Chaos is a Ladder

This past week and the one that follows will be looked back on as historic. The closure of Silvergate Bank, Silicon Valley Bank, Signature Bank, and the clear signs that others may soon follow will have signficant consequences for how future financial policy is formed. Was it a time of crisis nearly averted, an overreaction, or an underreaction that led to financial chaos?

It's impossible to know which story will be written until we actually live through it (at the time I’m publishing this the US government has made an effort to insure 100% of depositor assets of SVB & Signature, and have provided discounted liquidity to distressed banks, but other regional banks are showing signs of too little too late).

What is clear, is that this moment is historic. That makes paying attention to how stories develop, how we emotionally react to these stories, how tribes form around narratives and jockey for positioning, and most importantly, how each of us as individuals reacts and makes choices in these moments.

Below, I'll cover the past week leading up to Silicon Valley Bank getting taken over by the FDIC. I'm not going to go too deep into the details but will share the high-level story and links for you to dive deep into if interested. What I will do though is break down how this past week and the one that follows should be viewed from the lens of the digital transformation and the impact these events have on our ideas of self-sovereignty.

Bank Liquidity Crisis Puts Economic Systems in Jeopardy

Let me start by saying that this is an ongoing “crisis” where information is emotionally charged and likely to evolve by the minute. Case in point: as of this morning it’s hard to tell if the government response worked - First Republic Bank and other regional banks share prices are down 60% pre-market.

But with that said, I think it's a terrible idea to ignore what's happened over the last week and assume that it won't lead to more severe consequences in the near future.

Here are some of the most interesting stories, analyses, and opinions I've come across on what's happening with the American regional banking crisis underway and why it matters. I'll add some of my own color and how this "crisis" is relevant to the big ideas covered in this newsletter at the end.

Silicon Valley Bank, At Center Of Venture Capital Bubble, Suffers Record 47% Crash Amid Sudden Liquidity Crisis | ZeroHedge

It started with a bank run. Customers fearing the bank didn’t have enough money for all depositors rushed to pull out all their money, creating liquidity issues and forcing the bank into insolvency.

To address the bank run, Silicon Valley Bank sold treasury assets at a loss to meet depositors cash demands for withdrawals. And like all bank runs, the concern is that similar fears of insolvency will spread to other banks creating a contagion effect.

This was on display last week as SVB struggled with the beginnings of a bank run, all other banking stocks saw major pressure on their stock prices.

The key words from the Tweet above - duration mismatch - refers to when people want cash from their bank now which forces the bank to sell non-cash assets at any price to meet depositors' demands. In this example, SVB invested deposited cash into US Treasuries and when deposit withdrawal demand increased beyond the cash they had on hand, they were forced to sell the Treasuries.

If a bank sells the bonds at a loss... the bank must lock in those losses. At a certain point, that loss can create a massive hole in the bank’s balance sheet and create an insolvency issue. ie: exactly what happened with Silicon Valley Bank.

Here’s an overly simplified example:

Let’s say that last year, you go to buy a 10-year treasury bond that yields 1.5% interest. This year, the government is selling that same type of 10-year treasury bond, but it now yields 3.5% interest. Then your car breaks down and you have to raise cash quickly to replace the broken parts, so you look to sell your original Treasury bond that yields 1.5% on the open market.

Do you think that bond would be worth as much as the one that yields 3.5%? The answer is no. Why would someone pay the same price for a bond that yields 1.5% vs one that yields 3.5%? When you sell that bond on the open market it would be worth less than the original purchase price to make up for the lower yield. ie: that’s why financial reporters always say bond prices fall as yields rise and vice versa.

The problem is made worse by the fact that you need cash now and are likely to sell the bonds on the open market at a discount to make the sale quickly. A fire sale on a seemingly very safe investment that leaves you locking in a loss because of the duration mismatch (you need money now but the bond you hold hasn’t matured yet and conflicts with current yields).

This is the mismatch that converts a temporary unrealized loss into a real loss.

It happened with Silveragate Bank, although the bank itself was also harmed by the crypto industry entering a bear market.

And it happened with SVB which led to the FDIC to take over the bank to oversee and orderly process of getting insured depositors their money back.

This is what happens when banks fail.

US banking regulators take over Silicon Valley Bank | Financial Times (archive.is)

And it's clearly what's happening to many other banks (especially Regional Banks) at the moment as fear of contagion spreads and people rush to move their money. As depositors rush to pull out their money, they create a self-reinforcing liquidity crisis (banks not having enough cash forced to fire sale assets and lock in losses) for regional banks to meet withdrawal demands.

FDIC: PR-16-2023 3/10/2023 - This was the statement put out by the FDIC when it took over SVB. Pretty interesting to see the language used, the process, and who gets screwed versus who makes it out with money.

How Banks Fail - by Jesse Austin Campbell (substack.com) - If you want to know more about how banks work and why this mismatch can happen, read this essay.

It's actually not that hard to see which banks are at risk right now. Just look at the ones that are falling in share price the fastest. Shareholders are fleeing like rats from a sinking ship because when banks fail, equity holders get wiped out as happened with Silvergate Bank and SVB.

Why are some falling in share price more than others? Because some are more exposed to duration mismatches and cash liquidity issues than others.

