From: https://peruvianbull.substack.com/p/edging-armageddon

This past weekend, we were subject to another close shave with Treasury default. Speaker Kevin McCarthy and the Biden Administration were the newest contenders in a fight that is becoming all too common in our current fiscal landscape: the debt ceiling.

The debt ceiling, also known as the statutory debt limit, is a legal cap on the amount of debt the United States government can accumulate to finance its spending obligations. It is set by Congress, and any increase requires their approval. Essentially, the debt ceiling acts as a self-imposed limit to control the government’s borrowing capacity.

The current form of the debt ceiling took shape with the passage of the Second Liberty Bond Act in 1917, during World War I. This act established limits on the total amount of government debt that could be outstanding at any given time. It marked a significant shift in Congress’s approach, establishing a more fixed and permanent debt limit.

Over the years, several pieces of legislation have shaped the debt ceiling’s operation. The Public Debt Acts of 1939 and 1941 introduced the concept of a statutory debt limit, explicitly setting a dollar amount for government borrowing. The Graham-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act of 1985 attempted to link the debt ceiling with deficit reduction targets, imposing automatic spending cuts if those targets were not met.

The primary objective of the debt ceiling is to ensure that the government does not overspend or accumulate an unsustainable amount of debt. It serves as a “mechanism” to encourage fiscal responsibility and maintain the credibility of the United States.

However, this limit has long since lost any and all meaning. Per the Treasury’s own website–

“Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents.”

The ceiling has been raised by both parties, under virtually every President that has held the throne of power for the last 60 years.

Once a tool of financial restraint, it has been morphed into a political hot-potato- a game of political chicken where the parties use the impending doom of default to push through last minute spending and political priorities.

They’re using essentially nuclear brinkmanship to get things done.

The irresponsibility and shortsightedness of this cannot be overstated- as a true Treasury default would be catastrophic for the global financial system. I laid out so much in a Twitter thread on Friday, which I will lay out the basics here for review:

If the government hits the debt ceiling and Congress fails to raise it, the Treasury Department must resort to extraordinary measures to continue meeting its financial obligations. These measures include reallocating funds from various government accounts, suspending the issuance of certain types of debt, and implementing cash management techniques. However, these measures are temporary solutions and can only buy the government a limited amount of time before it runs out of funds.

In the case of the United States, this would mean the government not being able to pay interest or principal on its Treasury bonds, bills, and notes held by investors.

The first and most immediate consequence of a U.S. debt default would be a loss of confidence in American financial stability.

Treasury bonds have long been considered a safe haven investment, and a default would cause ripple effects in the many markets that use Treasuries as collateral- the repo markets, FX, swap, and money markets being just a few examples.

The value of the U.S. dollar would likely plummet as investors lose faith in its stability. This would lead to a decrease in the purchasing power of the currency, making imported goods more expensive and fueling inflation.

The EM crises that hit Thailand, Argentina and others would now come to roost in the States.

This is a serious problem because unlike other countries, the US does not have sufficient foreign exchange reserves as it is the world reserve currency.

Other countries have trillions of dollars in the vaults. We have $38B.

Interest rates would spike as investors demand higher returns to compensate for the increased risk associated with U.S. debt. This would affect borrowing costs for businesses and consumers, making it more expensive to obtain credit for investments, mortgages, and other loans.

This is occurring at record Federal debt levels- further pushing the US into a debt spiral.

Financial markets would experience significant turmoil. Stock markets could plummet as investor confidence wavers, leading to widespread panic selling.

Pension funds, mutual funds, and other investment vehicles heavily exposed to U.S. government debt would suffer substantial losses, similar to how the UK’s pensions blew up as their leveraged UK bond positions were all liquidated-

https://www.cnbc.com/2022/09/29/pension-fund-panic-led-to-bank-of-englands-emergency-intervention.html

The U.S. government would face challenges in raising funds to finance its operations. Without access to borrowing through Treasury securities, the government would need to rely solely on tax revenues and other limited sources of income. This could result in significant cuts to government programs and services- and government spending is a component of GDP.

We would see a collapse of GDP of several percent in just a month or two- reminiscent of the COVID shutdowns.

The global economy is intricately interconnected, and a default would disrupt markets worldwide, triggering a global financial crisis similar to the impact of the Lehman Brothers collapse in 2008.

