The U.S. Banking System, Federal Reserve, & USDC Post-SVB Collapse with Ram Ahluwalia

bankless Nation we have a special state of the nation for you today gotta talk about the banking crisis that happened last weekend I think David this week we're in a whole new world a lot has changed we want to dissect what what happened and what's changed what this means moving forward and we brought on an adult in the room someone that understands the financial system in the banking system much better than you and I do or uh maybe than we ever will and also understands crypto what are we

getting into today David yeah the really the big question is are we in a new market did something change fundamentally this this throws me back all the way back into I think January of 2022 where I remember Jim Bianco tweeting out that we have entered a new paradigm and that was the rising interest rates of the Federal Reserve and I didn't really understand the significance of that phase change of markets yet Jim Bianco called it like a nail on the head all the way back then and so now I'm wondering and I now I

think the market is wondering is are we entering a new type of phase change in the in the market uh Bank stocks were down across the board yesterday crypto started responding in like a logical fashion which is uh like even though it's logical still new and different and so I think this is the big question that we really want to uh to really ask is what has changed uh is there a structural difference in the world of investing these days and uh David

um it's not just you and I in this episode who do we have on to tell us that story yeah we're bringing on RAM alawalia who's the CEO of lumita wealth management we will introduce ROM shortly in a little bit but we uh were I asked Matt Walsh or friends over at Castle Island Adventures podcast uh who should we bring on and so um Matt uh suggested round uh and so Rahm actually had a Twitter space this last weekend during the middle of this confusion that was very insightful for me and put a lot of perspective into my brain so uh shortly

we will be bringing ROM on here in a second guys uh before we get in I want to tell you about our friends and sponsors uh rhino-fy embrace the inner Rhino all right this is a D5 platform so none of this behind what I'm showing you on the dashboard here none of this is custodial this is an overlay on top of decentralized protocols David tell them what Rhino Phi is up to and uh how folks can get started with this really cool application well while we have Trad banking totally breaking down we have

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multi-train Vision so there's a link in the show notes to get started you can also go to app.rino.fi to start working in the bankless world of banking because sooner or later it sounds like we all might need it these days if that's why we're all here isn't it to go bankless this is a way to do that go check that out uh Rhino dot Phi David what should folks get out of this episode what should they pay attention to as ROM speaks today yeah so there's a bunch of big over overarching headlines and I think we're going to try and touch on one by one by one one is Bank runs in the internet age

uh is that the new Arena that we have stepped into uh was silver uh was Silicon Valley Bank a special case and in what ways was it was it not a special case uh Signature Bank why was it targeted what is the impact on crypto uh how is this changing the landscape of banking all together uh yields are down fear is up is that a temporary blip or is that a complete and utter phase change in the market I think these are all very big important questions and the answers to these things are really going

to determine what the world of investing is like going forward as always guys we are learning as we go we are on the journey with you okay and if this is a face chain we need to know change because we need to know about it uh we start every episode this is front running the opportunity so what is the next opportunity we need to front run and what do we need to watch out for that's what we'll get into right after we hear from the Fantastic six sponsors that made this episode possible including Kraken our number one exchange for 2023 Guys these folks have been with

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self-professed Elder Millennial uh I subscribe to that that title as well uh ROM we got to keep the younger Millennials in line from time to time as you know you don't mean me yeah not at all but it's great to have you on ROM thank you for joining us uh can you help us make sense of what just happened in the past five days happy to lay it out and thanks for having me long time bankless premium subscriber big fan of the work that you do week in and week out uh so let's take a step back what we've seen is the

demise of Internet banks these are Banks born of the internet and destroyed by the internet through social media the speed information contact in digital withdrawals so those Banks started with of course silvergate Silicon Valley Bank which were highly indexed to technology in the crypto sector and of course Signature Bank so three banks in one week that are either in liquidation or an FDIC receivership and to put in context at the last time we had a major

