Arthur Hayes: In the face of banking troubles, owning gold and Bitcoin means you won't lose

Original: 《The Denominator》

Author: Arthur Hayes

Compiled by: GaryMa, Wu Says Blockchain

Abstract

In this article, Arthur Hayes elaborates on the current predicament of the American banking system, where "too big to fail" (TBTF) banks can receive government backing under various aid programs (such as BTFP) even when they face funding issues, while smaller non-TBTF banks may not be so fortunate. A recent example is First Republic, which could only be acquired by a TBTF bank with the assistance of the Federal Deposit Insurance Corporation (FDIC) after its equity was nearly wiped out. Arthur Hayes believes that in the face of such a dilemma, whether the Federal Reserve directly cuts interest rates or eases the conditions for aid, the ultimate increase in the U.S. money supply—the denominator (the meaning of Denominator in the title)—will benefit risk assets outside the banking system, such as gold and Bitcoin.

Countries prefer a sound banking system. A good banking system can gather citizens' savings and lend them to the government and productive companies. Ideally, this lending creates economic growth.

However, banking systems often run into trouble because they operate under a fractional reserve system—meaning they lend out more than they have in deposits. Their willingness to over-lend often puts them in a position where they cannot meet all depositors' withdrawal demands, especially during times of stress. These situations are typically caused by political pressures, profit motives, and/or poor risk management, leading banks to suffer massive losses, often due to bad credit or loan losses resulting from rising interest rates. This is followed by bank runs, and then the government must decide who should bear the costs to restore its illustrious banking system to solvency.

Should the costs of rescuing banks be borne by a combination of depositors, shareholders, or bondholders? Or should the government print money to "save" failing banks and pass the costs onto the entire citizenry, resulting in inflation?

The best-run banking systems establish a set of agreed-upon rules before any crisis occurs, outlining how these situations should be handled, ensuring everyone knows how to deal with failing banks, eliminating any surprises. Because the banking system is considered vital to the normal functioning of the country by financial and political elites, it is safe to assume that in almost every country, banks will be rescued. The real question is, which fools will be included in the denominator, responsible for footing the bill for the capital restructuring of banks? Regardless of any pre-agreed cost-sharing arrangements before any bank fails, once a bank actually collapses, every stakeholder will lobby the government to avoid being the one responsible for paying the costs.

Bianco Research has released a truly epic chart that clearly illustrates the current and future disasters of the U.S. banking system. This article will present some of their charts.

Direction of the U.S. Banking System

The U.S. government is currently hesitant in deciding the future direction of the banking system. Should it favor a decentralized, localized system dominated by small to medium-sized banks (i.e., the U.S. banking system before 2008)? Or should it opt for a centralized system dominated by a few large banks that primarily lend to giant corporations, super-rich individuals, and foreign banking systems?

After the global financial crisis, the so-called officials and institutions responsible for banking regulation decided to create a dual system. They identified 8 banks as "too big to fail" (TBTF) and provided them with unlimited government guarantees on deposits. JPMorgan Chase led the way, holding 16% of all U.S. deposits. Deposits in these large banks carry no risk. If a "too big to fail" bank makes a mistake, the U.S. government will print the necessary money to ensure all depositors can get their money back. These 8 banks are essentially state-owned enterprises, with profits privatized for shareholders, but losses borne by the citizens. In exchange, these 8 banks were given a set of new rules to follow. These large banks then spent hundreds of millions on political campaign donations to help adjust these rules and achieve the most favorable restrictions.

Other banks must fend for themselves in a competitive free market. All deposits are not guaranteed—due to the risks involved, one might think depositors should be clearly informed about how these banks lend. But in reality, depositors can only decipher the intentionally vague and misleading financial statements of banks and draw their own conclusions about whether a bank is well-managed.

All banks serve different types of clients. TBTF banks cater to large corporations and super-rich individuals, who are experts in securities lending and trading. TBTF banks are also channels for the Federal Reserve and U.S. Treasury's monetary policy, supporting the U.S. government by purchasing large amounts of U.S. Treasury bonds.

On the other hand, non-TBTF banks drive the true engine of the U.S. economy—namely, providing loans to small and medium-sized enterprises and ordinary people. They acquire resources that TBTF banks discard, filling their loan books with commercial real estate, residential mortgages, auto loans, and personal loans (just to name a few). Look at the two charts below, which depict how indispensable a strong network of smaller non-TBTF banks is to the U.S. economy.

Although these two parts of the U.S. banking system face different types of credit risks through their respective loan portfolios, they share the same interest rate risk. Interest rate risk refers to the fact that if inflation rises and the Federal Reserve raises short-term rates to combat inflation, the loans they underwrote at lower rates will depreciate, which is simply a matter of bond math.

