[00:01:23] Intro: You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

[00:01:43] Clay Finck: Welcome to The Investor’s Podcast. I’m your host, Clay Finck. Today I’m joined by Shawn O’Malley, one of our newsletter writers on our We Study Markets team here at T Investor’s Podcast Network. Shawn, welcome to the show.

[00:01:55] Shawn O’Malley: Hey, Clay, it’s a pleasure. Really excited to be on. Let’s

[00:01:58] Shawn O’Malley: dive into it today.

[00:02:00] Clay Finck: Today’s a little bit different of an episode than what I traditionally do here on We Study Billionaires with all the craziness happening in the world with what feels like bank after bank running into financial issues. You know, the stock market overall really hasn’t even flinched with all this happening. So, I wanted to bring Shawn on the show as his team has done extensive research on the banking crisis and really kept our newsletter readers informed as these new issues came to light day after day.

[00:02:29] Clay Finck: So, starting from the beginning, Shawn, the first bank that got hit was Silvergate on Wednesday, March 8th, they announced that they would be winding down their operations and liquidating the bank. Could you give the audience a rundown on what exactly happened at Silvergate and then we can cover some of the dominoes that followed?

[00:02:49] Shawn O’Malley: Yeah, it’s been a really fascinating story to follow. Honestly, I’ve probably been addicted to Twitter and reading the news, keeping up with all this. So yeah, just get started. The first thing to know here is that Silvergate Capital is a publicly traded parent company of Silvergate. So, there’s a slight distinction there, and basically they announced they would cease operations in response to quote recent industry and regulatory developments.

[00:03:12] Shawn O’Malley: What happened there is that for years we had this quickly growing crypto industry that was essentially completely unbanked. The issue really came to ahead in 2016 and 2017 when Bitcoin went mainstream, and that was when a lot of people really kind of heard about it for the first. There was a lot of excitement around blockchain technology, if you can remember.

[00:03:28] Shawn O’Malley: I mean, there still is, and it was finally at a scale that appealed to traditional financial institutions and Silvergate sort of saw an opportunity to carve out their own niche there. It became the face of crypto banking and that was honestly a really good bet to make for a while too. The banks’ assets grew quickly and it IPOed in November 2019 and just two years later, it share price had risen by an incredible 1500%.

[00:03:50] Shawn O’Malley: Part of its appeal for companies to, to work with them was the fact that it operated this realtime payments network called the Silvergate Exchange Network. And it was primarily for cryptocurrency exchanges and other crypto based institutions, and it enabled them to, you know, quickly transfer fiat currency.

[00:04:05] Shawn O’Malley: Funny enough, they also even acquired Meta’s DM Technology. If you remember, that’s what Facebook named it’s Libra Currency Project that regulators sort of ultimately shut down. So Silvergate was increasingly entrenching itself in this emerging industry, and it was really well positioned to benefit in the good times.

[00:04:21] Shawn O’Malley: Unfortunately, for them, and this is really gonna be a theme for most of what we discussed today, is that the Fed began hiking interest rates in 2020. And while that’s changed everything, so that crushed the stock market and weighed even more heavily on digital assets. When rates were zero, there was a really strong incentive to pile into tech stocks and Bitcoin.

[00:04:39] Shawn O’Malley: But as rates rose, that opportunity cost increased. You know why own any asset that doesn’t produce cash flows when you can get a four or 5% yield on government bonds? That’s essentially risk. Or at least that’s what they tell you, that reality popped when some call, you know what they call the everything bubble.

[00:04:55] Shawn O’Malley: You know, this euphoria we saw throughout 2020 and 2021. Of course, Warren Buffett says, when the tide washes out, we see who was swimming naked and taking excessive risks. And in this case, it wasn’t just risk, but actual allegations of fraud over at ftx, which at this point I think we’re all pretty familiar with the story.

[00:05:11] Shawn O’Malley: Crypto companies like Block5 and Celsius went down one by one as digital asset prices fell almost 80%. And for a bank, when these firms represent a large swath of your deposit base, this is a pretty devastating thing to have happen. Silvergate actually saw over 70% of its deposit base get drained, and because banks primarily fund themselves with deposits, that’s virtually impossible to survive at the same time that its deposit base was drying up, its assets were losing value due to rising interest rates, so it really just got squeezed from both sides.

[00:05:42] Shawn O’Malley: The risk here, which I really want to emphasize is distinctly different from 2008, is a failure to diversify their deposit base. You don’t want to be in a position where your depositors maybe all adversely affected at the same. Which is why banks typically try to diversify their deposits across a broad spectrum of clientele and industries and Silicon Valley Bank, which I’m sure we’ll talk about when under for similar reasons.

[00:06:06] Clay Finck: I think you hit on a really good point there, and that’s that many of the assets these banks are holding are falling in value due to rising interest rates, you know, call it treasuries, mortgage-backed securities. The values of these assets naturally fall as interest rates rise. So Silvergate had two issues where they had declining deposits, as you mentioned, and then they’re also dealing with the balance sheet side where the balance sheet is being impaired because of the higher interest rates. So, when you look at an asset like a treasury, it’s not really considered risky in terms of the credit or the person who purchases that treasury, the risk that they’re gonna be paid back on that bond. The risk with the treasury is that the value of it declines in value, and then, you know, if the bank needs to sell it, then they could run into a mismatch of their assets and their liabilities.

[00:06:53] Clay Finck: So there’s a lot of pressure put on banks, right? And what’s also putting additional pressure on banks is that depositors can also put their money into something like a money market fund. On average today, the average checking account pays close to 0%, and then maybe a savings account pays 1%. But you know, I look at Vanguard’s money market fund and it’s paying over 4%, 4.4% after fees.

