In their latest episode of the VALUE: After Hours Podcast, Tim Travis, Jake Taylor, and Tobias Carlisle discuss:
- What Caused The Run On Silicon Valley Bank?
- We’re Heading For A Financial Ice Age
- Fed Hikes Rates Until Something Breaks
- Fragility In The Banking System
- What The 10:3 Inversion Tells Us About Recession
- Is It Time To Change The Held-To-Maturity Rule?
- What Else Could SVB Have Done?
- Economic Problems Facing Japan
- Was There A Coordinated Bank Run On SVB?
- Should Bank Depositors Be Bailed Out?
- How Do Rates Impact Banks?
- Normal Accidents In Banking
- Buying Busted Tech
Links in this episode:
Tim Travis – ttvalueinvesting.com, Twitter: @timtravisvalue
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias: And I think that means we are live. It is Value: After Hours. I’m Tobias Carlisle, joined us always- [crosstalk]
Jake: Bank Run edition.[laughter]
Tobias: -by Jake Taylor and special guest, Tim Travis, who’s a specialist in banks value investing. Is that fair, mate?
Tim: That’s fair. Yeah.
Tim: Value investing, and a lot of the time, especially over the last decade, that’s involved financials. So, it makes sense.
Tobias: Yeah, I was going to ask you about that. It’s not because you have any particular affinity for banks. It’s just that it’s been a cheap financials environment. So, it’s paid to become an expert in that area?
Tim: Yeah, I think that’s part of it. I think also just working in the financial services industry, you get a feel for the different revenue streams of different companies like insurers or banks. And so, you just stay within your circle of competence. But absolutely, we’ve had big positions in energy before, large cap tech, healthcare. We kind of go wherever the value is and just as more of like a deep value guy, like you are, Toby. As you know, it’s a lot of financials.
Buying Busted Tech
Tobias: Lot of financials, a lot of basic materials. Busted tech these days. A little bit of busted tech around.
Jake: Is it?
Tobias: When I started out in the early 2000s, it was mostly busted tech. That’s the funny thing. You just buy like some shitty tech company on three times EBITDA, not knowing if it’s going to work or not because there’s always some bad news. They’ve lost a big contract or something like that. They’re wholly dependent on– They’ve got like a 50% client. So, the revs aren’t real, the EBITDA is not real. Somehow, they’ve figured it out. Three times goes to five times. That’s buy cheap and pray. That’s my investment strategy these days.
Tim: Those were fun. I remember Hewlett Packard, I think, 2012, 2011-ish, maybe. I remember after a string of just terrible acquisitions. I remember buying that stock for 20% free cash flow yield and they got better management. Yeah, there was a lot there. That’s when the enterprise part of the business was still connected to it. I know we’ve talked about Microsoft. When it was trading at 12 times earnings, little [crosstalk] negative– [crosstalk]
Tobias: It was only 10% free cash flow, right?
Tobias: 11.5% might have been– I saw it at 11.5% anyway. I didn’t buy it. Not that smart.
Tobias: Let me give some– [crosstalk]
Jake: Always get [crosstalk] at that point, right?
Tobias: Yeah, that’s right. Well, you had Ballmer in charge, and it had a year of revenues going down. So, it didn’t look that hot. San Diego, Comox Valley, Toronto. Brandon, Mississippi. Kerava, Finland. All right, what’s up? Las Vegas. York in the UK, Gothenburg. Wiesbaden. Hope I said that– Bristol, England. Squatter’s Crag in Australia, what’s up? Qatar. Amman, Jordan. That’s straight down the list. That’s a good spread.
I feel like we’ve got plenty of content for these– Every time we log off, something happens. We spent all last episode talking to the Big Short boys about what catalyst was going to take down this, like, what would be the Lehman moment? It turns out Silicon Valley Bank. That looked like it, but maybe not. Big rally today.
What Caused The Run On Silicon Valley Bank?
Tobias: Do you guys understand what happened with Silicon Valley Bank? Jake’s going to tell us what a bank is and then Tim’s going to tell us what happened with Silicon Valley Bank. What’s a bank?
Jake: Well, in the most basic version of it, it’s an institution that takes money in usually on shorter-term basis, lends it on a longer-term basis, and collects the net interest margin difference between those two, and calls that earnings, and then grows from there.
Tobias: Are you not allowed to call it–? Why is it not earnings?
Jake: Oh, it’s earnings. I’m being a little glib.
Tobias: The little regional banks make a lot more of their money from loans than the big banks do. They’re much more dependent on loans. The big banks have lots of other lines of service. They make money lots of different ways. Little banks make money-
Jake: Yeah, wealth management.
Tobias: -mostly on loans. Yeah.
Tim: Yeah, that’s true. A lot of people underestimate the diversification of the larger banks. You see them do pretty well in just about any environment, when volatility is spiking. I’m sure that big investment banks are printing money with the volatility we’ve seen over the last week. Then obviously, you’re right. The regionals are more net interest income oriented. But, yeah, I’d be happy to start on the Silicon Valley Bank. Really a classic 1980s style bank run with a modern twist. If you look at their deposit base, the growth was extraordinary. I think it was like 81% last year. I could be wrong on that. It was up a lot the year before too. The depositors were predominantly venture capital funds, VC companies, and a lot of those are burning cash. And so, they’re needing access to funds for payroll and whatnot.
The management of Silicon Valley Bank, instead of understanding the sensitivity there, it seems like they invested in longer duration securities to benefit, and they did it. The timing was bad. They got so many deposits when interest rates were so low that they took way too much risk on that and didn’t hedge appropriately.
Tobias: Before you move on there– [crosstalk]
Jake: Yeah, sure.
Tobias: This is worth diving into because what they’ve done is they’ve stuck most of it into Treasuries right?
Tim: Treasuries. Yeah.
Jake: And mortgage-backed securities.