In March of this year, after three banks failed, the Federal Reserve and U.S. Treasury hurriedly devised a rescue plan called the "Bank Term Funding Program" (BTFP). Under this plan, any bank holding U.S. Treasuries (UST) or mortgage-backed securities (MBS) can submit these securities to the Federal Reserve and receive 100% of their face value in newly printed dollars.

Given that the fractional reserve banking system based on fiat currency and the overall financial system under the U.S. framework is essentially a confidence game, its rulers do not take kindly to being exposed when the market reveals their tricks. Financial markets correctly perceived the essence of BTFP and viewed it as a hypocritical way to print money to "save" part of the U.S. banking system. The market expressed its dissatisfaction with this inflationary behavior by driving up the prices of gold and Bitcoin. Politically, various elected officials in the U.S. have done their utmost to protest these bank rescue plans. Con artists never like to be exposed, and the Federal Reserve and U.S. Treasury realize that when the next bank (or banks) needs rescuing, they cannot be so obvious about what they are doing. This means that any modifications to BTFP will need to be implemented secretly. The modifications we are most interested in involve the types of collateral eligible under the BTFP program.

Since the BTFP program was announced on March 11, 2023, gold prices have risen by 5% (white line), and Bitcoin prices have increased by 40% (yellow line).

But first, it is important to understand what led to this adjustment. Those TBTF banks, as well as those banks whose assets are primarily UST or MBS securities, benefited simply from the announcement of BTFP. The market knows that if these banks experience deposit outflows, they can easily meet their funding needs by submitting eligible bonds to the Federal Reserve and receiving dollars in return. But those non-TBTF banks are not so lucky, as most of their assets do not meet the funding requirements of BTFP.

Within less than a fiscal quarter, the market saw through BTFP and began to pressure non-TBTF banks. The market wondered, "If they cannot obtain support from BTFP, who will cover their loan losses?" This led them to ask, "Why should I hold equity in banks that cannot obtain implicit or explicit government support?" Especially given the recent First Republic rescue case, which indicated that the "cost" of the FDIC arranging a quick merger of a distressed non-TBTF bank with a healthy TBTF bank was to completely wipe out all equity and bondholders' claims. As a result, equity holders began to sell off shares of regional banks… a 99% loss is better than a 100% loss. Those who sell first benefit the most.

First Republic Bank was the first casualty after BTFP, and its liquidation process provides us with more clues about who is favored by the U.S. government and who is excluded. The politics of bank bailouts are toxic. Many ordinary citizens lost their homes, cars, and/or small businesses in 2008, while large banks received government support worth billions of dollars and paid out record bonuses, leading to widespread anger. Therefore, politicians are reluctant to support policies that are clearly bank bailouts, especially since the U.S. is (in theory) a capitalist society where allowing companies to fail is part of the system.

I believe U.S. Treasury Secretary Yellen has been admonished because of BTFP and has been told that the U.S. government must never again allow a bailout of failing banks. I think she has been informed that the free market must find a way to deal with the failure of non-TBTF banks, which means that tweaking BTFP to make any and all bank assets eligible for financing is impossible. Some time ago, U.S. President Biden told Federal Reserve Chairman Powell that stopping inflation is his top priority. The Federal Reserve does not want to go against the president's wishes and cannot lower interest rates to help stop the outflow of deposits from these struggling banks while inflation is still at 5% (which I will elaborate on later in this article). Political reasons prevent the two main financial institutions of the government (the Federal Reserve and the U.S. Treasury) from effectively adjusting their policies to respond to this banking crisis.

"I ran for president because I am tired of the so-called trickle-down economy (an economic theory that stimulates growth by reducing taxes and regulations on the wealthy and corporations). We now have the opportunity to build an economy that serves working families on the foundation of a rapid recovery. The most important thing we can do to shift from a rapid recovery to stable, sustained growth is to bring down inflation. That is why I have made addressing inflation my top economic priority."

U.S. President Biden stated in a Wall Street Journal op-ed in May 2022.

The Federal Deposit Insurance Corporation (FDIC) is the U.S. government agency responsible for liquidating failed banks, striving to compel TBTF banks to take "responsibility" for purchasing these failed banks. Unsurprisingly, these profit-driven, government-supported enterprises are unwilling to rescue First Republic Bank unless the government is willing to provide more funding. This is why, after several days of waiting and a 99% drop in stock prices, the FDIC was forced to take over First Republic Bank to sell its assets to meet depositor liabilities.

Note: The importance of a bank's stock price lies in two reasons. First, banks must have enough equity capital to support their liabilities, meaning they need a certain level of investment. If the stock price drops too much, they will violate these regulatory requirements. Second, a drop in a bank's stock price triggers depositors' flight, as they worry that there is no smoke without fire.