[00:07:18] Clay Finck: So that is such a widespread when investors are looking at the opportunity costs of where they can park their cash. So we’ll be talking a little bit more about money market funds later, but pivoting back to Silvergate. Silvergates collapses on Wednesday, March 8th, and then two days later we see Silicon Valley Bank was the next domino to fall on March 10th Friday, and then Silicon Valley Bank was the second largest bank failure in history in nominal terms at least.

[00:07:44] Clay Finck: So please give the audience a rundown on what happened with Silicon Valley Bank.

[00:07:50] Shawn O’Malley: Yeah, you raised some really great points, Sarah Clay, and I don’t disagree with any of that. To answer your question, really, in the same way that Silvergate had carved out a niche pretty successfully in the crypto industry, a Silicon Valley banker, SVB, as I’ll probably call it, had for years both the reputation that it was a go-to place for venture capital funded firms and other startups.

[00:08:08] Shawn O’Malley: Some reports suggest that half of all startups in the US had a relationship with SVB, which is a pretty mind-blowing statistic when you really think about it. And low interest rates created this boom in the venture capital space as investors wanted to push further and further out the risk curve to find returns.

[00:08:22] Shawn O’Malley: And these VC firms poured money into those startups, but companies just don’t spend all that money immediately, right? They have to, you know, store it in a bank. They draw it down over months and years between fundraising rounds for things like payroll and inventories, and they have to keep at least some of those funds in a bank.

[00:08:39] Shawn O’Malley: And servicing these companies is really where SVB specialized. They saw massive inflows through 2020 and early 2021, and their balance sheet actually tripled. They essentially had to buy something with all that deposit funding though to protect their net interest margins. So right as they had more funds and they know what to do with, they piled into, you know, and this is a theme again for today, supposedly risk-free government bonds really at their peak prices.

[00:09:03] Shawn O’Malley: And as the Fed began removing liquidity from the economy, as we know with rate hikes, the venture capital space hit a wall. Investor funding collapsed and companies spent down their cash balances draining the bank of its deposit funding. So while on paper, SVB might have looked diversified, catering to thousands of different companies, in reality, most of those companies were backed by a handful of the same venture capital firms.

[00:09:25] Shawn O’Malley: It’s the sort of thing that a banks management should have been well aware of, though. What sparked the brewing crisis in my mind was that for SVB, the fact that it’s a positive base was drone went down and it had to sell off holdings of primarily government bonds at a 1.8 billion dollar loss. To raise funds to meet withdrawal requests.

[00:09:43] Shawn O’Malley: The bank had marked these bonds, interestingly, as being held to maturity on its books. This is a bit of an accounting trick, but it meant that SVB didn’t have to show any unrealized losses on its income statement as rates rose. So at that point, when it became apparent that it had to sell bonds that it intended to hold for maturity and made those unrealized losses realized ones confidence in the bank was pretty much.

[00:10:05] Shawn O’Malley: To offset those losses, the bank announced as share sale to raise 2.25 billion dollars. But you know, let’s be honest, in emergency share sale isn’t the sort of thing that inspires confidence in investors, especially not at a bank. And in some sense, confidence and trust is kind of a core challenge for all banks.

[00:10:21] Shawn O’Malley: Without trust, you can’t operate a fractional reserve system. By definition. Really at this point, it was pretty clear that the bank was in trouble. It shares fell 60% in one day and fell another 20% in after hours trading. And really what happened is prominent VC firms panicked and advised their portfolio companies to withdraw funds from SVB, and at that point, the bank’s fate was essentially sealed.

[00:10:42] Shawn O’Malley: Regulators responded the next morning to probably the fastest background in history, which was really remarkable to watch. And honestly, it played out all on Twitter. A lot of people got to see it happen in real time. So state regulators and the FDIC took control of the bank. And then we had two days of this tension and uncertainty over what was gonna happen.

[00:10:59] Shawn O’Malley: We did a lot of calls for essentially a depositor bailout as the realization set in that most of the bank’s depositors were uninsured, and that there were thousands of companies and even more thousands of employees that were at risk of losing their deposits.

[00:11:13] Clay Finck: Now, let’s just follow right through. With the weekend Signature went under on Sunday, March 12th, and then Monday President Biden made a statement ensuring everyone that depositors would be made whole and the investors in any of those banks that failed won’t be made whole.

[00:11:32] Clay Finck: So that gives us three large bank failures in just five days. Silvergate, Silicon Valley Bank, and Signature. So I’m curious, what’s the overall magnitude of these three banks in such a short period of time?

[00:11:46] Shawn O’Malley: Yeah, so honestly it’s a surprise whenever banks fail, and I think it caught everybody off guards. Signature was a bit of a surprise.

[00:11:53] Shawn O’Malley: There were rumors that Signature was in trouble, but when it was announced that depositors at SVB would be fully protected, they also announced the same for Signature, which hadn’t actually been declared as a failure up until that point. So on the one hand, it was reassuring that depositors would be protected by the FDIC.

[00:12:08] Shawn O’Malley: But on the other, it was alarming that another bank had quietly failed and they tried to just slip that into an announcement that was expected to only be about SVB. What the government did though was enable all those VC backed companies and other depositors to access all their money Monday morning, thanks to the FDIC, and this is where it gets political because everyone has their own definition of a bailout.

[00:12:27] Shawn O’Malley: Strictly speaking, this wasn’t directly a taxpayer funded bailout because the funds are coming from the FDIC, which raises money from fees that it charges to license banks that essentially pay into an insurance fund. And regulators were quick to point out that the management of these banks have been terminated and that their stocks are now worth zero.

[00:12:44] Shawn O’Malley: So it wasn’t a shareholder bailout per se, but a depositor bailout backed by the entire banking system essentially. And the magnitude of this really shouldn’t be understated. We saw regional banks across the board get hit with panic selling and upticks and withdrawals even after authorities set the precedent of guaranteeing all deposits.