Recall there is over $7T of Treasuries held by foreigners globally- if the US defaults, and it is not remedied immediately, then theoretically these sovereigns could begin dumping their huge Treasury debt positions on the market.

Credit rating agencies would likely downgrade the United States’ sovereign debt rating. This would further increase borrowing costs, making it even harder for the government and businesses to raise capital.

In fact, this is already beginning to happen-

https://www.cnn.com/2023/05/24/business/fitch-places-us-on-rating-watch-negative/index.html

The consequences of a U.S. debt default would also have long-lasting effects on the country’s reputation as a reliable borrower. It could take years, if not decades, to rebuild trust among investors and regain the status of a safe haven for global capital.

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Default is an unacceptable outcome, and barring an increase in the limit, the Treasury would resort to austerity measures to ensure coupon payments continue to flow out- however with deficit spending still raging, this means severe cuts to many government programs. Social Security, pensions, and veteran’s benefits would be first on the chopping block- but many more would follow in time.

Thus our worst case scenario of a “technical” default would be averted- but at what cost? Recall Treasury would have to issue new bills to pay off maturing ones, a scheme I have described eerily reminiscent of a Ponzi scheme…

And all of this at record high interest rates! The yield on the new bills would be 5.25%, pushing the Treasury deeper into a debt spiral in even the best case scenario. Their auction schedule for the next few weeks can be seen below:

However, we can all breathe a giant sigh of relief. A new debt limit deal was reached Saturday afternoon, and unsurprisingly to those of us who follow this monetary mayhem, it promises to do nothing but make the situation worse. Congress still has to pass this deal, of course.

Here are the key aspects of the deal, provided by the NYT:

• Complete suspension of debt limit for 2 years, until 2025
• New work requirements for certain recipients of food stamps and the Temporary Aid for Needy Families program.
• It would limit all discretionary spending to 1 percent growth in 2025
• accelerate the permitting of some energy projects- such as a  new natural gas pipeline from West Virginia to Virginia.
• The debt limit agreement would immediately rescind $1.38 billion from the I.R.S. and ultimately repurpose another $20 billion from the $80 billion it received through the Inflation Reduction Act.
• The proposed military spending budget would increase to $886 billion next year, which is in line with what Mr. Biden requested in his 2024 budget proposal, and rise to $895 billion in 2025.
• A New York Times analysis of the proposal suggests it would reduce federal spending by about $55 billion next year, compared with Congressional Budget Office forecasts, and by another $81 billion in 2025. (Drops in the bucket considering the trillions of dollars of spending the government disburses annually)

Perhaps most importantly, this section was pointed out by ZeroHedge:

Although Republicans had initially called for 10 years of spending caps, this legislation includes just 2 years of caps and then switches to spending targets that are not bound by law — essentially, just suggestions.

Essentially what this means, as one Twitter user pointed out, is a removal of the budgetary limits on most government spending programs. Historically how government agencies operate, is they are given a budget and allowed to spend an amount, up to a cap, for a fiscal year. If they run close to that limit, the next year they are given the same limit, and usually plus a few extra percent, to achieve their priorities through that next calendar year.

After 2025, there will be no limits- the agencies will spend HOWEVER much they deem they need. They’ll worry about the bill later.

This is the stuff of banana republics…

Can you smell that?

Time to get your printer ready, Jerome.

A new financial crisis is brewing. Last month, 4 major banks collapsed or were shut down, and this past weekend First Republic Bank was seized by the FDIC and sold in a fire sale to JP Morgan Chase. There is an accelerating withdrawal of money throughout the entire system.

The cracks are widening, and Strange Things are going on in the world of banking. The gravitational fields made by the Fed to avoid prior crises are now creating a new crisis. Anything will be done to paper up the disemboweled banks bleeding from the latest hiking cycle.

Welcome to the Singularity.

Silicon Valley Bank (SVB) was a commercial bank that provided financial services to technology and life science companies, as well as venture capital and private equity firms. Founded in 1983 in Santa Clara, California, the bank had expanded to serve clients in major innovation hubs across the world, including New York, Boston, London, and China. Silicon Valley Bank was known for its expertise in the technology and life science industries, providing tailored solutions to help companies and investors navigate complex financial landscapes.

