This Time Really Could Be Different

The new global financial crisis as exemplified by the successive failures of Silvergate Bank, Silicon Valley Bank, Signature Bank, Credit Suisse and the potential failure of First Republic Bank is well underway.

Here’s the key takeaway: Despite a brief hiatus after the UBS-Credit Suisse shotgun wedding on March 19, the crisis may be far from over.

Other big bank failures and continued stress on the system should be expected in the coming months. That financial crisis comes on top of an emerging recession as shown by shrinking world trade, declining manufacturing output, monetary tightening, continued inflation, declining housing prices and many more hard data points.

The combination of a financial crisis and a recession is similar to the global financial crisis of 2008. Investors are rightly concerned about this combo crisis, but there’s another potential threat that may be more dangerous than a recession or panic that will make 2023 a trifecta for the ages.

That threat is the possibility of the U.S. Treasury going broke and defaulting on U.S. government securities and other payment obligations of the government.

This threat comes from the failure of Congress to raise the debt ceiling.

The debt ceiling is a statutory limit on the total amount of debt the U.S. Treasury is allowed to issue. The debt ceiling is reached every few years because the Treasury keeps issuing more debt to finance ongoing budget deficits.

The total U.S. debt today is about $31 trillion. That’s the amount of debt in the form of U.S. Treasury bills, notes and bonds. Of course, there are tens of trillions of dollars more in contingent liabilities in the form of promised Social Security benefits, Medicare benefits, student loan guarantees and mortgage guarantees.

But let’s leave all of those aside for now and focus on the $31 trillion of so-called bonded debt.

When the Congress and White House are controlled by the same political party (as was the case in 2021 and 2022), raising the debt ceiling if needed is routine.

But when one party controls the White House and the other party controls one or both houses of Congress as is the case today, a game of political chicken can result where both sides make demands and bargain down to the final days before the Treasury goes broke.

This has happened before in recent decades. Why are things so much more dangerous today?

First of all, the debt is bigger than ever and growing faster than ever. Of the $31 trillion in debt, about $10 trillion was added just in the past three years, mostly under the guise of “COVID relief” and the Green New Scam (wrongfully called the Inflation Reduction Act of 2022). The spending is out of control.

The second reason is that the Republican-controlled House of Representatives is guided by more fiscally conservative members who belong to the Freedom Caucus or were part of the Gang of Twenty who held up Kevin McCarthy’s election as House speaker through 15 ballots, the most in over 100 years.

Republicans are demanding fiscal accountability and reductions in planned spending on domestic discretionary items. Meanwhile, the White House is demanding a “clean” debt ceiling bill, which means no concessions to the Republicans.

Both sides are dug in.

Right now, the Treasury can issue new debt to replace maturing debt (that does not increase the total debt) but no more. Treasury is paying bills with slush funds (such as the Exchange Stabilization Fund) and with positive cash flow resulting from tax season.

Those gimmicks will run out soon.

Treasury is getting closer to the “X-Date” when it really does go broke. No one knows the exact day of the X-Date, but estimates converge around July 15.

Investors will soon start to demand much higher interest rates to compensate them for the risk of default as July 15 draws near.

Will the White House and Congress reach an agreement to raise the debt ceiling? Yes, probably, but it could come down to the wire.

This is just one more critical risk for securities markets on top of the bank crisis and recession.

Gold is a good safe haven until the crossfire stops.

The $64,000 question is of course, what comes next? Are the recent bank failures harbingers of a much bigger crisis? Read on.

Where Do We Go From Here?

Will this new financial crisis continue? We know that a banking crisis has already begun.

We witnessed five bank failures or rescues in 11 days including Credit Suisse, one of the largest banks in the world and the second largest in Switzerland. Combined losses of stockholders and creditors of these institutions exceed $200 billion. Market losses in the banking sector are much greater.

Walter Wriston, the greatest banker of the 20th century after Pierpont Morgan, personally tutored me on this topic 40 years ago. In a bank run, you can pull your money out of banks and invest in gold, silver, land or anything else. But you give the money to the seller and she puts it back in the bank. The point is the money always ends up in the bank. The system is a closed circuit.

Of course, it could go to a different bank, but all banks can borrow from each other through the fed funds market and the Eurodollar market. Again, the money always ends up in the bank. Putting cash in a coffee can (or mattress) is one exception, but if you try to withdraw more than $10,000 your bank will file a Currency Transaction Report (CTR) with the Financial Crimes Enforcement Network (FinCEN) and you’ll end up in a file next to Osama bin Laden. And the IRS gets a heads-up.