Tobias: What’s hurt them though? Is it the Treasuries or the MBS that hurt them, or both? Potentially, I guess.
Tim: Oh, both. Both would trade at a– If you’re doing a mortgage at 2.15%, 2.5% on a 30 year per se, that mortgage would be trading at a pretty big discount right now. So, both of those hurt them. And we’ve seen that in most of the insurance companies and the banks. You’ve seen book values decline unless there’s something aberrational where they’re able to buy back stock at a discount or something like that. So, that part of it’s normal. But what really got Silicon Valley Bank was what seems almost a coordinated bank run. You have depositors, in this case, pretty large VC funds and companies, and they’re able to communicate and say, “Hey, we’re pulling our money out. Maybe you should too.” With technology nowadays– That can affect any bank, of course, but especially Silicon Valley Bank, it seems almost like it was a coordinated bank run. [crosstalk]
Tobias: To what end? To make a short payoff?
Tim: That’s a good question. Realistically, that’s a question that should being asked. So, I’d be curious who’s buying credit default swaps on that bank and other banks, or buying puts or shorting the stocks, because it seems a lot like a coordinated bank run. I don’t know what would have prompted that so fast. I have no interest in Silicon Valley Bank. I’ve never used them. I’ve never owned the stock, neither with the other ones, the signature or silver gate. [crosstalk] Yeah, but bank runs just like Jake was saying, anyone would be susceptible to a bank run. I think that people need to focus on what prompted that in the first place.
Normal Accidents In Banking
Jake: We’ve talked before about the idea of what are called Normal Accidents. Charles Perrow wrote a whole book about it. We talked about it in the context of like a nuclear power plant. What ends up in these systems, the more complexity and the more tightly coupled a system is, the more at risk it is from small things cascading and turning into complete disaster. You think about Silicon Valley Bank’s deposit base, that’s a very tightly coupled system. It’s like, everybody knows each other, it could get through a network very quickly that they want to pull their money. You’re just in a much more fragile situation at that point, which makes them, their long lending, even more idiotic to not recognize that like, “Boy, we could get called to the mat here if everyone who runs in the same circles decides to change their mind about who they bank with.”
I think on top of that, you also had the fact that most banks have a lot less uninsured deposit base, because it’s regular people that are under $250,000 covered by the FDIC. This was a weird bank in that it had a very large uninsured deposit base as a lot of their base. So, they were even more blowing in the wind there. This is kind of a perfect storm of banking things that could happen, but I wouldn’t be surprised if–
The solvency issue, this was a liquidity issue for them, because they couldn’t tap resources fast enough on the asset side to meet the liquidation side of the deposit base. That same solvency issue though that they had from bonds not being worth what they were two years ago is, I think it still exists in a lot of other places. I’m not entirely sure that we’re completely out of the woods on this. The FDIC or basically, covering everything above 250 now helps with the liquidity issue, but the solvency issue still is floating around there. So, I’m not sure we’re all done and hunky dory now.
What Else Could SVB Have Done?
Tobias: Let me ask, what else could they have done? From their perspective, I guess they would say, “We were taking our deposit money and we’re putting it into the safest asset base that’s out there.” I heard Meb Faber interviewed on Fox Business on Sunday night-
Jake: Oh, yeah. Good job, Meb.
Tobias: -and he said something like– I retweeted. It’s on my Twitter stream. They said, “What happened with Silicon Valley Bank?” And he said, “They put all of their money into assets.” I liked his explanation because it’s so simple. They put all of their money into assets that wouldn’t do very well if interest rates went up, and interest rates went up and that collapsed the asset side of their bank. I think that’s a fair description of what happened. I don’t know, I have no great expertise in this, but that looked at me like they were putting in Treasuries. I just thought, what else?
There was this period in time when it didn’t look like interest rates were– Interest rates have been crushed for a long time. I think you and I might have said, JT, that the long run interest rates are around 6%, but it’s hard to imagine how we get back there in any short period of time. So, wasn’t it sensible, logical to just be sticking them into those Treasuries? What else could they have possibly done?
Jake: But shorter duration.
Tim: We’ve got to [crosstalk]. Yeah, shorter duration for sure, but you got to also understand that they have liquidity requirements. They’re encouraged to own heavy proportions of Treasuries to meet those. The big banks, the Citi groups, the JPMorgan’s, the Bank of America’s, their capital ratios are reflective of the change in the AOCI on their held for investment portfolio. So, those ones are–
Tobias: What’s the AOCI?
Jake: Accumulated other comprehensive income.
Tim: Correct. Yeah. And so, you see the changes in book value, and then you see the changes in how it impacts the capital ratios. Smaller banks are not as susceptible to that. They’re not under the same guidelines. I think they changed the number to maybe 250– I forget what it is. It’s still a massive number, but they increased the number that it originally was going to be that you could escape because it’s pretty onerous.
But the thing is, the held for investment notation is, I think, actually pretty reasonable. Because for a bank to take duration risk, whether it’s on a loan or it’s on a security portfolio, you don’t want them marking everything to market. If it’s an investment bank, that could be different. But in a situation where the job of the bank is to facilitate capital, you want them to be able to hold some of those securities for a longer time, still you want to hedge your interest rate risk and that sort of thing. That’s what the good banks do, but these are not 2008 MBS securities that they’re holding. They’re government bonds that ultimately–
The credit risk is not there. There is interest rate risk. So, they trade at a discount now, but ultimately, they will accrue to par. Don’t forget that, a lot of these banks were sitting on massive many billions of dollars of AOCI gains prior to the interest rate increases. And so, it goes the same way. You don’t want to give too much credit when things are more favorable and you don’t want to give too much blame when things are negative, especially when the government has wanted, the regulators have wanted them to hold these types of liquid assets.