[00:13:01] Shawn O’Malley: Banks like First Republic, which authorities are now working desperately to save lost over 70 billion dollars of its deposits to withdrawals, which amounts to nearly half of its deposit base at the end of last year. Just, just remarkable. Even big names like Charles Schwab were being hit by contagion concerns.

[00:13:17] Shawn O’Malley: The problem though is that structurally all banks face the same issue to varying degrees from a decade of near zero interest rates. If you combine that with record deficit spending during the pandemic, there is this tremendous amount about. 2.7 trillion dollars worth if you count mortgage backed securities of government bonds just sitting on banks, balance sheets that have lost value on paper.

[00:13:37] Shawn O’Malley: They were purchased at a time when bond yields were around 1%, so with yields on new bonds being issued closer to 4% today. The prices on older bonds have to fall so they can offer competitive returns. But if you’re the one holding those covid error bonds, unless you can hold them for years until they mature, then you’re gonna have to sell them at a discount.

[00:13:55] Shawn O’Malley: And that’s kind of a, a quick synopsis of the problem. Banks are saying broadly and where we’re at at scale, we’re talking about hundreds of billions of dollars in unrealized losses across the entire banking. Now, every bank has different levels of exposure and ability to absorb those losses. But when three banks fail, investors go into panic mode.

[00:14:15] Shawn O’Malley: They sort of throw the baby out with the bathwater. There’s not enough time to do a deep audit on every bank, and that’s how you get a contagion. People begin thinking that all banks are unsafe outside of maybe the five biggest clients withdraw their money and investors sell shares in the stock and bonds.

[00:14:29] Shawn O’Malley: And then this actually creates a crisis because the banks have to realize the losses on their assets. What we should remember is that bank depositors are actually a very risk averse customer base. If you think about it, the incentive to stay at a bank where there’s any hint of risk is pretty low. There’s some stickiness with their products, maybe lines of credit for businesses and debit or credit cards linked to accounts, but for the most part, losses or even just a delay in accessing your funds at a, your primary bank could be catastrophic.

[00:14:55] Shawn O’Malley: So even if a bank gets a bailout, just the fact that it was needed is enough to make people afraid just to show the point. Even after First Republic got an injection of 30 billion dollars worth of deposits from the country’s biggest banks to stabilize. You know, ask yourself, would you open an account there tomorrow?

[00:15:11] Shawn O’Malley: The answer’s probably not, because why would you, why not just go somewhere that isn’t making headlines for backgrounds? I’m not opening an account at First Republic anytime soon. There’s just no reason to. It’s easy enough to open an account elsewhere if there’s any whiff of risk and well, that’s essentially what we’ve seen.

[00:15:27] Shawn O’Malley: Ultimately these banks failed from a crisis and confidence inspired by granted real issues in the business cycle and tightening from the Federal Reserve, which is worsened by poor risk management on their end, and specifically a lack of depositor diversification, at least for SVB and Silvergate in particular.

[00:15:46] Clay Finck: I think you’re bringing up a really good point there that I think we’re gonna be touching on too, is that, you know, people aren’t gonna want to be going to these banks that they perceive as risky because there’s really no reason to. When you can go to a larger bank, the Federal Reserve and government might be more kind to, or more sympathetic to.

[00:16:03] Clay Finck: So now that we’ve covered many of the dominoes that fell during those five days, let’s talk a little bit more about the response by the FDIC, the Federal Reserve and the Treasury. Originally, the FDIC implied that those who had over 250,000 in deposits would get wiped out, but within just 48 hours it was announced that all deposits from those bank failures would be guaranteed.

[00:16:28] Clay Finck: And the Fed also announced that they would guarantee every deposit in the US banking system to prevent fears of, you know, bank runs. Anything else that might happen in the banking system? So Silicon Valley Bank is not the only bank with this issue being underwater on their bonds. A ton of banks are running into these issues because they really don’t have much of an option of where to park their cash.

[00:16:51] Clay Finck: So the Fed announced that these banks are now able to post their bonds at par value as collateral at the Fed. While the value of the bonds might be trading down 10 to 20%, now they’re at 80 or 90 cents on the dollar. The Fed will recognize these treasuries as collateral as if they’re trading at a hundred cents on the dollar.

[00:17:10] Clay Finck: Here’s the stat I also wanted to read to you that I got from Zero Hedge. According to the Washington Post, the total capital buffer in the US banking system totals 2.2 trillion dollars. Meanwhile, the total unrealized losses in the banking system based on a pair of academic papers is between 1.7 trillion and 2 trillion dollars.

[00:17:32] Clay Finck: So in other words, if banks were suddenly forced to liquidate their bond in loan portfolio, The losses would erase 77 to 91% of their combined capital cushion. What this essentially means is that a large number of banks in the US are terrifyingly fragile. So that’s what I got from Zero Hedge. And then there’s another piece here, a second report by the Wall Street Journal sites, a study from Stanford and Columbia Universities that found that 186 US banks are in distress turning back to the Fed and the government’s response specifically.

[00:18:07] Clay Finck: What are your thoughts on this, and what second order effects do you think this might lead?

[00:18:13] Shawn O’Malley: Sure. Yeah, those are some incredible stats. Really disturbing to think about. My, my biggest takeaway really though, is that the rules of the game aren’t fixed. Finance and life itself is sort of one big game in many ways.

[00:18:25] Shawn O’Malley: And what we’re seeing clearly now is that for better or worse, when needed, the rules can be rewritten. Whether it’s changing deposit insurance limits or emergency lending facilities, we shouldn’t underestimate how many different levers the government can pull to stabilize. And on a day-to-day basis, when we can look at things like regional banking ETFs, credit default swaps, bond volatility indexes, kind of pick your choice there, we can see them as a real-time scorecard of how well authorities are managing the crisis.

[00:18:52] Shawn O’Malley: The more they can tamp down volatility right now, the better. What’s interesting about banks is, They’re essentially private investment institutions that are based on this distributed public deposit base. And what we’ve seen recently, and even more so in 2008, is that when they fail, they sort of threaten to take everyone down with them.

