Arthur Hayes: The US financial crisis is coming and Bitcoin will become the last "safe haven"

Now let’s turn to the more pressing issue: how the banking system distributes the inevitable losses.

Countries like a sound banking system. A good banking system pools citizens' savings and lends them to governments and productive businesses. In an ideal world, this lending creates economic growth.

Yet banking systems frequently get into trouble because they have few reserves—that is, they loan out more money than they have deposited. Their willingness to lend money they don’t have often puts them in a position where they can’t meet all of their depositors’ withdrawal requests, especially during times of economic stress. These situations usually arise from a combination of political pressure, profit motives, and/or poor risk management that cause banks to incur large losses, usually from loans that were badly underwritten or from loan losses due to rising interest rates. A bank run ensues, and then the government must decide who will pay for pulling its glorious banking system back to solvency.

Should depositors, shareholders, or bondholders share in the cost of bailing out banks? Or should governments print money to “save” failed banks and pass the cost on to all citizens in the form of inflation?

Before any crisis occurs, a well-functioning banking system establishes a set of agreed-upon rules to govern such situations, ensuring that everyone knows how to deal with a failed bank, thus eliminating any surprises. Because the financial and political elites consider the banking system an integral part of a well-functioning state, it is a safe bet that banks will always be bailed out in almost every country. The real question is which suckers will be included in the denominator responsible for paying for the bank's recapitalization? Whatever cost-sharing agreement was reached before the bank failed, once the bank actually failed, all the relevant stakeholders would lobby the government to avoid being part of the denominator.

Bianco Research has published a truly epic chart package that clearly illustrates the current and future disasters in the U.S. banking system. Some of their charts are presented in this post.

The US government is at a crossroads, having so far been undecided about the type of banking system it wants for Pax Americana. Does it want a decentralized system of small and medium-sized banks that lend locally (i.e. the US banking system before 2008)? Or does it want a centralized system of a few large banks that lend primarily to national champions, the super-rich, and Jeffrey Epstein (i.e. the Chinese banking system)?

After the 2008 global financial crisis, the penny-pinchers in charge of banking regulation decided they would create a two-tier system. Eight banks were deemed “too big to fail” (TBTF) and given an unlimited government guarantee on their deposits. JP Morgan was at the top, holding 16% of all deposits in the US. There was no risk in depositing money with these mega banks. If a TBTF bank screwed up, the US government would print money to ensure that all depositors got their money back. Essentially, the eight banks were state-owned enterprises, with profits privatized by shareholders but losses socialized by citizens. In return for this sweet deal, the eight banks were given a whole host of new rules to follow. These mega banks then spent hundreds of millions of dollars on political campaign contributions to help tweak these rules and achieve the most favorable restrictions.

Source: Open Secrets

All other banks have to fend for themselves as they navigate the turbulent free market. Not all deposits are guaranteed - given the risks involved, you'd think depositors would be clearly informed about how these banks lend. Instead, depositors are left to interpret intentionally vague and misleading financial statements and draw their own conclusions about whether a particular bank is doing well.

All banks cater to different types of clients. TBTF banks primarily serve large corporations and the super-rich and are experts in securities lending and trading. TBTF banks are also conduits for monetary policy from the Federal Reserve (Fed) and the U.S. Treasury, and they support the U.S. government by purchasing large amounts of U.S. Treasury bonds.

On the other hand, non-TBTF banks power the real engine of the U.S. economy—that is, they provide loans to small and medium-sized businesses and to individuals with lower incomes. They take the scraps that TBTF banks discard from the proverbial table and fill their loan books with commercial real estate, residential mortgages, auto loans, and personal loans (just to name a few). Take a look at the two charts below, which depict how important a strong network of small non-TBTF banks is to the U.S. economy.

Although these two types of banks in the U.S. banking system face different types of credit risk through their respective loan books, they bear the same interest rate risk. The interest rate risk is that if inflation rises and the Fed raises short-term interest rates to counter inflation, then the loans they insure at the lower interest rate will lose value. This is bond math. (I discussed this phenomenon in detail in my article "Kaiseki Roasting.")

In March, when three banks collapsed within a week, the Fed and the U.S. Treasury scrambled to concoct a rescue program called the Bank Term Funding Program (BTFP), under which any bank holding U.S. Treasury securities (UST) or U.S. mortgage-backed securities (MBS) could hand them over to the Fed and receive 100% of their face value in newly printed dollars.