Tim: I’m not excusing what Silicon Valley Bank did. They took ridiculous duration risk without hedging it, and especially, they have a very idiosyncratic deposit base. I do think you need to look at how that bank run occurred, because you don’t want that. That’s not healthy for anything going on in this country or this economy.
Tobias: Do you think that that means that the problems are idiosyncratic to Silicon Valley Bank?
Tim: I do.
Tobias: Well, do you think that it’s potentially more systematic? Okay.
Tim: I think it is. If you look at the ones that got hit, it was Silver Lake. I believe it was Silver Lake. I think it was called– It was Silicone and it was the Signature. And so, two of those had crypto exposure. The other one was a lot of VC funds. The thing is, you don’t want to change the regulatory rules or the capital ratios in the middle of the game. They already did the smart thing. They basically doubled the capital requirements and the liquidity ratios after the global financial crisis. So, banks take a note safer than they had ever been. And so, these banks can meet their requirements. But if you’re saying, “Oh, well, you lost money because of higher interest rates,” and somehow just because you meet the actual capital requirements that the laws dictate, because you’ve lost money on your health for investment portfolio, somehow you’re not solvent or whatever, because if all your depositors leave, you’re not viable.
We need to not have bank runs. And so, I don’t know what that means for the FDIC. I think it’s tough for them right now to do anything, but guarantee those deposits. I’m not pro that, especially not in the Silicon Valley case. But I think that now you’ve crossed that bridge and it’s tough to differentiate between different banks or different depositors.
Fragility In The Banking System
Jake: A couple of things there. One, I don’t know the exact number. I’d be curious if someone else could ferret this out, but I thought I saw it at one point that there’s, call it, $1 trillion worth of uninsured deposits in banks right now. So, which effectively the Fed has put onto their own balance sheet now. That’s a liability. They’re underwriting another trillion dollars. Where if they have to come out of pocket for that somehow, where is that going to come from? Well, the asset side is going to come out of thin air, like, they print the money to give it to cover that. How is that not potentially going to be inflationary, which just keeps us raising the rates and potentially– We’re going to be in this difficult situation, I think, for a while.
The second thing– So, let’s ignore the panic and the bank runs the psychology side of things, and let’s look at, if you’re a bank and your deposit base, how do you keep your deposit base? You have to offer a competitive interest rate to the clients for them to stay. If you locked in a bunch of really low yielding long-term assets like MBS’s and Treasuries, and someone else lent short term and now they’re rolling back over with a 5%, let’s say, return on their asset side, they can offer a much more competitive rate now to depositors.
So, interactive brokers, let’s take as an example versus maybe Schwab, who might be on the longer side of things. Interactive brokers kept theirs low and now can offer– Well, will absolutely go out of their way to advertise how much more they can offer for cash balances relative to their competitors. And so, how eventually just the economics of being offered five instead of two because of the nature of the way the bank structured themselves, I think, erodes that potential base and how quickly that happens. It can look like a bank run and it doesn’t have to be a panic. It can start slow, and then build up from there, and then it turns into the psychology part of it kicks in, and now people are fleeing. It’s a very– [crosstalk]
Tobias: That’s a phase shit at some point.
Tim: Yeah, it can be a phase shift. I think it’s a fragile situation right now. [crosstalk]
Tobias: Is that what Silicon Valley Bank is? Is that the first of the phase shift that we’re seeing?
Jake: They were probably the most exposed to being super long duration and high interest rate sensitivity along with a very aggregated risk pool of depositors. So, it makes sense why it might be the canary in the coal mine. But it could happen at other banks on a slower, maybe like more played out basis. It wouldn’t surprise me.
Tim: Where you see that is, banks can manage for that. So, going into like, let’s say last year, a lot of them had excess deposits because there was so much cash on hand and interest rates were low and so they had too many deposits and so they’ve actually been surprised at how well they’ve been able to benefit from higher interest rates without paying more. On the deposit side of things, different banks have various advantages. A company like a bank of America or Wells Fargo, they offer services beyond maybe just interest rate, like were talking about earlier, before the show, just you might have your payroll or your estimated taxes in the accounts at those types of banks, and you’re not nearly as rate sensitive. So, I think where you’d see it is not some climactic, massive thing. I think you see, okay, deposit rates are going to go up a little bit.
Where you see that is, banks can manage for that. So, going into like, let’s say last year, a lot of them had excess deposits because there was so much cash on hand and interest rates were low. They had too many deposits. And so, they’ve actually been surprised at how well they’ve been able to benefit from higher interest rates without paying more on the deposit side of things. Different banks have various advantages. A company like a Bank of America or Wells Fargo, they offer services beyond maybe just interest rate.
We were talking about earlier before the show, just you might have your payroll or your estimated taxes in the accounts at those types of banks, and you’re not nearly as rate sensitive. So, I think where you’d see it is not some climactic, massive thing. I think you see, “Okay, deposit rates are going to go up a little bit. Net interest income or net interest margin gets squeezed a little bit. There’s plenty of room for that to happen. That is what’s expected to occur.” The idea that– Don’t forget, they offer CDs, they offer a lot of the banks now, almost all of them have some types of investment accounts associated with it. So, you could keep it in house where they’re still benefiting from it.
Where it takes on a different phenomenon is when it’s a bank run. So, yes, net interest margins should be squeezed. That’s better for everybody. The banks have gotten away with paying too low. I totally agree with that. But a huge difference is, people are trying to say, like, Schwab has an issue there. Well, they have huge, huge liquidity resources that they can use. They have plenty of capital, plenty of access to capital. The thing that we haven’t mentioned, guys, is that if you just take out bank runs and leave all the other factors in play, including credit, including commercial real estate, everything, they’re still making a ton of money. This is not a 2008. It’s not even a 2011.
Profitability is so much higher going into this. The reserves, because of CECL accounting are so much higher reflective of a recessionary environment that hasn’t materialized yet. So, I think we need to separate the bank run aspect of it with a solvency aspect. I think that’s important and I haven’t seen enough of that. I think it’s been a lot of panic the last few days, understandably.