[00:19:09] Shawn O’Malley: They profit in the good times, but in the bad times, you know, suddenly it’s, Hey, if our bank goes down, 2000 companies go under in the next week because we hold 80% of their cash deposits, which are mostly uninsured, and they won’t be able to make payroll. I hope you don’t get me wrong. Banks are absolutely critical to any modern economy, but you can also see why people despise them.

[00:19:30] Shawn O’Malley: People are citing moral hazard here, and I think that’s fair, but ultimately these failed banks are dead, and the only winners are the bigger banks that might bid on their assets at a discount. And are absorbing their customers, which we’ve seen a lot of in just in the last two weeks. That said, it probably does incentivize more risk taking on the margins just because they know, especially now that the worst case scenario is sort of capped by the US government, which has made it clear that depositors will not suffer from bank failure.

[00:19:59] Shawn O’Malley: So even if they blow themselves up, they’re hopefully not gonna blow up the entire economy. Funny enough though, I think the moral hazard, or maybe complacency is a better word for it, might exist. On the flip side with depositors, everyone has known about FDIC insurance limits. It’s not a secret. In fact, it’s common knowledge.

[00:20:17] Shawn O’Malley: There really is no excuse for a corporate treasurer to pretend like they don’t know better. Sure. We shouldn’t expect depositors to run due diligence on every bank they work with, but if you have $30 million. In your corporate bank account that only has $250,000 in insurance coverage, you should probably know that you risk losing $29,750,000.

[00:20:37] Shawn O’Malley: If that bank fails, you could as an alternative keep, say, $1 million in that bank account and another one or $2 million at a different bank. Spread the risk a bit and hold whatever amount you need to tap to sort of meet your weekly bills and then split up the rest in money market funds or short-term treasury bills right now.

[00:20:56] Shawn O’Malley: Around 8 trillion or about 40% of all deposits are uninsured. So clearly a lot of people did not do that. They have not split up their deposit risk, and there’s an argument that maybe they should face consequences for that. But now there are talks of this emergency extension of FDIC in insurance coverage to cover all deposits.

[00:21:14] Shawn O’Malley: And it’s hard to say what’ll happen, but my guess is that if we see another bank failure. This is probably the next step that has to happen. And if you look at it, regulators are already trying to figure out whether they have the powers to do this or whether they’ll need an act of Congress. But I think we probably end up raising FDIC limits once things have calmed down since it’s been a number of years since their last increase.

[00:21:35] Shawn O’Malley: But in my mind, this just furthers the precedent for what people call privatizing gains and socializing losses. It falls to society to protect depositors while private banks benefit from that protect.

[00:21:47] Clay Finck: A lot of people are understandably becoming concerned about depositors, fleeing from smaller banks, local banks, to the two big to fail banks because they know historically, you know, the two big to fail banks are gonna be made whole depositors are gonna be fine and your capital might be at risk at one of the other banks that aren’t one of the top big five banks.

[00:22:11] Clay Finck: So does this incentive only exists for those that have over the FDIC limit of 250K or should your regular everyday person be concerned about, you know, where they park their money and what bank they’re at.

[00:22:25] Shawn O’Malley: Yeah, I’ll just, I’ll zoom out a bit before answering that. Before the creation of FDIC, insurance banks failed a lot more than 9,000 banks failed in the four years before deposit insurance went into effect in 1934.

[00:22:39] Shawn O’Malley: That’s at least according to a paper from the FDIC themselves. The FDIC maximum has only been raised seven times in its 90 year existence, and the last few times were because of similar financial turmoil. So FDIC insurance is a good and very important thing, but the other thing we should know though, is the less volatility there is in the banking system, the better that is for society.

[00:23:01] Shawn O’Malley: I don’t believe most people need to be worried about their checking or savings account bank going to zero specifically for those who hold balances below $250,000, which is the vast majority of Americans. Like I said before, the rules of the game can be continuously rewritten and the government can do a lot to prevent doomsday scenarios from coming true.

[00:23:18] Shawn O’Malley: The way I see it, this is really a question for wealthier folks with large cash balances in their bank, and even more so for companies. Instead of maybe your savings going to zero. The risks that authorities have been responding to here is that maybe the small business you work for was at risk of losing access to funds.

[00:23:34] Shawn O’Malley: It needs to pay the bills each month. Even here, it wasn’t that people and companies with uninsured deposits would lose everything, but rather that in the panic of a bank run. It could take weeks or months for the banks to liquidate enough assets to meet those requests, but if you’re a mid-size company with maybe a few dozen employees, you’ve got bills to pay and you can’t afford to start defaulting on payments or not paying employees because your deposits are tied up for two months.

[00:23:57] Shawn O’Malley: Even if you get a hundred percent of your money back at a two month delay, your business is still gonna be devastated. So everyday Americans are at risk, but not in the way I think most people think, or talking about the 60 million Americans who work for small businesses and might have lost their job or their business if regulators hadn’t stepped in.

[00:24:13] Shawn O’Malley: The reason now that bank deposits are flowing to the big banks is because of the precedent we set back in 2000. These big institutions think Bank of America and JP Morgan have been designated as systemically important globally, meaning that they can’t be allowed to fail. And with each crisis we set a new precedent that sort of carries into the next one.

[00:24:34] Shawn O’Malley: We just saw this play out with Credit Suisse too. They’re one of the 30 banks globally that are considered systemic. And Swiss regulators responded swiftly and accordingly. They announced 50 billion in liquidity support for Credit Suisse to essentially buy themselves enough time to find a buyer. Better brand name who could absorb the bank and its deteriorating image, which really fell apart recently, but had been declining for many years due to scandals and mismanagement.

