The Emperor Wears No Clothes

I feel about as negative on our longterm prospects as I’ve been in years.1 “Our” refers to the U.S. and the established “western” culture.

Beyond the foundation of the U.S. system as a democratic republic, one could argue the U.S. banking system, Wall Street, and the U.S. technology ecosystem, Silicon Valley, are the two most valuable assets we have. In the last few months, we’ve learned that the venture capitalists can be bullied on governance issues, which is quite literally a crucial part of their job. And the bankers don’t understand relatively simple duration risk concepts, which is their job.

If you want to argue the above points, or call them inflammatory, the fact is we have copious examples of investors acting as poor fiduciaries, which again is their literal mandate. And the bankers, in a different but yet similar way, also couldn’t be trusted to not lose a depositors’ principal investment.

You had one job.

This week, which feels as dark as any, I am stuck particularly obsessing on our financial system and the banking industry. So lets dive in.

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I wrote in December 2022:

…fewer people comprehend that even marginally higher rates, which are likely to persist, have permanently changed the value of assets relative to when rates were held unnaturally low.

More recently the WSJ had a piece on Charles Schwab that illustrates how interest rate mismanagement can be excruciating:

Schwab executives expected the Fed would raise rates 0.75 percentage point in 2022. Instead the Fed raised them nearly six times as much, by 4.25 percentage points, in a continuing battle against the highest U.S. inflation in decades.

What?! 0.75 percentage points?!2 Note, I do understand that the FED puts out it’s mid- to longer-term rate projections and this 0.75 percentage points is aligned to that. But we all knew where rates were headed and it was much higher than a ~1% federal funds rate. Put it this way — if these bankers had more skin in the game, if it were there money, they would not have made these bets to eke out the tiny, minuscule increase in net interest margin that it delivered. The risk/reward was off the charts to the downside.

The result of this mismanagement are unrealized bond losses of nearly two times its tangible common equity.

The missteps of bankers have been front and center for a month now. They’ve been hidden in plain sight for much longer, though.

In June of 2022, the St. Louis FED made public its report on unrealized losses at U.S. banks. The report showed that losses were mounting across these banks’ securities portfolios. In fact, that was the title of the release.

This is the chart that has been making the rounds since Silicon Valley Bank went out of business. It shows the extent of these losses due directly to poor duration analysis, that started to mount in 2022, and continued into 2023.

What has not been discussed is that the FED stopped publishing ALL unrealized loss data on bank securities in Q2 of 2022. They had been publishing these data for decades.

This would be another piece of data that shows the regulators did know there was an issue. And potentially a big one. Call it a conspiracy theory but it also begs the question of the coincidence that the data feeds were discontinued precisely when the data started to look very ugly.

The regulators did not think, or at least hoped, there would not be an old school bank run due to this issue. But, as we know, hope is not a strategy.

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Leveling up a bit — the foundation of the current day U.S. economy is the Dollars’ status as the world’s reserve currency. This ties back to the bankers discussed above, as the Fed and the major U.S. banks play a significant role here.

Having the word’s reserve currency is an economic advantage like no other.

This allows the U.S. to run a deficit with less risk than other countries. The total today is ~$31 trillion. To put that into perspective, the number is often put over gross domestic product (GDP). During the great financial crisis, the debt was around 60% of GDP, near the top end of the historical range (~30% to 60% of GDP). Today it’s around 120% of GDP, approximately an all-time high.3 First, it’s important to note that the U.S. debt figure typically used, including in the above graph, does not include social security and medicare. Those future obligations are even larger and growing even faster.

Secondly, there is a real cost to the public debt. As of February 2023, per the Treasury, it costs $307 billion to maintain the debt through interest payments, which is 12% of total federal spending.

Some smart people will tell you the U.S. debt is not a problem. Essentially, what is the difference between 60% of GDP and 160% of GDP?4 The thought essentially being that a deficit is a deficit is a deficit and it’s impossible to predict a “breaking point”. And it’s true that the growing debt has not been a problem at any of these historical levels. However, I would prefer not push the limit when the limit is unknown.

This sample period is during a time when; (a) the U.S. has the world’s reserve currency as discussed, but ALSO (b) while the U.S. financial system and our companies’ innovation output have been second to none.

Take the reserve currency stuff off the table. Which, to be crystal clear, is the most important feature of the Dollar.

GDP growth is critical to outrunning this debt. If the banking system, which supports innovative U.S. ventures, falters or the innovations themselves aren’t meaningful enough to push collective well-being forward, the debt looks a whole lot more ominous.

In other words, the best way to actualize the theory that the debt does not matter is to successfully innovate.

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We need brilliant innovators. We need smart operators. We need well-meaning and intelligent regulators. These are important actors in the system. And sometimes it’s a problem when they know they’re important. This opens us up to being swindled, whether that’s by Sam Bankman-Fried or the management of a regional bank.

Sometimes, as it turns out, the emperor wears no clothes.

Editor’s Notes: The emperor wears no clothes — or the emperor has no clothes — is an expression used to describe a situation in which people are afraid to criticize something or someone because the perceived wisdom of the masses is that the thing or person is good or important.