How Do Rates Impact Banks?
Tobias: Do banks do better in a rising rate environment or a falling rate environment?
Tim: It depends on credit. They’re making way more money on net interest income over the last year and a half. It’s huge for Bank of America, for Citigroup, for all of them, pretty much. But then you also have the changes in reserve. So, credit was outperforming for years. 2019 was a great year for credit. And then with the pandemic and the lockdowns, they built up huge reserves, but the credit losses didn’t really materialize due to the stimulus. And so, now you’re seeing normalization. They’re already more heavily reserved, because they need to reserve now for the life of the loans. Another thing that doesn’t get talked about enough is CECL accounting is a huge change from how it was before. So, it depends.
So, they’re going to build reserves, especially for stuff like commercial real estate, credit cards. They already have pretty big reserves that’ll keep creeping up a little bit. They’ll make up for that on interest rates. There’s plenty of room for reduced net interest margins. That should be the consequence. There shouldn’t be bank runs.
Tobias: Do you feel like– that probably the catalyst for– If there’s going to be a catalyst for any sort of volatility in the stock market, it’s unlikely to come from something like Silicon Valley Bank, unlikely to come from something like the regional bank. It’s going to come from somewhere else.
Was There A Coordinated Bank Run On SVB?
Tim: It always seems to filter two banks at some point, especially right now. I think you get three weeks from now, we’ll see earnings. Three or four weeks from now, we’ll see earnings for the banks. They’ll probably be pretty good. I estimate that most of those metrics will be pretty healthy. So, I think the businesses are doing well. But there was a different panic phenomenon. I think that not saying that there aren’t fundamental issues with duration. That’s obviously Silicon Valley Bank made idiotic mistakes in regards to duration and their deposit portfolio. But I think all of that is very manageable. I think what you’re seeing is a bear raid. It almost looked like somewhat-
Tim: -coordinated bank run on Silicon Valley Bank. Then the Signature thing, I saw 20% of their deposits. It was just fear running the day on Thursday and Friday and Monday too.
Tobias: Was it, whatever it was, Silver Lake or Silver Gate, whatever that-
Tobias: -like the crypto-type bank? Was that the thing– that something happened there that stumbled, and then all of the VCs have chatted to each other and said, “Oh, Silicon Valley Bank’s also–“? It’s possible it’s not coordinated in the sense that they were trying to achieve something. They were just like, “Yeah, we’re all pulling our money out. We’re going to stick it somewhere else. I don’t know where we’re going to put it. Crypto solves this.”
Tim: Exactly. No, it totally is. I think it scared the market on Sunday night. The policy where they’re taking treasury bonds or mortgage-backed securities, and exchanging liquidity, that’s very favorable for the banks. I agree with Jake. I think it is inflationary to do something like that. And so, there’s negative consequences to it as well. But then when Signature Bank got taken under, it’s like, “Okay, well, who’s the next one?” Who’s the next one?
So, the next one in line has actually been a pretty well-run bank from my understanding of it, First Republic. And so, I think there just has to be a delineation as is, “Okay, well, what is it? Is it a stock price declining that is going to do this or is it a certain amount of deposits going out or what?” I just think you have to have a clear regulatory framework which should exist. So, I think if the dominoes stop there, I think this could be a very short-lived crisis and you just get back to the economy, okay? How do offices do, how do people hold up when credit, that sort of thing.
Jake: It’s hard to imagine that any regional bank is going to be very bullish with their loan book right now. They’ve got to be pulling back the horns big time, which should be somewhat contractionary from an economic standpoint.
Tobias: Silicon Valley Bank looks like it’s out there being pretty aggressive.
Tobias: They’re fully backstopped and they want the deposits back. That’s the deposit side. I don’t know how much they’re lending on the other side. I don’t know if I want to be lending too much.
Jake: Well, who’s going to lend for- [crosstalk]
Tobias: San Francisco.
Jake: -home construction or just your neighborhood bank that’s going to loan to build a strip mall or something? I would imagine that there’s a fair amount of risk appetite that’s been sucked in with this.
Tim: 100%. I’ve seen evidence of that, especially, Orange County is a big real estate Mecca, like a lot of the other sunbelt areas. I think there’s evidence of that. People are trying to resort to things, like, hard money lending and that sort of stuff. And that capital is very expensive. So, you’re exactly right. That’s deflationary in itself.
The other thing that should get mentioned is just, when you saw Treasuries rise in value and rates drop like they did so severely [crosstalk] the last few days, that has an offsetting impact on the AOCI number, right?
Tim: So, it turns that number pretty dramatically. Obviously, some of that’s been reversed today with the hot core CPI data. But that’s the best of benefit– [crosstalk]
Jake: We’re just like bouncing off the guardrails here– [crosstalk]
Tim: Oh man, it’s crazy.
What The 10:3 Inversion Tells Us About Recession
Tobias: I had a look at the 10:3 inversion today. The data goes back to January 1982. So, it’s not comprehensive. Whatever that EDGAR SEC website, whatever it is. The widest it’s ever been was 1.32– or the steepest it’s ever been 1.32, and that was in January 2023. And today, it’s 1.32 again. So, it’s the second reading. It’s the steepest it’s ever been since 1992. I tweeted that out.
Jake: So, bullish?
Tobias: I don’t know if any of that means anything.
Tobias: I have no idea what all that means. Cam Harvey’s disavowed his own research in relation to this thing. Every other one has had a pretty nasty recession that’s followed. Everybody’s saying it’s not going to happen this time. At this point, I feel like I’m just a scientist. I’m just interested in seeing what happens. So, I don’t have a view on whether– [crosstalk]
Jake: I feel more like I’m watching a play. I just want to see what happens in the third act here. [laughs]
Tobias: That’s kind of how I feel.