bank run it was in 2008 and it was in the UK it was it was a northern Rock Bank they had lines around the block physical lines and in today's world you have digital Bank runs that are enabled by better ux where you can put away transfer online and the fragility that the public has confidence in their Bank can help to accelerate these Bank runs I'll pause there so ROM you're saying that this is maybe the world's first uh large example

of a digital Bank Run that's that's how you see the events of the past you know five days to week or so that's correct it's these are digital wire transfers now there's some other special circumstances around this so the three Banks were primarily commercial Banks as opposed to retail Banks and that matters for a few reasons one is as you know the FDIC Insurance cap is up to 250 000 and Commercial deposits from a crypto Venture fund a hedge fund a protocol VC

Etc as well and excess of that so there's a higher propensity for depositors and Commercial depositors to panic if they believe their bank is not going to be safe and sound and ROM commercial just means uh not retail more business focused so larger account Holdings in general usually above 250k because they're trying to meet payroll that sort of class exactly right big user business startups uh Venture funds hedge funds exactly and part of the crazy story that we're going to be

talking about is the multivariate nature of it there's like interest rates there's uh Elizabeth Warren to talk about there's all these things but I would I really want to just carve out and Silo off this this topic of Commerce station of internet banking in the age of the internet era and social media right just the the connections that I'm been seeing uh being made here is that the pipes for ins and for fitting a bank run through are larger than they've ever been before as well as the virality of

social media is larger than it's ever been before so forget crypto forget inflation forget interest rates forget uh political targeted sectors of of banking we are simply just talking about the modern day technology of banking is probably the most susceptible to a bank run that they've ever been before ever just by a nature of that's what happens when technology progresses that's like one big pin in the story correct ROM you nailed it these are Banks born from the internet they were destroyed by the internet and Banks rely on public

confidence in the United States and across the world we have a fractional Reserve banking system no Bank can survive a full-fledged Bank Run uh By Design By Design banks are one of the few entities that deliberately engage in borrowing short lending long and have the backing of a centralized Authority in this case the FDIC and the federal reserve banks are doing liquidity credit and duration transformation it's a kind of a financial Alchemy and you've talked about aspects of this in your prior

podcast around money in the history of money and all the rest but maybe I can just walk through a quick contrast of what banks do and then I'll that'll tease up the kind of the multivariate issues that you laid out David so let me contrast a Securities brokerage account from a bank account when you have a brokerage account let's say Charles Schwab and let's say you own some stock Tesla Apple etc those Securities are custodied by Schwab or maybe bny Mellon the dtcc uh and they're not in general being lent

out in fact you can have those Securities delivered to you to your door if you want on the other hand when you make a deposit a bank the bank reports to you that you've got say a ten thousand dollar cash deposit now the reality is Banks and these custodians are very different banks behind the scenes are re-hypothecating what that means is they're taking your deposits and of course they're lending out uh and what the banks are doing is they're giving you instant liquidity you have a demand deposit you've actually made a loan to the bank that's a Perpetual loan

that's priced that par and has the perception of no credit risk and a zero-day duration loan but on the back end what is the bank doing the bank is making longer d-rated loans those loans are illiquid and therefore the banks are engaged in this kind of like a financial Alchemy of liquidity transformation maturity transformation meaning longer term loans and credit risk transformation you have the perception of no credit risk but in fact they are taking on some risk and

the way this financial Alchemy or this kind of magic works is you need two things you need to prevent Bank runs and the way we do the United States is FDIC Deposit Insurance and we learned this from the Great Depression when there were a number of Bank runs that caused the Great Depression if you can stop a bank run by guaranteeing deposits then the magic show can go on and the second thing you need is a central bank like the Federal Reserve that can provide liquidity to the asset side of the

bank's balance sheet if you have those two things then the banking system should work and I'll say one other comment what you saw in crypto the last two years was non-banks pretending to be Banks if you want to explain the failure avoid your Celsius block fine Genesis what were they doing they were taking short-term deposits they were lending long it's great to be a bank but it doesn't work if you get a bank run so for example Genesis couldn't sell their illiquid Assets in time they also also got caught up in this after this duration mismatch