[00:24:59] Shawn O’Malley: And ultimately they did find a buyer. It was by no means a good deal for Credit Suisse, but they were well beyond the opportunity for that. Swiss regulators pushed UBS into a, this shotgun marriage with Credit Suisse for a 3 billion dollar price tag, which was a huge discount to the 8 billion dollar market cap. It traded out just a day or so.

[00:25:17] Shawn O’Malley: To make the deal happen, what they essentially had to do was wipe out 17 billion dollars worth of Credit Suisse’s bonds, and they provided 9 billion dollars in guarantees to UBS, meaning that basically they’re removing all the risk from the deal. For UBS who gets to buy its rival at a discount while having much of the losses, it incurs for doing so subsidized by the government.

[00:25:38] Shawn O’Malley: In many ways for ubs, it’s sort of a sweetheart deal. You can’t imagine carving it up much better for them. I wouldn’t think so. Even the most mismanaged bank, if it’s systemically important, can be backstop by regulators. And a solution we all know will be found as a depositor, especially a company with a large corporate account.

[00:25:55] Shawn O’Malley: Of course you want to hold your money at a bank that essentially can’t go under, and that really is going to hurt hundreds of smaller banks across this country.

[00:26:03] Clay Finck: So you mentioned Credit Suisse there and how there’s been more recent developments with them as well. So, Swiss regulators wiped out 17 billion dollars worth of Credit Suisse bonds, so they could close out their sale to UBS for around $3 billion.

[00:26:19] Clay Finck: These bonds are called AT1 Bonds, which I’ve never even heard of. Maybe you could talk a little bit about what those are and what exactly is going on with Credit Suisse and why the listeners should be aware of what happened with these bonds and with this sale to UBS.

[00:26:34] Shawn O’Malley: It’ll make for a great script in future movies that document the saga.

[00:26:39] Shawn O’Malley: You know, we’re gonna be watching movies for sure about this in maybe two years, sort of with the stability of global markets on the line. You know, going down sun late into Sunday evening, UBS Credit Suisse and Swiss regulators reached this last minute deal that valued Credit Suisse at just 0.76 Francs, Per share, which is a 99% fall from its peak, which is honestly a stunning collapse for this 166 year old banking institution that’s supposed to be globally systemic in its importance.

[00:27:11] Shawn O’Malley: So Credit Suisse, you know, the reason why this was necessary is because it was reportedly losing 10 billion dollars per day and its deposits. So things were getting pretty desperate. And what happened was around the 17 billion dollars. As you said, of what’s referred to as additional tier one bonds or at one s needed to be wiped out to make the deal attractive for UBS.

[00:27:32] Shawn O’Malley: And these bonds, or these types of bonds were introduced after the 2008 financial crisis to transfer banking risk away from taxpayers and on the bond holders at Credit Suisse. They were popular investment products to sell that could seemingly boost returns on portfolios at, you know, quote unquote low risk and many European banks issued AT1 Bonds despite their higher interest rates because they had this, what was called a bail-in feature, which reassured regulators, they had enough capital buffer to protect against a crisis. And in a crisis, these bonds could convert to equity when certain triggers were reached, such as capital ratios falling below a level, a certain level, or if regulators had to intervene on a bank’s behalf.

[00:28:11] Shawn O’Malley: But finance 101 tells us that bond holders, the lenders of capital to a business should sit above shareholders who are the owners of a business and in a company’s capital structure, meaning lenders should get paid back first while shareholders who stand gain more in the good times should probably lose the most in bad times.

[00:28:29] Shawn O’Malley: And while we’re definitely in the bad times, unlike other European banks though, Credit Suisse’s AT1s included this provision where bond holders could lose their entire investment. Before shareholders did, and now a one holders will get nothing. At least that’s how it seems while shareholders receive UBS stock in exchange for their shares that they held in Credit Suisse.

[00:28:49] Shawn O’Malley: Ironically, a 2021 report from Credit Suisse themselves suggested these bonds were very safe because the average European bank would need to lose almost two thirds of its capital to breach contractual triggers. And they said in their view, this is, you know, a relatively remote scenario. And while remote as it may be, here we are, it happened.

[00:29:09] Shawn O’Malley: The complete write off of Credit Suisse’s bonds from one of the largest issuers of AT1s will weaken investors’ appetite for these types of securities going forward. And basically that would make these bonds more expensive for banks to issue in the future, which reduces their ability to make new loans into the real economy.

[00:29:27] Clay Finck: Another thing that’s sort of caught my attention throughout all of this was watching bond yields just like drop like a rock with all these bank failures. And maybe that means many investors are going to safety and buying more treasuries and anticipating that the Fed’s gonna lower rates. But I saw a chart that showed that the drop in the bond yields it.

[00:29:48] Clay Finck: The chart was referencing the two-year. But the daily change in the yield was one of the biggest changes we’ve seen in decades and that kind of points to just the volatility we’ve seen overall in the markets. As you know, US treasuries are kind of the foundation of the financial system, and if that’s not stable and it’s very volatile, then it’s gonna send ripple effects throughout the rest of the economy.

[00:30:09] Clay Finck: So I wanted to ask you about bond yield specifically. I just pulled up the ten-year today. It was around 4% at the beginning of March, and today it’s around 3.5%. It’s come back and rebounded a bit since it dropped really fast. So what is your interpretation of these interest rate moves?

[00:30:27] Shawn O’Malley: Yeah, good question.

[00:30:28] Shawn O’Malley: Things are moving fast, but it feels like expectations are resetting and investors anticipate that the Fed will have to sacrifice its fight against inflation to basically prioritize financial stability. Two year bond yields fell at their fastest pace in decades, and part as a flight to safety, but also because of a changing outlook in the Fed’s hiking trajectory, which I can touch on a little bit more.