Given that the fiat-based fractional reserve banking system and the Pax Americana financial system in general are a confidence game, the powers that be did not react kindly when the markets deemed their antics to be bullshit. Financial markets correctly saw through the BTFP and recognized it as a thinly disguised way of printing $4.4 trillion to “save” the US banking system. Markets expressed their displeasure with this inflationary move by pushing up the prices of gold and Bitcoin. On the political front, many US elected officials did their best to make a big fuss about these banking bailouts. Fraudsters never like to be exposed, and the Fed and US Treasury realized that their intentions could not be so obvious the next time banks needed a bailout. This meant that any adjustments made to the BTFP needed to be implemented in secret. The adjustments we are most interested in have to do with the types of collateral that are eligible for the BTFP program.

Since the BTFP announcement on March 11, 2023, gold has risen 5% (white) and Bitcoin has risen 40% (yellow).

But first, it’s important to understand what caused this change. TBTF banks—and any bank with a significant portion of its assets in U.S. securities or MBS securities—benefited from the mere announcement of the BTFP. The market knew that if and when these banks experienced deposit outflows, they could easily meet their cash needs by handing over eligible bonds to the Fed and getting dollars back. But non-TBTF banks were not so lucky, as a large portion of their assets were not eligible for BTFP funding.

In less than a quarter, the market saw through the BTFP and put pressure on the non-TBTF banks. The market wanted to know, “Who will pay for the interest rate losses on their loan books if they can’t use the BTFP?” This made them ask themselves, “Why would I own equity in a bank that can’t get implicit or explicit government support?” This question is especially important because the recent bailout of First Republic Bank showed that the “cost” of the FDIC arranging a failed non-TBTF bank to merge with a healthy TBTF bank was a total loss for equity and bondholders. So shareholders started selling their shares in regional banks…a 99% loss is better than a 100% loss. Whoever sells first will sell the best.

First Republic Bank was the first post-BTFP casualty, and the way it ended gives us more clues about who is in favor and who is out of favor with the U.S. government. The politics of bank bailouts are toxic. In 2008, when the big banks received hundreds of billions of dollars in support from the government and handed out record bonuses, many citizens were angry that they had lost their homes, cars, and/or small businesses. Politicians were therefore reluctant to support what appeared to be an obvious bank bailout, especially because the U.S. is (in theory) a capitalist society, and allowing companies to fail is considered part of the system.

I’m sure that US Treasury Secretary Janet Yellen was reprimanded for the BTFP and told that under no circumstances could the US government bail out more bankrupt banks. I imagine she was told that private markets would have to find a solution to manage the failure of non-TBTF banks – meaning that tweaking the BTFP to make any and all bank assets eligible for funding was out of the question. Not long ago, US President Joe Biden told Fed Chairman Jerome Powell that stopping inflation was his top priority. In order not to go against the President’s wishes, the Fed could not lower rates enough to help stop the outflow of deposits from these shaky banks when inflation was still at 5% (I’ll elaborate on this later in this article). For political reasons, the two main financial arms of the government (the Fed and the US Treasury) were unable to change their policies to effectively respond to this banking crisis.

“I ran for president because I’m tired of so-called trickle-down economics. We have a chance right now to build an economy that works for working families, building on a historic recovery. To transition from a rapid recovery to steady, stable growth, the most important thing we can do right now is to bring down inflation. That’s why I’ve made addressing inflation my top economic priority,” U.S. President Joe Biden wrote in a Wall Street Journal op-ed in May 2022.

The Federal Deposit Insurance Corporation (FDIC), the US government agency responsible for liquidating failed banks, did its best to bring the TBTF banks together to fulfill its "duty" to acquire loss-making banks. Unsurprisingly, these profit-driven, government-backed companies were unwilling to participate in the rescue of First Republic Bank unless the government was willing to put up more money. That's why many days later, after a 99% drop in the stock price, the FDIC took over First Republic Bank in order to sell its assets to repay the depositors' debts.

Note: Bank share prices are important for two reasons. First, banks must have a minimum amount of equity to back their liabilities, or exposure. If share prices fall too much, they violate these regulatory requirements. Second, falling bank share prices prompt depositors to flee banks because they worry that there is smoke without fire.

At the 11th hour before the market opened on Monday, May 1, 2023, the FDIC offered the largest TBTF bank, JPMorgan Chase, a private deal in which JPMorgan agreed to acquire First Republic Bank. The deal was so good that JPMorgan CEO Jamie Dimon said on a shareholder call that the bank would immediately recognize a $2 billion profit. JPMorgan Chase, with its government guarantee, refused to buy a failing bank unless the government gave it a very favorable deal that would make it $2 billion immediately. Where is Jamie's patriotism?