Tim: I still think we did see a technical recession last year. Whether you want to call it one or not, we can define things however we want. But there was a technical recession last year.
Tobias: Was it recession? It wasn’t a bailout.
Jake: Especially if you use real time.
Tobias: [unintelligible [00:28:41]
Jake: Prices moving up 8%, but unit [crosstalk] everything are down. So, I’m not sure how you consider that not a recession.
Tobias: I actually have some sympathy for the view, not a technical recession. I understand why they said that, but the definition is the definition. But I still think that every other indicator is there. I don’t understand why everybody’s so eager to suggest that it’s not a recession. There’s not one coming.
Tim: I think there’s a recession coming. I think there’s a recession. I don’t think it has to be– Our recent memory of a recession is 2008. It just like when people tell stories of their grandparents or whatever, saving the tin foil stemming from the Great Depression. The Great Recession was dramatic, depending on your industry. If you were in the markets, we all remember, it was unbelievable.
Tobias: That’s why financials have been so cheap for so long, because everybody thinks that the next one looks like the last one.
Tim: True. Yeah, if you look at take like Citigroup’s tangible book value per share, obviously, since after they had to raise all the capital and stuff like that. But what you see is you see actual growth in some of those tangible metrics. But you see the valuation just keep staying really cheap. So, you’re absolutely right. Remember the banks? Citigroup probably in 2000, it probably traded at five, seven times book value or something. AIG too. A lot of them did. That’s the thing.
Return on equities are a bit lower now. The banking system is a lot dramatically, dramatically safer than it was before, which is why I think this is kind of a concocted crisis. It’s like, sure, if you assume that there’s a bank run on these massive enterprises that have all these earnings history and 50-year histories, and they have to somehow sell all their assets, which they’re allowed legally to say, held for investment, yeah, that’s going to be a problem for anybody. But I don’t see why you’d get those bank runs. I would be curious to know who bought credit default swaps prior to that bank run occurring. It’d be interesting.
Jake: Somewhere Michael Burry smiles in the dark.
Tim: Was that tweet–? Did you guys see his tweet yesterday?
Tim: I don’t know if it was sarcasm or what. You never know. He’s an interesting guy.
Jake: [crosstalk] One thing I haven’t heard anyone ask is if one of the core issues was that rates moved up quickly from relatively low, what’s happening in Europe or Japan, where a lot of the similar dynamics might be playing out of rates moving up quite a bit from, in that case, negative, just moving from negative to positive. There’s a lot of convexity down at that zero bound as far as bond pricing goes. I wouldn’t be surprised if there’s some shoes to drop there too, eventually.
Tim: Yeah, I think they have to hold a lot of liquidity. Just like the US banks, they have to hold a ton of liquidity. So, that’s part of it. The other thing is the European banks. And Japan. I don’t follow Japan as closely, but they had to figure out ways to make money when there was, basically, negative interest rates. You know what I mean?
Tobias: What do they do? Do they have a raffle?
Tobias: [unintelligible [00:32:27] the front of the bank?
Tim: Yeah, fleet financing, insurance. There’s lots of different ways. Diversification between different regions and stuff like that. When you see 80% deposit growth and then they just pile it into a bunch of longer duration, MBS and Treasuries at 1.5%, and the deposit base is what it is. I’ve heard that, I don’t know for sure…
Clearly, we want stock in your company and we’ll extend loans or stock options, that sort of thing. So, those people abandoned them and there was a run in– I just think that the idea of extrapolating that to all these other banks is a big mistake.
Tobias: JT, we didn’t do your Veggies last week. Do you want to–? [crosstalk]
Jake: Oh, yeah.
Tobias: So, it’s a segue and then–
Jake: It’s not much of a segue, but yeah. [laughs]
Tobias: It’s the best I could do.
Gribbin’s Ice Age On Milankovitch
Jake: Yeah. Yeah, this is inspired by– I read this book called Ice Age: The Theory That Came In From The Cold! by John Gribbin. John Gribbin, I’ve done other books of his before. He’s a really interesting author. I like him a lot. This actually came from– Munger recommended this in the early 2000s at one of the annual meetings. This book is mostly about this guy named Milutin Milanković. Milanković, I guess, maybe. I’m not sure how it said. But he was this Serbian scientist, born in 1879, and he grew up in war-torn Serbia, which at that time was stuck between two decaying empires. You had the Austro-Hungarian and the Turkish-Ottoman Empire, and they were like fighting and they would like trade Serbia back and forth, and basically in the fighting, which an awful situation in a lot of ways. But he was trained as a civil engineer, and he’s actually well recognized expert in designing very large concrete structures at that time. Foreign governments would contract him to come and be a consultant on these giant infrastructure projects.
But he had this side hobby that was nearly all consuming for him. What he wanted to understand was how did the sun drive long-term climate? Actually, not just for Earth, but for other planets in the solar system as well. It took him literally 30 years of these hand calculations, because back then there wasn’t a computer to crunch all this stuff. He’s with a paper and a pen, literally, like, working the math out for the sun and hitting the Earth at different points and how much energy is transferred from the sun to the Earth, and how does that impact climate?
Part of the reason that it took 30 years for him to do it is, because he had to go off to war a few times. During World War I, he was captured and imprisoned. And luckily, he had all his, what he called, his cosmic papers with him. And so, he was sitting in a cell working interrupted on all of this math. You think about scientists today conducting research. You don’t think about them doing it from a prison cell– So, anyway–[crosstalk]
Tobias: With pencil and paper.
Jake: Yeah, with a pencil and paper. So, anyway, Milanković, he created this comprehensive mathematical model that calculates the differences in solar radiation at various Earth latitudes and along with the corresponding surface temperatures. The model is like a climate time machine in a lot of ways. You can look forward and backward using it. And so, he hypothesized that long-term elective effects of changes in Earth’s position relative to where the sun is is a strong driver of Earth’s long-term climate. Those changes were responsible for triggering glacial periods, AKA, ice ages. So, he looked at the Earth’s orbital movements, and there are really, like, three things that go towards that. I’ll try to move through these quickly, since it’s esoteric science stuff.