[00:30:49] Shawn O’Malley: At the same time, rate hikes may be less needed anyways, though because the banking crisis fears have already tightened financial conditions and ways that the Fed failed to, such as widening the spread on yields for corporate bonds and central banks are in emergency response mode to help financial contagion, which to me makes the prospect of, you know, meaningful rate hikes at this point in the future. Pretty unlikely. Funny enough, we’re chatting right before the Fed announces its next rate hiking decision, so I don’t want to say anything that’ll, you know, make me look poor one way or another. But this is sort of the most uncertainty for sure we’ve seen around any Fed policy meeting in a while, and I don’t think anyone knows what’ll happen, but a few weeks ago, just to show how things have changed, people were entertaining the idea of a jumbo 50 basis point hike. Then a week ago, in the midst of the crisis traders placed around a 30% chance on the Fed being forced to pause, which is a huge swing from ex in expectations. And then as things have seemingly come a bit under control, fingers crossed in the last couple days. The consensus is that it’ll probably be 25 basis points.

[00:31:50] Shawn O’Malley: Like I said, we’ll see. Maybe they pause now or maybe they try to make a point to markets that they’re committed to fighting inflation and they’ll do another hike. But I think we both agree that hiking isn’t sustainable and they may even be cutting rates this year if the economy turns down as banks pull back on lending nor swans to everything we’ve discussed.

[00:32:07] Shawn O’Malley: But markets had been essentially tallying the Fed via an inverted yield curve, which we talked a lot about generally, is that, you know, for months they were tightening too quickly and the terminal rate would be lower than official estimates coming out of the Fed. So you could argue that a pause was already justified or at least that’s what markets were sort of banking on.

[00:32:25] Shawn O’Malley: Ironically, the US government is in this position where it has relied on American banks to fill the void in purchasing treasuries to fund deficit spending. Since 2013, that’s when central Banks around the world began moderating their demand for treasury bonds and in response, regulators encourage the American banking system to hold those government bonds and their balance sheet and to even treat them like cash except for the glaring reality that they’re not cash.

[00:32:49] Shawn O’Malley: Treasuries have duration risk, and can lose value when interest rates rise, which is what we’ve seen over the past year at a pretty unprecedented pace. Now, the US government is in this really awkward position where it sort of relied on the banks to fund its spending, and it in a way, put them in this position.

[00:33:06] Shawn O’Malley: And that reliance has made banks vulnerable, especially to the rate hikes that the Fed has in sort of inflicted on them. You know, at a time when the Fed is desperate to preserve its credibility by proving that it can bring inflation down towards its 2% target. I think if we kind of pull all the pieces together, the re release valve is likely to be inflation and the US seller’s value, which means that in my view, the hiking cycle is probably done, or at least very close to pausing.

[00:33:32] Shawn O’Malley: We’ll see what happens next, but risk assets are jumping at the chance that the Fed may be returning to the good times of lower rates in quantitative easing. We seen the NASDAQ lead the way there. Just in the past week or so, the Fed has expanded its balance sheet by around 300 billion dollars to support banks, and this offsets about half of the progress it had made in an entire year with quantitative tightening and just to show how bad things have gotten.

[00:33:56] Shawn O’Malley: Borrowing at the Fed’s discount window, which, which you’re not familiar with. It’s very taboo to, to borrow from typically in good times, at least, that’s for sure. Borrowing their jump from 5 billion dollars in the week, ending March 8th to 152 billion dollars last week, and that’s more than any week during the 2008 financial crisis.

[00:34:14] Shawn O’Malley: So I don’t think that means. Mass insolvency for the banks. Not necessarily the point I’m trying to make, but it does show just how elevated fears are and nobody wants to be caught off guard by a bank run and everybody’s trying to position themselves even in a, you know, borrowing from the fed discount window, which might have been previously taboo.

[00:34:30] Shawn O’Malley: They would rather take that risk than essentially get swarmed by a bank run.

[00:34:35] Clay Finck: Man, you made a really good point there of, you know, banks and maybe other financial institutions treating us treasuries like cash. My mind instantly goes back to 2020, 2021, whenever it was where they were saying, we aren’t even thinking about thinking about raising rates.

[00:34:51] Clay Finck: So when they’re buying bonds at those times, they probably aren’t too concerned about those bond values going down. Now a lot of institutions are in trouble. Maybe even listening to the Fed and their outlook on rates. So I’m a little bit hesitant to ask it, but I’m going to anyways. What is your outlook on interest rates and where you maybe see things going in your research?

[00:35:12] Clay Finck: It seems to me that Powell was pretty adamant on keeping rates high and like you mentioned, a continued attempt to tamp down inflation. You know, in my mind he would rather error on the side of potentially being too tight with monetary policy than being too loose in order to try and keep inflation from spiraling out of control.

[00:35:29] Clay Finck: So what sort of outlook are you seeing in light of the recent events?

[00:35:34] Shawn O’Malley: Well, my view has been that the Fed will hike until it breaks something and well, it sure feels like they’ve broke something, doesn’t it? Which raises the question of, okay, what now? And I think that’s what you’re getting at. With Powell, we know that he takes very seriously the mistakes of past Fed chairman, especially in the seventies and eighties when inflation was prematurely thought to be under control.

[00:35:58] Shawn O’Malley: So Powell doesn’t want to be the guy who has to hike rates into the double digits because he underestimated how persistent inflation can be, right?. At the same time though, there’s just not a lot of room to hike more in a world built on debt, the more debt you have, the more sensitive you become to rates.

[00:36:13] Shawn O’Malley: In my view, honestly, the Fed is backed into a corner. Hike rates, and you threaten to blow up the financial system, pause rate hikes, and maybe even cut, and you jeopardize losing credibility over fighting inflation and credibility is one of any central bank’s most important policy tools, so they can’t afford to lose that.