To incentivize companies to stay with them, SVB would offer a range of financial products, and include bonus “gifts” such as free subscriptions to many of the essential SaaS services that startups need (Salesforce, for example.) More insidiously, however, the bank offered to help firms raise additional capital if they stayed with the bank, and kept this money in their account.

This is eerily reminiscent of Mafia rackets, where businesses were given incentives to keep a gang as their business partner in a money laundering scheme.

As a result of these policies, Silicon Valley Bank had a unique customer base- almost entirely high end VC, PE and startup clients who held millions of dollars in each deposit account.

Silicon Valley Bank, like any bank, is constrained by a variety of regulations that limit the types of investments it can make- loans and bonds, especially “Tier 1” HQLA (High-Quality Liquid Assets), would make up the majority of its balance sheet.

During 2021 and the first quarter of 2022, the Fed had been plowing $120B a month into the market via QE, and interest rates were suppressed near the zero bound. This created a massive influx of capital- deposits at SVB ballooned from $61bn at the end of 2019, to a peak of $174bn at the end of 2022.

With limited places to put these funds, SVB had poured them all into Treasuries and MBS in hopes of remaining compliant with federal regulations.

We can see their balance sheet below:

However, this would soon come back to haunt them.

While digging through their financials, I found something startling. Their assets were segregated into two different types: AFS and HTM. AFS stood for Available for Sale, these were assets that were liquid, marked to market (meaning that if there were losses, they would be counted as unrealized losses on the BS). HTM stood for Hold to Maturity- these were bonds and MBS that would be held until the maturity date of the instrument.

Strikingly, HTM securities were not hedged for interest rate risk and did NOT have to be marked to market. They assumed that the risk profile for these bonds was ZERO.

What was even more terrifying is I soon found out that this is an industry standard practice- SVB is not alone. Any bank chartered in the US, if it holds HTM securities, does not have to record an ECL (Expected Credit Losses) on them and thus will not hold any cash in reserve, or hedge against the security falling in value!

Here’s a further breakdown. They held billions in MBS, CMBS, and even variable-rate CMO- Collateralized Mortgage Obligations.

All that for a drop of blood. The average yield on all securities was a measly 1.56%.

They had plowed billions of dollars worth of deposits into these securities at ultra-low interest rates, and as the Fed began its hiking cycle, a vicious problem began to confront them.

Debt securities trade inverse to the interest rates on them- so the higher the Fed hiked, the more the market value fell. For a while, this was managed fine as they kept receiving deposit inflows.

However, late in 2022, some VCs began to get worried and warned their companies to begin pulling out of SVB.

The Fed’s hiking cycle caused billions of dollars in unrealized losses on their balance sheet, with around $22B coming from AFS securities- however, this was only part of the picture as HTM securities did not have to be marked down.

Like any bank, they are fractionally reserved- $14B of cash deposits and cash equivalents backed up $173B of deposit liabilities.

However, this figure is misleading as it includes other securities. When I looked closer, they only had $2.3B of actual cash on hand.

This process accelerated in January and February. They ran out to raise capital, but the markets smelled a corpse. The capital raise failed and on March 9th the stock collapsed 62%.

During the next 24 hours, 85% of SVB’s bank deposits were withdrawn or attempted to be withdrawn.

That’s the fastest bank run in history.

By the end of Friday, March 10th, they would be in FDIC receivership and the bank would be closed.

Within the month of March, Silvergate, Silicon Valley, Signature, and Credit Suisse would all collapse. First Republic would fall in late April, and PacWest now stands at the brink.

The problem that plagued these banks was a different beast than 2008- instead of making bad loans, they had made bad investments. The Fed had promised infinite liquidity without repercussions, and the risk management committees, bound by regulation, had followed the rest of the banking sector headlong into bonds when the prices were at their highest.

Now, with inflation still raging and the Fed stating they are “unfinished” with the hiking cycle, the banking sector has a massive gaping hole blown through it.

According to the chair of the Federal Deposit Insurance Corporation (FDIC), there were $620 billion of such unrealized (or paper) losses sitting on U.S. bank balance sheets in early March.

However, this does not account for all securities. More sober estimates put this figure closer to $1.7T dollars! (See here)

Banks as a whole have been using the HTM loophole to shift more and more securities into this designation, in order to avoid mark-to-market losses on their books. At the same time, they’ve reduced the amount of AFS securities.

