The Bloodletting

The Bloodletting

I am a self-confessed crypto idealist. Notwithstanding all the FUD and/or alleged fraud in the sector, I continue to believe in crypto as a force for good. The foundation for such belief may be hard to fathom given all that is going on, but it is rooted in the notion that the TradFi system is structurally overleveraged to a degree that it simply cannot de-lever back to a healthy state without causing societally unacceptable damage, meaning that change simply cannot come from within that system and therefore, MUST come from outside.

The obvious question then arises; how that change would work? This is the million-dollar question. Nobody knows the answer, but it is the topic of wild speculation on the interweb. Everything from returning to the gold standard, de-dollarization, hyper-bitcoinization, and the "Great Reset" post which we can start over with a clean slate.  All are easy to postulate but hard to actually imagine let alone prepare for.  

As it is one of my favorite topics to ponder, I have spent a lot of time on it.  Listened to most of the so-called experts and in doing so have come up with my own thesis: That the reality is likely to be less dramatic and more gradual in nature than many envisage.  I believe it is more likely to involve a slow migration of healthy/valuable assets and economic activity from the old (overleveraged) system to a new (less levered, more efficient & transparent) system, post which the excess leverage and legacy assets in the old system will simply be written-off and/or discarded.

In a way, it is not dissimilar to a vampire attack in which the attacker ("vampire") with strong reserves, assets, and liquidity buys up the healthy assets of the victim (legacy TradFi). In the context of the banking system, it's similar to First Citizens buying the performing loan portfolio of Silicon Valley Bank together with the deposits funding that portfolio at a massive discount leaving the Federal Deposit Insurance Fund (read the taxpayer) with the "L".

It has long been my contention that non-fractionally reserved banks or banks with limited (single digit) leverage, would be inherently more stable than fractionally reserved / over-levered counterparts. It is true that leverage ratios have been reduced from the high 20s to the mid-teens in the wake of the great financial crisis but I believe they continue to be too high as was highlighted again sharply by recent developments at Silicon Valley Bank, First Republic, and others. Sure, they completely fumbled the asset & liability matching and all of this was completely missed by the supervisors/regulators, but at heart, the returns from excessive leverage and risk-taking are the forbidden fruit that no banker can resist indefinitely and thus if we were to simply cap the allowable leverage at a much lower level and/or make the risk-taking fully transparent, we would solve a lot of problems - by taking away the fruit.  

The issue is one of returns, banking today is already a low-margin business and much of the banking industry provides returns on equity that are lower than the current market rate, hence they trade at significant discounts to book value.

Let that sink in for a moment... Even with the vast amounts of leverage currently employed by banks, paying next to nothing to their depositors, most banks still can't make a return on the equity capital that exceeds the risk-free rate plus the current equity market risk premium. Whilst making it hard for ordinary (SME) lenders to borrow as it is easier to just "park" funds at the FED or buy Treasuries, they are obviously failing miserably at their utility function toward deposit holders and SME lenders.

To put it another way; you could not capitalize most of the existing banking system from scratch as you would have to raise the required equity at a discount. It exists merely because the existing equity and assets are "trapped" and because they still generate huge income and earnings streams that are the self-sustaining money trough that feeds hoards of banksters and regulators, yet they are in effect the ultimate zombies feeding off that which is economically/clinically dead.

If leverage were to be curtailed further and banks would be forced to focus their utility maturity transformation function on the real economy (i.e. provide loans to the real economy instead of buying government bonds), banking would go back to being a very boring, a low margin utility service, bank stability would be much enhanced and the whole sector would necessarily be stripped of all the existing excess as there simply wouldn't be any money to pay for it.  Sounds so simple until you consider the vested interests of the sector as it exists today.

It is my best guess, that however inconceivable the above outcome might be, it is exactly what will happen. Caitlin Long's initiative to create a fully reserved bank (Custodia) and indeed most of the onchain lending activity that is 100% or more collateralized (i.e. not fractionally reserved but the opposite) are the tell-tale signs that there are people thinking about an alternative future and are willing to forego the fruits of leverage to achieve such. This activity is and will remain healthy and slowly but surely as it gains traction and appreciation for what it stands for (the moral high ground) economic activity will shift to this new system causing the old overleveraged system to slowly be starved of the liquidity it requires to keep re-financing and re-hypothecating its assets until the point that whatever is left gets written-off or marked to actual market (M2AM) and refinanced by the new system.

But what would this new paradigm look like, and what would be the first dominos to fall? While it is difficult to predict what such an unprecedented situation would look like, by looking at some of the existing cracks in the wall we can make a few guesses at what might break first. Commercial real estate is currently a major pain point for large investors, as interest rates rise at an abnormal rate and more people continue to work from home even after the pandemic, commercial real estate positions are becoming increasingly problematic on major players' balance sheets. As the debt on these portfolios becomes ever more expensive to service and the overall value of the assets (read collateral) plummets the holders of these positions become more and more likely to write down the position and book the loss, but who are holding these multi-billion dollar over-leveraged positions?

Pension funds, Insurers & Banks....none of which will be allowed to actually fail, and thus ultimately us "the people".

The potential losses that these positions represent and the leverage stacked against them are currently so large, that resolving matters through a deflationary bust (i.e. taking the loss)  is societally and politically wholly unpalatable. However, pleasing it may seem to Austrian economists and/or libertarians, which is why central banks will not be able to fake independence for much longer. They are the tail wagging the controlled demolition dog and once this becomes more evident people will lose faith in their ability to control, the pensions they were promised, and the over-levered /  fractionally reserved banking system. During this transition (which I believe we are in) increased asset price and rate volatility will force over-levered/underreserved players to become more conservative/less fractionally reserved and thus force the bloodletting whilst the powers at be attempt to avoid cataclysmic collapse and/or deposit incineration by printing whatever is necessary to fill the void (as they did with SVB), thus socializing the losses.

The non-fractionally reserved banking renaissance will therefore not be a classic vampire attack, but a slow bloodletting of the excess of the existing overleveraged system as healthy assets/activity slowly migrate to the new system with limited and fully transparent leverage, higher efficiency, and less waste.

The future is bright / let's build it together.  Florence.Finance