On Monday, May 1, 2023, just before the market opened, the FDIC presented JPMorgan Chase with a very favorable deal, agreeing to purchase First Republic Bank. The deal was so excellent that JPMorgan's CEO stated in a shareholder conference call that the bank would immediately gain $2 billion in profit. JPMorgan, as a government-backed bank, refused to purchase the failing bank unless the government provided it with such a favorable deal that it would immediately gain $2 billion in profit. Where did the patriotism of JPMorgan's CEO go?

Do not let the numbers distract you; the important lesson from this bailout is that the First Republic Bank deal clarifies the prerequisites for TBTF banks to purchase and nationalize failed banks. Let’s explain these conditions one by one.

Conditions:

Equity holders and bondholders will be wiped out.

Response:

If your bank experiences interest losses on its loan portfolio (every bank does), and those loans do not meet BTFP's criteria, you must sell that stock immediately! You do not want to be liquidated by the FDIC. Short sellers are not the culprits behind the collapse of these junk bank stocks. Rather, it is the holders who sell out of fear of a 100% loss of capital.

Conditions:

Government-backed TBTF banks must acquire the assets of failed banks through takeovers. TBTF banks can only do this with additional government assistance from the FDIC.

Response:

In the case of First Republic, JPMorgan received cheap loans from the FDIC, which absorbed 80% of the losses on the loan books. Essentially, the government seems to expand the eligibility of collateral for TBTF only when TBTF banks first acquire the failed banks. This is clever; most politicians and their constituents will not realize that the U.S. government has expanded its support for the banking system without formally announcing it. Now, the FDIC's balance sheet will be filled with potential losses from the loan portfolios of failed banks and low-interest loans provided to TBTF banks. Therefore, Powell, Yellen, and the Biden administration cannot easily be accused of printing money to bail out banks.

Critical Assumption

If you believe that at critical moments, U.S. policymakers will always take whatever necessary measures to save the banking system, then you must agree that all deposits in federally chartered banks will ultimately be guaranteed. If you disagree, then you must believe that some bank depositors will suffer losses.

To assess which side is more likely to be correct, just look at the banks that have failed so far in 2023 and how they have been handled.

In all cases where the FDIC has taken over banks, depositors have been protected. Fortunately, even though Silvergate declared bankruptcy, it was still able to compensate depositors. Therefore, even if you are in a non-TBTF bank, your money is likely safe. However, if the FDIC takes over a bank, there is no guarantee that a TBTF bank will suddenly step in to ensure depositors are safe; if a bank declares bankruptcy, there is also no guarantee that it has enough assets to fully pay all deposits. Therefore, for your best interest, it is advisable to transfer all funds exceeding the $250,000 insurance limit to TBTF banks that have full government deposit guarantees. This will inevitably drive a large amount of deposits from non-TBTF banks to TBTF banks, further exacerbating the deposit outflow issue.

The reason U.S. Treasury Secretary Yellen cannot provide comprehensive deposit guarantees to all banks is that it requires action from the U.S. Congress. As I mentioned above, people are not interested in seeing politicians implement more bailouts for banks.

Deposit Outflow

Non-TBTF banks will continue to accelerate their loss of deposits.

First, as I mentioned above, to ensure your deposits are 100% safe, you must move your money from non-TBTF banks to TBTF banks.

Second, deposits from all banks will flow into money market funds. Money market funds deposit funds with the Federal Reserve and/or invest in short-term U.S. Treasuries. Think about it—would you rather earn 5% in a money market fund or 0.50% as a bank depositor? If you can transfer your money and earn nearly 10 times the interest income in the time it takes to watch a few TikTok videos, why would you keep your money in a bank?

Even if you do not know what a money market fund is and just want to keep your money in a bank, there is now no reason to deposit it in a non-TBTF bank. TBTF banks can lose deposits, and you do not have to worry because ultimately the U.S. government backs them. Non-TBTF banks are completely doomed, and deposit outflows will continue to lead to bankruptcies.

If inflation, interest rates, and banking regulations remain unchanged, then all non-TBTF banks will go bankrupt, and no bank will be spared—a 100% bankruptcy rate. This is guaranteed!

Well, maybe that’s a bit aggressive. The only banks that will survive are those that maintain a full reserve model. This means they accept deposits and immediately deposit those funds overnight with the Federal Reserve. This is an extremely safe banking model, but unfortunately, the Federal Reserve does not like this type of banking. For reasons unknown, they have rejected applications from banks hoping to adopt this business model.

The U.S. Money Supply as the Denominator

If my prediction about the ultimate fate of all non-TBTF banks is correct, then how much can the U.S. money supply grow? That is the real question. Through BTFP, we know the potential expansion is at least $4.4 trillion (i.e., U.S. Treasuries and mortgage-backed securities on the balance sheets of U.S. banks that can be converted to cash at any time).