The first is the shape of Earth’s orbit, which is not perfectly circular. It’s called eccentricity. To that is due actually to the gravitational pull of Jupiter and Saturn. Even though the sun makes up a huge part of the mass of our solar system, Jupiter and Saturn are such that they’re big enough that they actually impact the circle that Earth makes around the sun. Anyway. So, currently, Earth’s eccentricity is near its least elliptical. It’s most circular. It’s actually slowly decreasing in the cycle. That takes about 100,000 years, just based on where Jupiter and Saturn are.
The next thing that impacts it is the angle of Earth’s axis tilted with respect to its orbital plane, which is called obliquity. And so, that is actually the reason that we have seasons. So, the greater the axial tilt, the more extreme the season due to being tilted toward or away from the sun. And so, Earth’s axis today is currently at 23 degrees, which is about halfway in between the two extremes that it moves around in. That happens on about 41,000-year cycles, like, how much does it tilt.
Then, the third thing is the direction of Earth’s axis of rotation. It’s pointed. And so, that’s called precession. P-R-E-C-E-S-S-I-O-N. As the Earth rotates, it wobbles a little bit around its axis. This is actually due to tidal forces caused by the gravitational influence of the sun and the moon. So, the Earth bulges at the equator because of this gravitational pull, and so there’s like a little bit of a wobble to it. And so, that actually changes somewhat the effects of the sun hitting the Earth. That has about a 25,000-year cycle.
So, you have this like 100,000, 400,000, and then like 25,000, and all of those are moving on different cycles. And so, they line up, and then they move away from each other over different time periods, and you sketch all that math out and you end up with these climates that happen over periods of time. They’re actually measurable. And so, what ended up happening was that he had this theory– He actually died in 1958, and his model at that point was largely discredited because there was no way to really prove it. But they started doing these drillings into the sentiment in the ocean, like, deep sea, where it’s actually very little amount of silt is laid down, but it’s a very consistent amount and so, they can then date it.
Using carbon dating, they could figure out how deep is the sediment, like, what does it look like? Then there are indicators within there of actually microbial DNA that they capture from what died at that time and then fell down to land on the bottom. They can tell what was the temperature actually, based on putting all these pieces of the puzzle together. It turns out that he was pretty right about all this stuff.
NASA’s website says that this Milanković cycle only explains about 25% of our current climate and the other part they’re leaving open for more of manmade stuff. I don’t want to get into a bunch of political, which is what climate has turned into. So, let’s zoom out and get to our tortured analogy of all this.
Tobias: This is the best part, when you got to bring it back.
Jake: Yeah, let’s try to land it. Shit.
Jake: So, it was a very counterintuitive finding for Milanković’s work, because it’s not the colder winters that actually lead to ice ages, which you might think. It’s actually the build-up of these huge glaciers that overtook most of northern Europe, and Canada, and the northern US roughly 20,000 years ago. They came from actually mild summers. So, the summer didn’t get hot enough to melt the ice off and then the winter just kept laying more and more of it down. And so, it’s actually mild summers that call it the problem of creating an ice age.
Similarly, I think, when we have cheap debt for a very long time, accommodative monetary policy and fiscal policy bailouts, which, by the way, I wrote all this piece before anything was happening in the last week. We shield the economy from bankruptcies, which, if you look at the bankruptcy numbers over the last 10 years, it’s been record low bankruptcies happening, which happens when you have cheap money. You can always just borrow, and extend, and keep the game going, right? But what I think you end up with is very mild financial summers and therefore, you don’t get the burning off of the ice and it builds up.
Then when it actually does get cold, you end up with potentially like a financial ice age, where it becomes a much more devastating consequence, because actually, the life is not adapted to that level of ice and coldness. So, it’s sort of setting yourself up for bigger problems by not actually having a little bit warmer summers that burn off the ice in a financial sense. So, I don’t know, if I landed that one or not, but– [crosstalk]
Economic Problems Facing Japan
Tobias: I like the analogy. Let me ask you though. Isn’t Japan is like, I don’t know how far ahead of the US. I perceive Japan as being a little bit further ahead of the US, in terms of they’ve got much more government debt relative to the size of their population. They have historically had a very– It’s one of the biggest economies in the world, lots of innovation, also one of the older populations in the world, and a huge amount of government debt. So, I think in some sense there– I don’t know if the US is necessarily going in that direction, but that’s the sentinel or the position that you could get in if you don’t reverse before you get to that point. It doesn’t seem to me nothing really bad has happened so far for Japan. “So far” is doing a lot of work in that sentence. Do you think that’s fair?
Jake: Yeah. [laughs]
Tobias: It feels like there should be some tipping point at some point, but evidently Japan hasn’t got there yet, and they’re a generation ahead. Tell me what’s wrong with that analogy. What’s wrong? How’s that forward?
Jake: Well, I don’t think that there are the exact same correlations between the US and Japan. I think the vibrancy of the US economy is quite a bit different. I think you have a very homogenous population with no immigration in Japan, which I think actually allows you to suffer more in certain ways. You just won’t make changes, because everyone is in it together. It’s like very family oriented, kind of collectivist in a lot of ways that the US isn’t. So, we have a lot more immigration. We have, I think, a more vibrant economy that changes more, and that is willing to adapt to whatever the conditions are, whereas I don’t get the sense that Japan has been as more of an ossified system that is a little more static, and therefore, it just decays more. I’m not sure the US fits that mold necessarily.
I do agree debt to GDP numbers. There’s a lot of things like zombification. All of that does seem to have some parallels. But I don’t know. I would be hopeful that we are vibrant enough to maybe avoid that path, because growth is what solves all of these problems. How do you get rid of debt problems? You grow out of them.