[00:36:32] Shawn O’Malley: In my opinion, we’re probably heading into a recession now if we’re not already in one. I think this temporarily bails out the Fed in its inflation fight since banking crises and recessions are definitely disinflationary at least typically. For example, we’ve seen oil prices fall off below $70 fears that the global economy will seize up and following energy prices is disinflationary because well, energy is an input into everything, so I don’t put a lot of weight on the idea of a soft landing, cuz I think any slowdown and price growth that brings inflation down to 2% is probably gonna be the result of some sort of prolonged economic weakness. If it becomes clear in a recession that we’re in a recession, you can imagine how the Fed might even be tempted to cut rates in response then we’re just in a similar position in a year or two from now.

[00:37:19] Shawn O’Malley: When we come out on the other side of a recession, the same structural factors causing inflation will be there and will rear their head when economic growth starts to accelerate again and rates would have to once again go higher. Yet we would face the same challenge of having too much debt, making us very interest rate sensitive.

[00:37:35] Shawn O’Malley: So to summarize, I wouldn’t be surprised if rates fell over the next year in response to a recession while disinflation temporarily picks up. But I think that would be a head fake. I expect inflation to structurally be higher over the next decade. A lot of reasons, but to put it briefly inefficiencies have just been injected into the global economy from covid to war In Europe, sanctions increased defense spending, which is very unproductive, underinvesting in the energy sector and reshoring of production to places where you have more expensive labor costs.

[00:38:05] Shawn O’Malley: These are all inflationary problems that you’re not gonna fix by manipulating interest rates or a, you know, an 18 month recession is gonna fix. And if inflation proves persistent short of doing yield curve control, interest rates would also need to be higher over the next few years to account for that.

[00:38:21] Clay Finck: There’s a lot of talk now that the Federal Reserve raising interest rates may impact the demand side of the equation and lower demand, which is obviously what they want. But it may even exacerbate and make the supply side of the equation even worse as the cost of capital increases. And all these supply chains are just so concentrated into a select number of players.

[00:38:43] Clay Finck: I’d also like to touch on how investors can potentially prepare themselves for this type of environment. Some of the staples of financial wellness that come to mind include having a strong emergency fund and cash savings be prepared for market volatility, both financially and emotionally. What sort of things do you believe that investors should consider here?

[00:39:04] Shawn O’Malley: As people have joked about online, we’re at the point in the cycle where the government and banks are calling up Warren Buffett to address this crisis, and that’s not because they’re looking for advice per se, right? He’s not really a, necessarily a banking expert. It’s because they wanted to contribute funds towards backstopping banks and preventing crisis. He’s got one of the biggest rainy daveon out there just waiting for the optimal time to be deployed. And he famously did that in 2008 when he invested 5 billion dollars into Goldman Sachs. He arguably saved the bank and made a 3 billion-dollar profit doing so. So my point there is just to say, there are these periods when great investors step up and find assets to buy when a market panic has put them for sale, well below their intrinsic value.

[00:39:48] Shawn O’Malley: But to do this, you have to have cash on hand. And really that’s harder than you’d think because when markets were soaring in 2021, people thought you were a total moron for not investing every penny you had. And now it looks pretty smart to actually have some cash stored away to capitalize on mispricings and fear in the market.

[00:40:05] Shawn O’Malley: Of course, to someone like Buffet, he’s mastered this behavioral paradox, right? He doesn’t let FOMO misguide him and the good times, and he certainly doesn’t panic in the bad times. And really, if you feel panicked now and a lot of people do, I had moments where I was just feeling very anxious. You know, I would say take 24 hours to reset, go for a walk.

[00:40:23] Shawn O’Malley: Get some sleep. Log off Twitter. That doesn’t mean we shouldn’t be concerned, but we certainly can’t make good decisions when we’re blindsided by fear. So really just by listening to podcasts like these in many ways, you’re off to a great start. You’re informing yourself, and the better you understand a situation, the better you will be at making calculated, unemotional decisions.

[00:40:42] Shawn O’Malley: Still, that’s easier said than done, but my point is really twofold. Be financially and emotionally prepared for a crisis with just one or the other. I think you’re still doomed for trouble. An emergency cash fund that you hold that you’re too scared to deploy isn’t very helpful. And on the other side, if you’re a master of Zen, but you have no spare savings to invest or even cushion losses, well, I don’t think that’s particularly helpful either.

[00:41:06] Shawn O’Malley: I’d encourage people to focus on being informed, preparing financially to take advantage of crises, sort of like having a rainy day fund with Warren Buffett, as we mentioned, and practicing emotional discipline. It’s also really a great opportunity to review your portfolio. Maybe you don’t want to be holding so many biotech or Chinese stocks, whatever it is, make sure you know why you hold what you do and just be intentional about it.

[00:41:29] Shawn O’Malley: In my opinion, this is about all anyone can really do in anticipation of crises, which we know will happen generally, but might not know the specific trigger for.

[00:41:38] Clay Finck: I think it’s important to keep in mind that when fear spreads nowadays, it spreads faster than it ever has in history because of things like social media and technology.

[00:41:49] Clay Finck: You know, it’s really easy to just get caught up in that. You see the headlines, you see your friends texting you, you see all the capitalized tweets trying to get your attention and trying to like spark that. Fear can spread really fast. So we, like you mentioned, we need to be emotionally prepared for that.

[00:42:03] Clay Finck: Markets can and probably will move faster today than they ever have before. Especially when you consider all of the leverage in the system and leverage can lead to contagion. You know, one bank failure going down the next day, another bank can go down and that contagion ha can happen really fast and that fear can be sparked really fast.

[00:42:23] Clay Finck: So I think you bring up a good point. When your cortisol levels are high and you’re anxious and you’re fearful, maybe turn off your phone, go on the walk. Maybe occupy your mind with other things. Maybe just have checks in place that prevent you from making silly mistakes like panic selling or whatever else.

[00:42:41] Clay Finck: I think that’s why it’s really important to just have a strong emergency fund or, a strong cash position, so you’re able to meet any near term liabilities. It reminds me of a Napoleon quote where he talked about military genius, and I think it applies to investing as well. He says, the man who can do the average thing when everyone else is losing his mind.