Now we also know that the preferred method of the Federal Reserve, U.S. Treasury, and banking regulators is to strongly encourage TBTF banks to take on the liabilities of non-TBTF banks. TBTF banks absorb this public service by obtaining cheap capital funded by government-printed and taxpayer-funded losses. Therefore, the money supply will effectively expand by the total amount of loans from non-TBTF banks, which is $7.75 trillion.

It is important to note that these loans must be supported due to deposit outflows. As deposits dwindle, banks must sell loans at below par and incur losses. Realizing losses means they fall below regulatory capital limits, and in the worst-case scenario, they do not have enough cash to fully pay depositors.

The only way for all non-TBTF banks to avoid bankruptcy is if one of the following occurs:

1. The Federal Reserve lowers interest rates, causing the yields on reverse repos or 3-month Treasury bills to drop below the 2-3% range. The 2-3% range is an estimate of the blended yield on bank loan portfolios. The Federal Reserve may lower rates either because inflation is declining or because they want to prevent further pressure on the U.S. banking system. Then, banks can raise deposit rates to match or slightly exceed the rates offered by money market funds, and bank deposits will grow again.

2. The collateral eligible under BTFP expands to include any loans on U.S. bank balance sheets.

Option 1 would loosen financial conditions, leading to increases in risk assets such as Bitcoin, gold, stocks, and real estate.

Of course, this is due to a decrease in the price of money.

Option 2 expands the amount of money that will ultimately be printed. Again, this only supports risk assets outside the banking system. This means that gold and Bitcoin prices will rise, while stock and real estate prices will fall. Stock prices will decline because bank credit disappears, and companies cannot fund their operations. Real estate does not belong to the financial system, but in nominal dollars, its prices are so high that most buyers must finance their purchases. If mortgage rates remain high, and no one can afford the monthly payments, home prices will fall.

This is an increase in the money supply.

In any case, gold and Bitcoin are rising because either the money supply is increasing or the price of money is decreasing.

But what if the price of money continues to rise because inflation refuses to slow down, and the Federal Reserve continues to raise interest rates? Just last week, Powell emphasized that the Federal Reserve's goal is to eliminate the inflation beast, and then he raised rates by 0.25% during the banking crisis. In this scenario, non-TBTF banks will continue to fail as the spread between money market funds and deposit rates widens, leading to depositors fleeing, resulting in bankruptcies, ultimately requiring their loans to receive government support. As we know, the more government-backed loans there are, the more money must ultimately be printed to cover the losses.

The only way the printing press will not start is if the U.S. government decides to let the banking system truly collapse—but I firmly believe that the American political elite would rather print money than adjust the size of the banking system.

Many readers may think that the problems in banking are purely an American issue. Considering that most readers are not citizens under the U.S. system, you might think this will not affect you. Wrong! Due to the dollar's status as the reserve currency, most countries adopt U.S. monetary policy. More importantly, many non-U.S. entities, such as sovereign wealth funds, central banks, and insurance companies, hold dollar-denominated assets. Whether you like it or not, the dollar will continue to depreciate against hard assets like gold and Bitcoin, as well as useful commodities like oil and copper.

Don't Be a Victim of "Dilution"

If inflation remains high and the Federal Reserve continues to raise interest rates—or simply maintains current rates—more banks will fail, and we will see more TBTF bailouts, with the government continuing to support the creation of increasingly larger TBTF banks. This will expand the supply of money and gold, and Bitcoin will rise.

If inflation decreases and the Federal Reserve quickly cuts rates, ultimately, banks will stop failing. However, this will lower the price of money, and gold and Bitcoin will rise.

Some may ask why I have not considered the outcome where banks can survive long enough until their low-interest loans mature and are replaced by loans underwritten at higher yields. Depositors will not wait 12 to 24 months while bank deposit yields are essentially 0% and money market fund yields are 5%. A few simple operations can complete the transfer of deposits in under 5 minutes.

Holding gold and Bitcoin is a winning strategy unless you believe that political elites are willing to endure a complete failure of the banking system. A true failure would mean a large number of chartered banks going bankrupt. This would halt all bank lending to businesses. Many businesses would fail because they cannot fund their operations. The creation of new businesses would also decline in the absence of bank credit. With soaring mortgage rates, home prices would plummet. Stock prices would fall because many companies heavily purchased low-interest debt in 2020 and 2021, and when there is no affordable credit to roll over the debt, they will go bankrupt. Without the support of a commercial banking system to purchase bonds, long-term U.S. Treasury yields would soar. If a politician is in power during these events, do you think they would be re-elected? Impossible! Therefore, while monetary authorities and banking regulators may talk about no longer bailing out banks, when trouble truly arises, they will dutifully press that "print money" button.

So, Up Only! Just make sure that when the "dilution" comes, you are not in that diluted denominator.