Silvergate, Reverse RPs and the “Theology of Prosperity”

January 25, 2023 | Watching the markets in recent days, it occurs to us that the fascination of the Federal Reserve Board with employing “confidence” as a mechanism of monetary policy begins to backfire. Consider the righteous indignation of the mob denied the right to gamble their worthless fiat currency on crypto tokens and other products of the imagination. The anger is most pronounced among the losers in the group, those sitting in the audience not sufficiently clued in to sell in mid-2021, when speculative icons like Silvergate Capital (SI) traded at many times book value.

Source: Goggleh

One especially savvy colleague in the advisory community reports that some clients are positively outraged by the growing official focus on SI and other insured depository institutions, banks that were foolish enough to touch crypto tokens. For financial professionals, crypto always has been an AML and KYC train wreck waiting to happen. Advisors also report being incredulous at the desire of some clients to double down on the crypto mirage, even as the various crypto "exchanges" go bust, as though confidence and faith were all that is required to breathe life into these barren possessions.

Crypto, of course, is not an asset as much as a bad idea that was given life by the Fed via Quantitative Easing. Like the shareholders of the GSEs, who have finally been put out of our misery by the courts, the crypto faithful are now full-fledged American victims. Crypto faithful really believe that people are way too bearish on crypto. We are reminded of the crowd in the classic 1956 Cecil B.DeMille film "Moses," with Edward G. Robinson playing Dathan, who encouraged the idolators to turn away from God and worship the Golden Calf.

The basic view of Silvergate among the faithful, including a number of prominent people in the religious community, is that the bank was doing a legit business and FHLB bailout was "kosher." No, it was not. Seeing a bank need to fund one third of its assets at the FHLB is a sign of impending default and resolution. Hello. Kate Berry of American Banker nailed this story last week.

Once upon a time, Silvergate was actually in the mortgage business, providing warehouse finance for jumbo lenders in Southern California. After shooting most of the personnel on the well-regarded mortgage team at the start of 2023, CEO Alan Lane is now left with a small bank that apparently has pledged all of its salable assets for a loan with the Federal Home Loan Bank of San Francisco.

Once the $4 billion repo transaction unwinds, we assume that the bank shuts down. Looking at the bank’s Q4 earnings results and the actions of Lane and SI management over the past year, we have a hard time understanding why the State of California and the Federal Deposit Insurance Corp have not closed institution to protect the remaining depositors and the bank insurance fund.

Book value of the SI common has fallen from $46.55 at the end of 2021 to below $13 at 12/31/2022. Tier one capital has fallen from 11% of assets at the end of 2021 to below 5.5% today (including $200 million in negative AOCI), a serious red flag for regulators.

Deposits are down by more than 50% over the past year and the bank reported a $800 million loss in Q4 2022. The $4.3 billion in short-term borrowings from the FHLB shown at year-end, up from $700 million in Q3 2022, represents the last desperate effort by Lane to save the bank. And yes, having 1/3 of bank assets financed with the FHLBs is another moral hazard red flag for regulators.

Beyond the ugly financials, however, it is important to understand that the fall of Silvergate is a larger story about the end of the “theology of prosperity” that was a key driver of the crypto confidence game. Think of SI as evangelical Christianity and Opus Dei meets party poker/FX trader, with a dash of millennialism thrown in for added flavor. Many players in the world of crypto believed that their focus on this pretty standard form of financial fraud would actually bring them wealth and economic freedom. Instead, the holders of crypto are likely to be disappointed, over and over again.

The larger and possibly more significant mess involving crypto and Signature Bank (SBNY) in New York is another case of confidence c/o QE causing real world damage to banks and investors. Unlike SI, which is too small to care in a systemic sense, SBNY is a $110 billion asset commercial lender that is systemically important. The fact that SBNY’s management team would allow this valuable banking franchise to be put at risk by involvement in crypto fraud demands attention from regulators, shareholders and policy makers.

As lenders like SBNY back away from crypto exchanges and their “affiliates,” the wreckage among the community of faithful grows. CoinDesk reports that SBNY is refusing to process transfers on its crypto platform of less than $100,000 for Binance, effectively cutting off the giant crypto casino from the Fedwire. Given the still unknown risk to SBNY and other banks in terms of KYC and AML violations, this move is probably the first step toward an exit by all US banks from facilitating cash transfers for all crypto.