[00:43:00] Clay Finck: So just stick to your investing strategy, investing plan, and don’t just change it, you know, all of a sudden. And then I also had this, another tip I wanted to share that I picked up from Gautam Baid’s book, The Joys of Compounding. I’ve been going through that book on the show. He had this chapter that’s about journaling, and he talked about how when we’re going through these market periods of volatility and these market gyrations, he’ll journal about the headlines and some of the things he is reading.

[00:43:28] Clay Finck: Maybe people are messaging him more than usual, and he’ll just kind of journal about what’s on his mind, what he’s seeing and maybe what his emotions are at that point. And then I think that can be really helpful in the future when you look back, because when those types of periods happen in the future, you can be like, okay, I’m recognizing patterns here and what’s happening then is very similar to something that’s happened in the past. So that is a really good tip I picked up from that book. When you put things on paper, you can’t really lie about it. And when people try and recall the past, it’s kind of a distorted version of the past. So putting the pen to paper can be really helpful.

[00:44:05] Clay Finck: One thing I’ve been utilizing in my own investing in personal finance strategy is parking some of my cash in a money market fund. Like I mentioned earlier, Vanguard offers 4.4% interest on cash, but there’s no FDIC insurance on that. So I’d like you to expand on that and maybe what risks investors should maybe be aware of if they park some cash in a money market fund.

[00:44:30] Shawn O’Malley: Agreed. Yeah, you make some great points. And like we were talking about, I would encourage everybody to have a rainy day fund to some extent, whether it’s your personal life or investing. But the products offered differ by institutions in terms of ease of withdrawals, minimum investments, fees, stuff like that.

[00:44:44] Shawn O’Malley: But money market funds or high yield savings accounts are great options for a rainy day fund, especially if you open one. And I think this is really important at an institution that isn’t where you do your primary banking and just keep your checking account. There can be some behavioral advantages to this where you see it as a separate pot of money that you might avoid tapping into for regular living expenses.

[00:45:04] Shawn O’Malley: I think it works great for saving for something intentional. You know, maybe a wedding, a vacation, or just storing cash in the event of a big downturn where risk assets become at attractively priced. That’s how I think about it. The key difference between them, you know, money market funds and maybe high yield savings accounts is that one has FDIC insurance and one doesn’t.

[00:45:23] Shawn O’Malley: So high yield savings accounts do have the insurance, whereas a money market fund doesn’t have the same principle protection with insurance. Both are very safe, but high yield savings accounts or really any savings account at a bank is just gonna have that extra layer of insurance protection. And a money market fund, you’re taking slightly more risk, but you can also earn a slightly higher return.

[00:45:42] Shawn O’Malley: If you have a lot of cash you want to store conservatively, you could consider keeping $250,000 maybe up until that insurance. And a high yield savings account, and then any cash beyond that. If you’re really concerned about uninsured deposits and maybe some of the things we’ve talked about today have freaked you out, you could put the rest in a money market fund, earn a bit more income than you know for the risk you’re taking.

[00:46:03] Shawn O’Malley: Granted that you wouldn’t have the insurance protection, and then any cash beyond that you keep, you could hold in just a money market fund and earn a little bit more income and essentially get compensated for the extra risk you’re taking and more so than you might in a bank account.

[00:46:17] Clay Finck: Yeah, you make a good point.

[00:46:18] Clay Finck: Pointing out the high-yield savings accounts. I know some offer higher rates than others, so maybe just look at what you know, sort of rates your bank offers, and then consider maybe a money with market fund if you want to take a little bit more risk and step outside that FDIC insurance limit. So we’ve covered a lot today, Shawn. Covered a lot of ground. I really appreciate you joining me to help flesh out what’s happening. Before we round out the episode, I’d like to give you the opportunity to tell the audience a little bit about We Study Markets and the great work your team is doing with the newsletter here at TIP.

[00:46:50] Shawn O’Malley: I really appreciate the opportunity to be on.

[00:46:52] Shawn O’Malley: It’s been a ton of fun today and hopefully we’ve been able to provide some value, and maybe clarify things for people in a very uncertain time. In terms of the newsletter, it’s sort of my passion project a little bit. I feel like I’ve poured my heart into it, and fortunately I have two great co-writers, Weronika Pycek, who is on our YouTube channel, and then Matthew Gutierrez.

[00:47:11] Shawn O’Malley: And they both joined in the last few months. And really, I think we’re doing a great job of covering the market each day, Monday through Friday. We try to have very markets-focused news coverage, explaining two to three important stories for people understand that’s unfolding in sort of the financial news.

[00:47:26] Shawn O’Malley: Giving people a snapshot of what the markets are doing, at least in terms of prices. And then we try to, you know, because we’re a long-term oriented company here and we’re all value investors, we try to do a deeper dive into a specific topic that might be relevant for people to know about. And so those tend to be a little longer.

[00:47:43] Shawn O’Malley: But, yeah, each day I think there’s something for everybody to find that they like in reading the newsletter, whether it’s the looking at the market chart, reading the news, reading the deep dive, and then even on the weekends we try to be less news focused and a little more lifestyle thinking about things like having a rainy day fund and how to hedge, you know, strategies for making sure that you don’t panic and sell at the wrong time in markets, and stuff like that.

[00:48:04] Shawn O’Malley: So, I’ve had a lot of fun working on it and I hope people are interested in subscribing.

[00:48:08] Clay Finck: That’s great. We’ll be sure to get the link to sign up in the show notes, for those in the audience who would like to join the newsletter, they can also go to theinvestorspodcast.com/westudymarkets to get signed up as well.

[00:48:20] Clay Finck: Shawn, thanks so much again for joining me today. I really, really appreciate it.

[00:48:24] Shawn O’Malley: Thanks for having me on Clay.

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