As the Tweet above emphasizes, any bank that has an issue will likely need to raise capital to address immediate needs. That means selling more shares on the open market, a dilutive process that makes existing shares on the open market less valuable. Additionally, who is going to pay top dollar for shares in a regional bank right now?

So, where's it all heading?

The same place it always does - in some capacity, if bank runs spread, expect the government and Federal Reserve to ease financial conditions.

I wrote most of this newsletter Friday of last week and by Sunday, March 12, the US government had in fact stepped in. As of this morning, I suspect we’re just getting started with government interventions.

SVB Receivership: US Mulls Fund to Backstop Deposits If More Banks Fail - Bloomberg

There’s a lot more I could add to the story itself, but I’ll leave that to mainstream media and instead move on to some takeaways.

A few macro level ideas to take away from all this:

#1 What we learned from recent crypto organizations collapsing (BlockFi, Celsius, Voyager, FTX, etc) is that if there's even a small chance of a bank collapse, a run will start.

The game theory is - you can move your money and protect 100% of it - or you can play the lottery and hope at best nothing happens. In a worst-case scenario, you’ll lose all your funds but most likely a bankruptcy/liquidation proceeding will take place over several years and you’ll eventually get some but not all of your money back in the future.

Most people are not going to take that risk especially those that live paycheck to paycheck and businesses that have to make payroll. Most will move all their funds which in turn perpetuates the bank run, forces banks to sell more assets, realize more losses, and pressures banks toward insolvency. The point - when there's even a hint of a bank run, get your money out immediately. Don't wait to verify. Don’t wait to be told what to do. Move your money.

#2 Twitter reports breaking news infinitely faster than mainstream media. The caveat being that a lot of rumor, conjecture, unverified sources, and outright misinformation and fear mongering for profit proliferates.

Despite these downsides, if you want an edge on the mainstream population, you need to learn and understand how social media breaks news in real time, how to make sense of the truthfulness of news as it breaks in real time over social media, and how to convert that information into actionable decision making when there is a fog of war effect in play. ie: you likely won't have complete information when news is breaking - how do you make decisions based on partial information in this circumstance?

Breaking news on social media is a frontier of Future Shock. Most people will wait for complete information and wait for someone to tell them what to do. But if you don’t learn to make decisions based on incomplete information, you’re going to have an increasingly hard time in the digital age. This is the nature of the information environment moving forward.

#3 Bank runs in the digital age happen at lightning speed. It's unprecedented how fast money exited Silvergate and Silicon Valley Bank.

It’s all made possible by the speed with which information now travels (social media in everyone’s hands at all times) and how quickly funds can now be transferred (mobile banking).

It reinforces the need to adjust conventional wisdom around what is safe personal finance and what new risks are now becoming apparent in this era. 

#4 It now makes sense to consider diversifying your capital (specifically, your liquid cash and savings) across a multitude of institutions. And of course - this is yet another example of how self custodied, permissionless digital assets like bitcoin are showcasing their value proposition in the digital age. Your money won't be frozen by a bank if it's held in your cold storage wallet.

#5 This rapid-fire sequence of events is an example of Future Shock.

The speed that the bank runs happened, the technology that fueled it in unexpected ways, and the simple reality that we are increasingly forced to make new types of high-risk choices with incomplete sets of information.

Most people will wait for the herd to make a decision before acting. They'll wait to be told what to do. But as an aspiring sovereign individual, you need to focus on designing your OODA loop, your decision-making framework to incorporate the increasing frequency of these future shock type events.

#6 Understand the tradeoffs in the digital age often boil down to convenience, speed, and cost vs resiliency, eliminating single points of failure, and optionality. You need to understand the tradeoffs of the choices you make and the downstream effects of "being wrong" are rapidly evolving. The best choices balance a mixture of the former and the latter from above.

#7 Combine all these points and understand that the digital transformation is a rapid evolution of society. It will feel like chaos at times. But remember that human societies always gravitate towards order. Chaos in this sense doesn’t need to be a pit of despair. Instead, it’s a ladder of opportunity. Don’t avoid or ignore what’s happening. Pay attention, learn from it, and focus on where order is beginning to reestablish itself. Treat the chaos as an opportunity. Position yourself ahead of the herd.

That’s all for now. I’m sure I’ll have more to share on this story next week.

Rapid Fire

• Iran, Saudi Arabia agree to resume ties, with China's help | AP News Very interesting. China continues to force its way onto the global stage as a dominant superpower and reinforces the multipolar nature the global society is evolving towards.

• New Threat to Town, School District Budgets: Rising Rates - WSJ - These towns are ideal for building policies to attract location independent individuals and their capital.

• U.S. nuclear plant splits first atoms in Georgia | Fortune - Energy independence at a scale that meets digital age needs will be a digital age fault line. Countries that embrace nuclear energy are more likely to thrive than those that don’t.

• The Surprising Effects of Remote Work: More Marriages, More Babies, Bigger Houses - The Atlantic - Congrats on the sex!

• WTF Chart Of The Day: Jobless Claims Finally Rise As Layoffs Soar At Fastest Pace 'Since Lehman' | ZeroHedge - A breakdown of the recent US job report. This will influence the Fed’s rate hike decisions.

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