Tobias: Inflate it away. Print money.
Jake: Well, that’s one way.
Jake: But ideally, the better way is– [crosstalk]
Tobias: That’s the way we’re doing it, isn’t it?
Jake: GDP per capita is the important number here. And so, if you can grow the GDP per capita in such a way that shrinks the obligations of the liability side as such, that’s ideal. That’s what we did after World War II when we had a very large debt base that we financed the war. We then grew out of that debt issue over the next 30 years.
Tobias: Japan said that they don’t allow companies to go bankrupt. They allow a lot of cross holdings so that they have those zombie companies that basically the business has shrunk so much they just can’t service their debt anymore, but they just let them keep on lumbering on because they employ so many people.
Jake: Jobs. Yeah.
Tobias: Are we sort of starting to do that?
Jake: Probably, the most uncharitable version of– We’ll see. A lot of it depends on how do we respond to the next time that there’s stress. Do we allow the system to cleanse or do we just keep papering over the bullet wound?
Fed Hikes Rates Until Something Breaks
Tobias: We’ve shown what we’re going to do, haven’t we? We all know that. We know exactly what’s going to happen. The argument this whole way through has been the Fed will hike interest rates until something breaks. So, people are like, “Well, Silicon Valley Bank’s broke.”
Jake: Something broke.
Tobias: Yeah. So, therefore, they should stop. But at the same time now, you’ve got red hot inflation readings. They’re going to have to keep on raising rates to deal with that. When they cut– the market will fall over at some point and they’ll cut. The market is down on the year, down on the six-month, down on the one-month, down on the five-day, up a little bit today. Up a lot today, to be fair. I feel like we are seeing this slow-motion crash. We haven’t seen the face of the market yet. The market shows you its face every– We saw it in March 2020 at the bottom when it’s just full-on panic. When I open Twitter, you get a contact high from the fear–
Jake: Yeah, from the fear.
Tobias: That’s when you know that they were there.
Jake: Is that’s why you made Wile E. Coyote the–? [crosstalk]
Tobias: Go back and look at them. I’ve been doing a few crash test dummies, I think, last week.
Jake: Because he’s not looking down, therefore he won’t fall as long as he doesn’t look down?
Tobias: Yeah, that’s my point. What do you think, Tim?
Tim: I think last year, if you look at it, bonds have never had a year like that since they’ve been tracking the performance. So, there was a lot of carnage and that’s what’s interesting now is that the real damage was last year relative to interest rates. So, a lot of those kind of losses of what we saw last year. They don’t necessarily always have to realize it. Yeah, you could be right. I think that there’s fertile ground for more of a sell off. I also think that there’s some decent signs. Like the consumer is still relatively strong. It can be pretty hard to find employees. Unemployment is pretty low. If inflation does slow down a bit and the Fed stops raising rates, obviously that would help a lot of industries. I don’t know how realistic that is in the short-term that they could actually cut or anything like that.
If there’s a recession, I think it could be a manageable one as long as it’s based on root fundamentals. I think what I don’t like about just the current crisis is that I feel like it’s somewhat manufactured and that it’s not something that necessarily needs to occur. But if you yell “fire” in a crowded movie theater, you’re going to create a problematic situation. So, that’s I think something that should be watched out for.
Tobias: Yeah, I think it’s probably more of an accident than coordination. Obviously, I don’t know.
Jake: I like Hanlon’s razor on this one.
Tobias: What’s that?
Jake: Never attribute to malice that which can be explained by stupidity.
Tim: Yeah, it could be a combination of both. It could be a combination of both.
The bank made its share of problems. Clearly, I have no compassion for what the management strategy of that bank was by any means. But to get an actual run on the bank, it’s interesting how that came about. Just the fact that it’s VC companies and all their portfolio, that’s not normal. That’s not like how the deposits are at your local, regional bank. So, it’s an interesting dynamic. Yeah, the one thing I just– [crosstalk]
Tobias: Do you think–?
Tim: Oh, sorry, go ahead.
Jake: I was going to ask a question. The amount of money that was pulled out of Silicon Valley Bank is kind of staggering, like how fast it happened. Do you think that today’s tools, and let’s say the Fed as one of them as a big tool. Pun intended.
Tobias: I agree with that characterization.
Jake: Is that well suited for today’s world where things can happen just incredibly fast? I’m worried that they’re just going to be always fighting the last data point that came in and the world is just moving so quickly that they’re like– [crosstalk]
Tobias: Isn’t that always the case?
Jake: Yeah, but maybe more so than– A huge percentage of the deposits flew out of that in three days. That’s amazing, right?
Tim: Yeah. Look, I am not someone– If you look at who was getting bailed out, equity holders got wiped out, creditors pretty much got wiped out, the depositors definitely got bailed out without a doubt. It’s an interesting breed of depositors. It’s not the Average Joe that has 50,000 over the minimum requirements per se. So, that should understandably cause some frustration.
Jake: Tim, are taxpayers on the hook for Silicon Valley?
Tim: Only for the different.
Tobias: No, the Fed’s got it.
Tim: Well, they’ll raise the premiums on the banks. So, the banks will end up paying for it over time. But don’t forget. It’s only the excess over the assets that they’re able to realize that the taxpayer theoretically would be on the hook for. The banks normally pay for it via an insurance premium that gets collected over time. So, I think that could be worked out. But to your point, Jake, I think realistically you can’t have an implicit guarantee on just like Silicon Valley Bank and Signature Bank and then not do the same thing, because the world is different after that. It is. It’s a huge change. We saw the same thing with the GSEs. It’s just not realistic to have the status quo as it is. And so, I hope we don’t have to learn that the most painful way possible.
Tobias: Does it feel like if bonds are down– bonds had their worst year in whatever, like history or modern history over the last year, equities had a bad year, but equities have had lots of worse years than that. It seems to me like equities somehow just skated completely over the speed bump.