So that’s not a practical solution. The bottom line is money always ends up in the bank. Again, the system is a closed circuit.

The recent bank failures and rescues were accompanied by extraordinary regulatory actions. These actions have thrown the U.S. banking system and bank depositors into utter confusion. Are all bank deposits now insured or just the ones Janet Yellen decides are “systemically important”? What’s the basis for that decision?

The most important question is: Is the crisis over? Has the Fed done enough to reassure depositors that the system is sound? Has the panic subsided?

The answer is no. The panic is just getting started. We base that answer on the history of the two acute financial crises in recent decades — 1998 and 2008. The 1998 crisis reached the acute stage on Sept. 28, 1998, just before the rescue of Long Term Capital Management (LTCM).

We were hours away from the sequential shutdown of every stock and bond exchange in the world. But that crisis began in June 1997 with the devaluation of the Thai baht and massive capital flight from Asia and then Russia. It took 15 months to go from a serious crisis to an existential threat.

Likewise, the 2008 crisis reached the acute stage on Sept. 15, 2008 with the bankruptcy filing of Lehman Bros. But that crisis began in the spring of 2007 when HSBC surprised markets with an announcement that mortgage losses had exceeded expectations. It then continued through the summer of 2007 with the failures of two Bear Steans high-yield mortgage funds and the closure of a Société Générale money market fund.

The panic then caused the failures of Bear Stearns (March 2008), Fannie Mae and Freddie Mac (June 2008) and other institutions before reaching Lehman Bros. For that matter, the panic continued after Lehman to include AIG, General Electric, the commercial paper market and General Motors before finally subsiding on March 9, 2009.

Starting with the HSBC announcement, the subprime mortgage panic and domino effects lasted 24 months from March 2007 to March 2009. Averaging our two examples (1998, 2008) the duration of these financial crises is about 20 months. This new crisis is one month old. It could have a long way to run.

On the other hand, this crisis could reach the acute stage faster. That’s because of technology that makes a bank run move at the speed of light. With an iPhone, you can initiate a $1 billion wire transfer from a failing bank while you’re waiting in line at McDonald’s. No need to line up around the block in the rain waiting your turn.

In addition, the regulatory response is faster because they’ve seen this movie before. That begs the question of whether regulators are out of bullets because they’ve already guaranteed almost everything so they don’t have more rabbits to pull out of the hat. This could be the crisis where the panic moves from the banks to the dollar itself.

If savers lose confidence in the Fed (we’re almost there) not only will the banks collapse, but the dollar will collapse also. At that point, the only solution is gold bullion.

Further evidence for a continued crisis comes from the fact that no sooner was the Credit Suisse shotgun wedding completed than investors aimed their sights at Deutsche Bank, another perennial weak link in the chain. Who’s next? Barclays? Santander? We don’t know. Neither do regulators or investors. But we do know more failures are coming.

By the way, this is not really a banking crisis even though it plays out in the form of bank failures. I don’t want to get too deeply into the weeds here, but it’s really a Eurodollar crisis.

Eurodollars are dollar-denominated deposits held at foreign banks, and therefore outside the jurisdiction of the Fed and U.S. banking regulations. Although they’re called Eurodollars, the banks where they’re deposited can be anywhere in the world. It’s a global system.

The eurodollar market is actually one of the world’s major capital markets. They need a constant supply of depositors parking their money in foreign banks. These banks face a liquidity challenge if deposits drop.

What’s going on behind the curtain is a Eurodollar crisis caused by a shortage of Treasury bill collateral to support derivatives positions, and shrinking balance sheets as a consequence of the collateral shortage. Why doesn’t the Treasury just issue, say, $2 trillion of new T-bills and let the primary dealers and Fed underwrite them with as much printed money as needed?

One reason is that neither Jay Powell nor Janet Yellen understands what I just described. The other reason is that we’re up against the X-Date when the Treasury runs out of cash and can’t borrow more because of the debt ceiling. Is Congress ready to raise the debt ceiling?

Nope. It’s the usual Democrat versus Republican game of chicken with no resolution in sight. So we go from bank runs to a Eurodollar crisis to a Treasury bill shortage to a debt ceiling standoff in no time. Do regulators and financial journalists understand this? No, they don’t know how to connect the dots.

We can’t rely on regulators this time. We’re on our own.