so with all this solvencies that insolvencies whether inside in crypto or now that we're seeing them outside of in crypto you're saying it's the same underlying pattern through and through so the insolvencies of of Celsius you can solve regardless of the mismanagement of Celsius uh the insolvencies of Celsius genetics Etc all the crypto firms that have already happened now we've seen them in three Banks but you're saying the underlying structure is still the same there's people that had instant obligations while they were also taking uh long-term

uh stances in the market yeah so when non-banks pretend like Banks watch out because when the cycle turns and the liquidity leaves the system you're going to see who's naked now obviously there was fraud in the case of Celsius and other actors as well can I ask a question clarifying question about this uh ROM so all right so fractional Reserve means if everyone tries to withdraw their funds at the same time it breaks down because there are assets there that have kind of longer maturities and kind of the money's not there because it's being and that's how

banking business model works I got it and that's true whether you're Celsius or whether you're a Silicon Valley Bank understood all right but can you tell us about the assets that these banks are actually investing in because it's got to be different than Celsius and it's got to be different than blockfi right so in the case of a Celsius or a block fi they're investing in this these highly volatile crypto assets I hate to call them risky in some cases they're very risky but like definitely volatile right they could lose 80 percent at the snap of your

fingers you never know yes I gotta assume a Silicon Valley Bank is not going and buying like D5 tokens and you know going levered long they have to have much less risky uh Investments here that are like similar to Dollars much more similar dollars to Dollars than um volatile crypto asset can you tell us about that side because that does seem like it's different it should be different in the U.S banking system versus a Celsius or a blockfire voyager that's absolutely right so let me talk about what banks generally loan to or

invest in and then svb because svb is a very unique animal so Community Banks and they're about four thousand plus of them generally loan against commercial real estate and that could also be financing commercial industrial loans or construction loans uh and that's the bulk of loans for Community Bank now you have these Mega Center Banks and these other Regional banks that also offer credit cards so they take those deposits and they finance credit cards or auto loans uh historically in the past

student loans and banks will also Finance mortgages now generally banks will make a mortgage and then sell it to Fannie Mae and Freddie Mac but to the extent that for example First Republic makes mortgages that Fannie and Freddie will not buy and they'll just fund that with their deposits so that's what they do and in general you'll notice that banks finance real assets that have cash flow if you're financing a mortgage you've got a collateral it's called a house if you're financing an auto loan you've got collateral it's called a car citizens finances Apple sale cell phones

and if you're financing a student loan there's human capital behind it generating cash flow so banks are conservative in fact the average return on an asset for a bank is around two percent Silicon Valley Bank's a bit different Silicon Valley Bank not only had primarily commercial depositors and 90 of those deposits were uninsured because of that concentration they also did Venture debt uninsured Sorry Wrong by fdicate because they're above the 250k limit you got it exactly FDIC uninsured and they had two types of lending

programs and a venture debt financing and they also provided credit facilities to VC funds I'll explain that briefly so in Venture debt let's say you do a series a round and you need some additional account but you want to do a quick Bridge Silicon Valley Bank could underwrite you and give you a loan they might take some warrants for that and Silicon Valley Bank gives you cash flow and you pay back Silicon Valley Bank in the next round it's a very unique business Silicon Valley Bank does no

other major Bank does that much less a community bank the other bank the other product they had of course is financing Venture firms so for example a venture firm might have a hot deal it takes three weeks to do a capital call they want to provide an investment now so they'll borrow from Silicon Valley Bank that's called their credit facility and so we're starting to what sounds like mix the world of banking with the world of venture uh and and just normal Financial Services apply to these

various different Venture firms but uh just at a high level like spinal reflex response Banking and Venture seems to go hand in hand a little bit less just by in nature of the risk that the Venture industry does have is that is that a fair intuition ROM banks have an important role to provide bank accounts and enable payments uh to businesses I mean banks are in the business of payments lending and custody that's what a bank is uh so you know making Venture debt loans