HTM securities also are not allowed to be hedged.

Which means that none of these bonds have been hedged for interest rate risk. Even if they were allowed to do so- what would that change? The system as a whole would want to hedge the trillions of dollars of interest rate risk they carry, and who would take the other side of that trade?

If any firm did, they would face the same fate as AIG did during the 2008 Financial Crisis…

Silicon Valley then, is not unique. In a startling research paper entitled Monetary Tightening and U.S. Bank Fragility in 2023, the authors made several terrifying points:

They then continued:

“Marking the value of real estate loans, government bonds, and other securities results in significant declines in bank assets. … The median value of banks’ unrealized losses is around 9% after marking to market. The 5% of banks with the worst unrealized losses experience asset declines of about 20%. We note that these losses amount to a stunning 96% of the pre-tightening aggregate bank capitalization.”

There are 190 banks across the US, with $300B of deposits, that are at substantial risk of failure.

The entire banking system is at risk. At first, the deposit flight was simply out of the small commercials and into the bulge brackets, the large prime banks that are the “Too Big to Fail” institutions from the 2008 financial crisis.

But now, the deposit flight is widespread. Hundreds of billions of dollars of deposits are missing from the banking system, even the prime banks- where did they go? (See here)

One of the primary beneficiaries has been the shadow banks- the opaque financial institutions that can take on deposits and lend them out through the monetary plumbing that underlies the system.

Money Market Funds, for example, have seen $640B in inflows since the end of last year. In an ill-fated attempt to prevent collateral shortages in the shadow banking system, the Fed opened up the Reverse Repo window to allow MMFs and banks to park their cash overnight and hold Treasuries as collateral.

This was discussed in-depth in my DD on MMFs here: (Major Signals Flashing Code Red in the Shadow Banking System, RRP Hitting $1T is just the tip of the Iceberg) (August 4th, 2021).

The cash parked in the RRP window has held above $2T now for months, and the award rate (the interest rate paid on RRP cash deposited) has been steadily increasing, and stands at a record 4.8% as of writing.

The MMFs are therefore able to offer attractive rates, often in excess of 4%, while the banks are confined to near 0% interest on deposits.

This financial gravity created by the Fed’s RRP is sucking cash out of the banking system and into the shadow banks, at the same time that the traditional banks are bleeding from the hole blown through them via their bond portfolios.

Just the other week, Apple announced a new high-yield savings account, paying a shocking 4.15%, and this product is to be managed by Goldman Sachs.

This move has contributed to over $60B of outflows from big US financial groups such as Charles Schwab, State Street and M&T.

(See here)

Why hold deposits when you can plow funds into a shadow bank and hold positive yielding Treasuries instead?

The system is being drained. With Treasuries finally providing higher rates, at a “risk-free” yield, the Fed and Treasury combined have essentially created a massive money laundering scheme via the banks.

In a fractional reserve banking system, they only have a few percent of the deposits as the actual cash on hand- so it doesn’t take that much to push many of these firms over the edge.

The FDIC, the supposed savior of the system, is a dead man walking- the Deposit Insurance Fund (DIF) balance was $128.2 billion on December 31, 2022, up $2.8 billion from the end of the third quarter. The reserve ratio increased by one basis point to 1.27 percent as insured deposits increased 1.4 percent.

This fund exists to back up $19 TRILLION of deposit liabilities throughout the American financial system.

The worst part? The dominos will continue to fall as the gravitational pull rips more banks into pieces. Now, the failure of the latest firm, First Republic, has put the total failure amount (adjusted to inflation) HIGHER THAN 2008.

And that’s not even counting Silvergate or Credit Suisse!

As the fallout continues from the most disastrous Fed policy error in a century, only one question remains to be asked: Who will be left to hoover up the wreckage? Only the big boys like JP Morgan, who was announced this morning as the winning bidder for First Republic.

Desperate to prevent a widespread bank collapse like the 1930s, the Fed will heap increasing quantities of liquidity onto the system. The prime banks will swallow more and more assets, growing ever larger.

As the system moves beyond the event horizon, the money backing ALL liabilities will move to Infinity.

The Fed has created a singularity from which there is no escape.

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Thanks for reading!

You can follow me on Twitter here: https://twitter.com/peruvian_bull

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