Jake: It’s [unintelligible 00:52:17] what have graveyard?
Tobias: Well, yeah. That’s how I feel. When we’ve seen this in the past, the Fed will keep on raising rates until something breaks. And then really, probably, what I’m talking about is the market, like individual regional banks blowing up, probably, they can rationalize that, but at some point, the market corrects. Then go back and look at what they’ve done every single time the market corrects, they lower rates. The first count of five or six rate cuts won’t do anything to the market. I don’t know. John Hussman’s theory about why the market rallied in March 2009 was they stopped having the banks having to mark to market. He says that little accounting change was the biggest–
Tim: It did. But that was because it was a stupid accounting policy in many ways, because what happened was it was a self-fulfilling prophecy, where the securities, the credit default swaps, and the RMBS were trading at such extreme levels that basically, when they had to mark to market, it showed that the banks had to keep raising capital. And then to do that, you’re issuing stock at lower and lower prices. But it was all a lot of uneconomic stuff because what happened to those RMBS securities in the following years. They were some of the best securities you could have owned. So, the prices were uneconomic.
If you want your banking system to be like a day trading environment, if you want it to be basically a day trader with everything marked to market, I understand that investment banking. Retail banking and investment banking are two different things. I think that there’s legitimate reasons for not– If you want someone to loan 30 years on a mortgage or 10 years on a business loan to a small business, you don’t necessarily want that loan marked to market to foster capital availability, in my opinion.
Is It Time To Change The Held-To-Maturity Rule?
Jake: Tim, speaking of changes, do you think that they will consider changing that held to maturity rule where maybe they can release things out of held to maturity without repricing the entire portfolio?
Tim: That’s a good question. That could be possible. I definitely think you’re going to see regulators and government officials focus on that. Maybe you have the same requirements that the big banks have, where they have to reflect it on capital. But give them time to build up to that level to where they’re able to do that. And that does increase the cost of the banks and ultimately, that flows through to depositors and stuff like that. But, yeah, I think that would be a reasonable thing to look at and you just give them a few years to build up to that.
The immediate thing is just getting out of the immediate crisis, because there is one. They did. They guaranteed all the deposits, and right now it’s implicit. I think that you have to address that. You can’t just leave it open ended, because then bears and stock market traders, they’re going to manufacture a crisis that might not necessarily exist.
Jake: There’s a Chesterton Fence question to this that I wonder about, which is, if it’s such a good idea to insure all of these deposits, why haven’t we been doing this all along for hundreds of years that we’ve had banking or at least since 1913, let’s say?
Tim: Probably because anything that favors the wealthy is going to be spark partisanship and polarization. Most people aren’t impacted by having balances over the minimum. So, that’s what’s so crazy about this. If this was just a normal regional bank that had some mishaps and it’s just a regular kind of deposit base– I’m not saying anything bad about the deposit base. It’s not a regular deposit base, and then they build it out that then maybe, “Okay, hey, we did this for one mistake. That’s not going to keep happening.” I don’t know how you do that for this particular one and then not do it for the other regionals. I don’t blame depositors, in general. Your mom shouldn’t need to pick, if the bank is sound. That’s a regular– [crosstalk]
Jake: Yeah, your mom’s not putting $250,000 plus in the bank, right? We’re not protecting grandmas here.
Tim: No. I don’t know. No, they are not.
Jake: They should be sophisticated enough to solve this problem, if you’re managing that much money?
Tobias: Do you deal with this problem at all? I don’t store sums of money like that. So, I don’t know. I don’t know what I would do.
Jake: I definitely do. You don’t keep that much cash in the bank.
Tobias: Yeah, [unintelligible [00:57:25] call account.
Jake: That’s foolhardy.
Tobias: Yeah, that’s fair.
Should Bank Depositors Be Bailed Out?
Tim: Oh, yeah. Inflation, obviously, you’ve got to adjust those numbers because there’s a lot more money sloshing around right now. So, payroll, and taxes, and things like that are bigger. I don’t know. I don’t blame depositors. I don’t think that’s the people to blame. The FDIC, it’s paid through bank insurance premiums. They’ll raise those levies. The banks are heavily, heavily regulated, and obviously, there probably was some regulatory lapses there. So, I just don’t think– Bailing out, yes, these depositors got bailed out. I normally don’t think that– I don’t think that’s the worst thing in the world, when depositors get bailed out. I don’t want the executives, or the banks, or the equity holders. They shouldn’t be bailed out in that would be my opinion.
Tobias: The FDIC could just guarantee them all, right? There’s a cost to guaranteeing them. It’s insurance on those deposits. You just charge that fee, you make it mandatory. [crosstalk]
Tim: Right. There’d be less problems, if they did it now because they might have to do it now, because if you get a few more bank runs, when people realize that there’s money to be made through doing it, not saying that that was planned. I’m saying that was something that easily could happen. then the cost will actually be higher. So, you got to realize, right now there’s a problem where there’s this implicit guarantee. And so, the ultimate cost will probably be a lot lower. Even TARP, for as much as people hated TARP, the actual losses were pretty negligible relative to the level of crisis.
The problem there was that executives and people like that did not go to jail, but for the most part, equity holders were wiped out or virtually wiped out. I think defining bailout is like defining risk. You’ve got to define who’s getting bailed out and why. I don’t think equity holders of Silicon Valley Bank feel like they got a bailout. Rightfully so.
Tobias: And on that note, thanks, gents. Thanks, Tim. If folks want to get in contact with you, Tim, how do they go about doing that? Have a shoutout.
Tim: Yeah, my website is ttvalueinvesting.com. So, feel free to reach out to me on there. Also, my Twitter handle, which I think is @timtravisvalue, that I don’t even know for sure.
Tobias: I’ll link it up in the show notes.
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