Last week Jemimah Kelly wrote in the Financial Times that some of the worst offenders in the world of crypto fraud are busily building a new game even as many financial regulators around the world continue to, well, do nothing. Su Zhu and Kyle Davies, co-founders of the bankrupt crypto hedge fund Three Arrows Capital, are apparently erecting a new vehicle for crypto fraud called GTX, Kelly reports. Yet despite these efforts by hardened crypto grifters to steal yet more money from credulous retail investors, the faith in crypto assets is slowly wanning.

Of greater concern than the end of crypto is the risk to market confidence more generally as QE becomes quantitative tightening or QT. Investors believe as an act of faith that the FOMC is going to reduce inflation and put the markets back to a happy place something like Q1 of 2020 before COVID. The only trouble is that the Fed has essentially lost control of its own balance sheet, leaving open the question whether the US central bank can continue to tighten for much longer and how global markets will react to this public failure.

Bill Nelson of Bank Policy Institute asks precisely this question in a recent missive, wherein he notes that the failure by the FOMC to force down the use of reverse repurchase agreements (RRPs) by money market funds and banks has created a structural problem. RRPs are effectively a form of T-bills created by the Fed without Congressional authorization to subsidize money market funds and banks. Now the Fed cannot take away the duration it provided with these ersatz T-bills.

In order to shrink the Fed’s balance sheet, RRPs need to decline – a lot – from the current level over $2 trillion. The chart below from FRED shows the major assets in Fed’s portfolio of Treasury debt and MBS on the left scale and liabilities in terms of RRPs on the right. Or maybe another way to put the Fed's dilemma is that those MBS on the NY Fed's balance sheet need to repay before the balance sheet shrinks significantly.

During a recent conclave at the Council on Foreign Relations, Federal Reserve Governor Christopher Waller said roughly $2 trillion of reserves could be taken out of the banking system without disrupting banks. Waller, an academic economist with no financial markets experience, does not address when and how the FOMC is going to tell money market funds to exit RRPs. Keep in mind that those MBS on the Fed’s balance sheet have fallen to low single-digit levels of prepayments annually.

The problem is that the Fed via RRPs has essentially decided to issue $2 trillion in T-bills without explicit fiscal authority from Congress. The MM funds and banks certainly prefer holding RRPs with the Fed and will not exit unless forced to do so. But given the current issuance schedule for the US Treasury, forcing MM funds and banks out of RRPs will have the effect of lowering short-term interest rates as investors scramble to buy a limited supply of T-bills. Nelson notes:

“In September 2022, Patricia Zobel, the acting System Open Market Account Manager, gave a speech (available here) in which she stated “Overall, as the Federal Reserve’s balance sheet declines, I expect money market interest rates to rise relative to the ON RRP rate, and for market participants to shift investments away from the facility moderating the decline in reserves.”

Nelson reports that the FOMC seems to believe that as the Fed’s balance sheet gets smaller, money market rates will rise relative to the interest rates it pays on reserves and ON RRPs. But sadly the markets are not cooperating. He continues:

“As rates on repos with non-Fed counterparties and treasury bills rise relative to the ON RRP rate, money funds should switch from ON RRPs at the Fed to other investments. However, so far, the process is barely working. On September 8, when Zobel gave the speech, the market repo rate was 2 basis points below the ON RRP rate and the ON RRP facility was $2.2 trillion. Currently, the market repo rate equals the ON RRP rate and the ON RRP facility is $2.1 trillion.”

When it becomes clear that the FOMC is unable to significantly shrink its balance sheet, investors are going to surge back into the equity markets. Stocks are, after all, one of the few true havens from inflation unlike crypto tokens. But if inflation in housing costs and other key areas of consumption do not decline, then what? When the Fed cannot force down housing prices, then QT has failed.

If the Fed cannot reduce its balance sheet back down to pre-COVID levels, then the inflation in stocks, home prices and other tangible assets is going to become permanent. Consumer will go from chasing happy dreams of free money c/o crypto and QE, to being crushed by continued inflation in key asset classes like housing and financial investments. As the shrinking population of equity investors ride the updraft up, consumers will increasingly ask “what’s in this for me?”

As and when the American political process produces a candidate able to frame the policy failure on the part of the Fed regarding inflation into terms understandable to consumers, then the faith in the entire system will come into question. We will not destroy the dollar system because of the resurgence of gold or the evil machinations coming from Beijing and Moscow. We will destroy the dollar system because of hubris on the part of central bankers, who think that they can control the workings of the world’s largest economy by playing God with the Fed’s balance sheet.

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