Don't let these numbers distract you from the important lesson of this bailout. The First Republic Bank deal illustrates the prerequisites for TBTF Bank to be nationalized through acquisition. Let's take a look.

condition:

Stockholders and bondholders were wiped out. A donut, a bagel, a duck egg.

Response:

If your bank has interest losses on its loan portfolio (every bank does) and those loans don't qualify for BTFP, you MUST sell those shares immediately! You don't want to get busted by the FDIC. Short sellers are not responsible for the plunge in these shitty bank stocks. Long term holders are selling out of fear of a 100% loss of capital if the FDIC steps in.

condition:

A government-guaranteed TBTF bank must acquire a failed bank by taking over its assets. A TBTF bank can do this only with additional government assistance from the FDIC.

Response:

In the case of First Republic Bank, JPMorgan Chase received a low-interest loan from the FDIC, while the agency took 80% of the losses on the loan book. Essentially, it appears that the government will only extend BTFP-eligible collateral if the TBTF bank acquires the failed bank first. This is clever, and most politicians and their voters will not realize that the US government has extended support to the banking system without formal announcements. Now, the FDIC's balance sheet will be swollen by potential losses on failed bank loan books and low-interest loans to TBTF banks. Therefore, Powell, Yellen, and the Biden administration cannot be easily accused of printing money to save the banks.

Key Assumptions

If you believe that, in a pinch, U.S. policymakers will always do whatever is necessary to save the banking system, then you have to agree that all deposits in federally chartered banks will ultimately be guaranteed. If you disagree, then you have to believe that some bank depositors will suffer losses.

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

Note: Technically, Silvergate was not taken over by the FDIC because it declared bankruptcy before it was fully insolvent.

In all cases where the FDIC seized a bank, depositors were protected. Thankfully, Silvergate was able to get depositors compensated despite declaring bankruptcy. So, even if you are in a non-TBTF bank, your money is likely safe. However, if the FDIC seized the bank, there is no guarantee that a TBTF bank would swoop in and leave depositors unscathed. If a bank declared bankruptcy, there is no guarantee that it would have enough assets to pay all deposits in full. Therefore, in your best interest, you would be better off moving all funds above the $250,000 insurance limit to a TBTF bank with a full government deposit guarantee. This would inevitably drive a large amount of deposits from non-TBTF banks to TBTF banks and further exacerbate the deposit flight problem.

The reason Treasury Secretary Janet Yellen can't provide a blanket deposit guarantee to all banks is that this would require Congress to pass it, and as I said above, there is no appetite to see politicians impose more bailouts on the banks.

Deposit outflow

Non-TBTF banks will continue to lose deposits at an accelerated rate.

First, as I said above, to be 100% sure that your deposit is safe, you have to transfer your money from a non-TBTF bank to a TBTF bank.

Second, all bank deposits will go to money market funds. Money market funds deposit money with the Fed and/or invest in short-term U.S. Treasuries. Think about it - you can earn 5% in a money market fund, or 0.50% as a bank depositor (see chart above). If you can use your phone to transfer your money and earn almost 10 times more interest in the time it takes to watch a few TikTok videos, why would you keep your money in the bank?

Even if you don't know what a money market fund is and just want to keep your money in a bank, there is no reason to invest in non-TBTF right now. TBTF banks can lose deposits and you don't have to worry because at the end of the day, the US government explicitly guarantees that you will always get your money back. Non-TBTF banks are completely screwed and deposit outflows will continue to cause bankruptcies.

If inflation, interest rates, and bank regulation remain as they are, there is no way a non-TBTF bank will not fail. There will be a 100% failure rate. Guaranteed!

OK, maybe that's a little aggressive. The only banks that survived were the ones that kept operating models completely intact. That meant they accepted deposits and immediately deposited those funds overnight at the Federal Reserve. It was a super safe way to do banking, but unfortunately, the Fed didn't like this kind of banking. For unknown reasons, they rejected applications from banks that wanted to adopt this business model.

Denominator

If my prediction about the ultimate fate of all non-TBTF banks is correct, how much more can the US money supply expand? That is the real question. Based on BTFP, we know that the potential expansion is at least $4.4 trillion (i.e. the amount of USTs and MBS on US bank balance sheets that are readily redeemable for cash).

We also now know that the preferred gimmick of the Fed, the U.S. Treasury, and the banking regulators is to insist that TBTF banks assume the debts of failed non-TBTF banks. The TBTF banks perform this public service by receiving cheap capital and loss absorption paid for by government printing and U.S. taxpayers’ money. Thus, the money supply is essentially expanded by the total amount of loans (7.75 trillion) of non-TBTF banks.

