to make more money. Innovation will no longer matter, as the game is now taking higher investment risk.
Customer Service
The airline industry has gone through several bailouts and government-supported restructuring. Due to infinite government support, there is no good reason for the larger legacy carriers to be on time, offer good customer service, or refund a ticket when a flight is canceled or delayed. Innovation is slow and prices go up. When young, innovative carriers like Virgin America or JetBlue enter the market, they are either quickly bought and dissolved, or elbowed out via government agency maneuvering.
The future of banks is similar. In the near-term, banks will start charging to hold customer deposits and tack on additional fees for service.
It will be difficult to withdraw money, particularly large sums, and with withdrawal fees attached. Customer service will be a concept of the past. Just like how flight attendants went from offering in-cabin service to becoming air-traffic cops, bank tellers will be more focused on charging fees and monitoring how money is spent, reporting more transactions to IRS and other agencies.
Solution
People now have tools to become their own banks. Bitcoin will become more popular for everyday transactions and as savings accounts. Eight years ago I had the privilege to sit down with John Mac in his midtown Morgan Stanley office, and have a discussion with him and my dear friend, the late Scott Minerd, about how blockchain could disrupt banking. John told me to “look around the city at all the tall buildings with legacy bank names on them. These buildings, including the one we are in, are filled with people that are mostly obsolete, they just don’t know it yet. Within the next 10 years, blockchain technology will change everything.”
John was right.
Disclaimer
The opinions expressed in this paper are those of the author. They do not purport to reflect the opinions or views of Valkyrie Investments Inc. or its affiliates (“Valkyrie”).
This paper is for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to sell or buy any security in any jurisdiction where such an offer or solicitation would be illegal. This paper should not be used as a basis for making any investment decision. This paper does not constitute a recommendation or take into account the particular investment objectives, financial situations, or needs of investors. The contents of this paper are not legal, tax or investment advice, and investors should consult their own advisors concerning an investment in digital assets.
Certain of the statements contained herein may be statements of future expectations and other forward-looking statements that are based on the author’s views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. In addition to statements that are forward-looking by reason of context, the words “may, will, should, could, can, expects, plans, intends, anticipates, believes, estimates, predicts, potential, projected, or continue” and similar expressions identify forward-looking statements. Neither the author or Valkyrie assume any obligation to update any forward-looking statements contained herein and you should not place undue reliance on such statements, which speak only as of the date hereof. No representation or warranty (including liability towards third parties), expressed or implied, is made by the author or Valkyrie as to the accuracy, reliability or completeness of the information in this paper.