Note to Ned Davis Research subscribers: I encourage you to check out the ECON_51 report to verify my $7.75 trillion number.

It’s important to remind you that the reason these loans have to be secured is because deposits are fleeing. As deposits flee, banks must sell loans at well below face value and realize losses. Realizing losses means that their capital is below regulatory limits and, in the worst case, they don’t have enough remaining cash to pay depositors in full.

The only way all non-TBTF banks won't go bankrupt is if one of the following happens:

1. The Fed cuts rates and the yield on the reverse repo facility or 3-month Treasury bills falls below the 2% to 3% range. The 2% to 3% range is an estimate of the blended yield on a bank's loan portfolio. The Fed may cut rates either because inflation is falling or because they want to prevent further stress on the U.S. banking system. Banks can then raise deposit rates to match or slightly above the rate that money market funds can offer, and bank deposits will grow again.

2. Collateral eligible for BTFP is extended to any loan on the balance sheet of a U.S. bank.

Option 1 Financial conditions ease and risk assets like Bitcoin, gold, stocks, real estate, etc. are pumped, all of which are rising.

This is a fall in the price of a currency.

Option 2 expands the amount of money that will eventually be printed. Again, this only supports risky assets outside the banking system. This means gold and Bitcoin prices go up, and stocks and real estate prices go down. Stocks go down because bank credit disappears and companies can't finance their operations. Real estate is not part of the financial system, but it's so expensive in nominal dollar terms that most buyers have to finance their purchases. If mortgage rates stay high and no one can afford the monthly payments, house prices go down.

This is an increase in the money supply.

Either way, gold and Bitcoin are rising because either the money supply is increasing or the price of money is falling.

But what if the price of money continues to rise because inflation refuses to let up and the Fed continues to raise rates? Just last week, Powell was stressing that the Fed’s goal is to kill the inflation beast, and then he raised rates by 0.25% during the banking crisis. In this scenario, non-TBTF banks will continue to go bankrupt as the spread between money market funds and deposit rates widens, causing depositors to flee, which leads to bankruptcies and ultimately their loans being backed by the government anyway. As we know, the more loans the government guarantees, the more money it will eventually have to print to cover the losses.

The only way the printing presses won’t get out of control is if the US government decides to actually collapse the banking system — but I fully expect the US political elite would rather print money than right-size the banking system.

Many readers may think that the problems in the banking industry are purely an American matter. Considering that most readers are not peaceful citizens of the United States, you may think that this does not affect you. Wrong! Due to the reserve currency status of the US dollar, most countries adopt the US monetary policy. What's more, many non-US institutions, such as sovereign wealth funds, central banks, and insurance companies, have assets denominated in US dollars. Whether you like it or not, the US dollar will continue to depreciate against hard assets such as gold and Bitcoin, and useful commodities such as oil and copper. You are also in the denominator, like a hot-blooded American fool.

If inflation remains high and the Fed continues to raise interest rates - or simply maintains them where they are now - then more banks will fail, we will see more TBTF bailouts, and the government will continue to support the creation of larger and larger TBTF banks. This will expand the supply of money and gold, and Bitcoin will rise.

If inflation falls and the Fed cuts rates quickly, eventually, banks will stop failing. However, this will lower currency prices, and gold and Bitcoin will rise.

Some may ask why I didn't consider the outcome that banks survive long enough for their low-rate loans to mature and be replaced by loans underwritten at higher yields. Depositors don't wait 12 to 24 months with bank deposits essentially earning 0% and money market funds earning 5%. Click, swipe, and in less than 5 minutes your deposit base is complete thanks to your mobile banking app. There just isn't enough time!

You can’t lose by owning gold and Bitcoin , unless you believe that the political elite is willing to tolerate a complete failure of the banking system. A true failure would mean the collapse of a large number of chartered banks. This would stop all bank lending to businesses. Many businesses would fail because they cannot finance their operations. In the absence of bank credit, the creation of new businesses would also decline. As mortgage rates soar, house prices would plummet. Stock prices would fall because many companies that bought up cheap debt in 2020 and 2021 would go bankrupt when there is no affordable credit to roll over the debt. Long-term U.S. Treasury yields would soar without the support of the commercial banking system buying bonds. If a politician were in power during a period when these things were happening, do you think they would be re-elected? No fucking way! So while the various monetary authorities and banking regulators may talk a big game about no more bank bailouts, they will dutifully press that “brrrr” button when trouble really comes.

So it only goes up! Just make sure you're not the last fool denominator of the Western financial system when the bill comes. Grab your Bitcoin and get out!