like the jury's out there's a reason other Banks don't do that and Silicon Valley Bank hadn't had an edge in that business and that edge was the implicit backing of silk Silicon Valley to refinance or have a new Equity around so that they wouldn't actually have losses this is one of the reasons I believe that you haven't seen a major Bank acquire Silicon Valley Bank because if that Venture debt portfolio 70 billion dollars and they're going to experience defaults as we go through a cycle uh then they don't want to be stuck holding

the bag right so Silicon Valley Bank specifically engaged in Banking and Financial Services for a particular industry because it had Edge as you said that made that activity probably less risky than other Banks but other banks are still won't touch it just because it's new and novel and potentially more risky because they don't have that edge is that a fair summary it's risky right so so what Silicon Valley Bank was doing was making loans to unprofit tech companies that's what it is so when you're taking a loan is a you're taking credit risk you expect to get paid back

more than the equity shareholder if you take a make a loan to a profitable company arguably you're actually taking Equity risk and now we're you know we had 14 years of QE we had valuations we had easy money it was easy to refinance and the risks was low uh and it was a great growth engine for Silicon Valley Bank but of course in addition to that Silicon Valley Bank had egregious uh Investments they did with long duration treasuries we can get into that which led to their demise okay so they have a

different portfolio of assets that are protecting the deposits in uh Silicon Valley Bank than almost any other bank and those are skewed towards like credits towards these kind of startups and VC firms I'm wondering ROM if you could kind of explain this uh to us so this is a tweet you said one of these Banks is not like the other and then you're showing this chart um of impact of unrealized Securities losses on Capital ratio and apologies for the podcast listener but there's a visual here that if you want to catch

that you gotta tune into YouTube for this particular part but what we're seeing here is sivb which Silicon Valley Bank I imagine it's like kind of a an outlier dot you see all by a little bit it's a lot by a lot you see all of the other Banks and they're kind of like you know up to the I guess uh six to fourteen percent range you know the trend line looks like it's between like eight and and uh 13 or something like this and then you have this outlier bank so what is this chart showing us so what

this is saying is that silvergate effectively had no equity well this is silver yet this is Silicon Valley Bank okay this is Silicon Valley correct so what so banks by law are required to hold Capital right what so what is a bank A bank's got about 10 on average of what's called tier one Capital that's the equity of the bank and then 90 of the balance sheet is financing primarily from depositors and in general those depositors are insured by the FDIC so you can see why government actually has

a key risk on Banks and they supervise Banks so we talked about the lending side of Silicon Valley Bank those are those E-liquid loans but Silicon Valley Bank and other Banks also have a Securities portfolio and by regulation these Securities portfolio consist of what's called hqla high quality liquid assets those are generally treasuries and mortgages so what this is saying is that if you mark to market the treasuries and mortgages on the balance sheet for Silicon Valley Bank that Silicon Valley

Bank has zero equity ah what how so how is that possible that's because the mark to Market of the Securities that they purchased is just a lot lower than the VA the par value of them what versus the purchase price of the of the bond right so in uh in q421 now this is Peak crypto this is Peak Venture funding record funds raised Silicon Valley Bank had record inflows

of deposits the or like tens of billions of dollars record inflows and in a short interval of time what they did is they bought the longest duration treasury bonds and duration is when you expect the average time you expect to receive a cash flow so the longer the duration the more interest rate risk you have so this is before the FED started raising rates although the Fed was talking about raising rates then and inflation was going up so this is what that seems dumb because they were

essentially betting that the FED wouldn't raise rates I don't know that they were conscious it was it's in my view it's a great it was grossly negligent they took tens of billions of deposits and they bought long duration treasuries now what happened last year of course we saw 60 40 didn't work right the stock impossible to work well the 40 is bonds those Bonds were down 20 percent and here's what happens so here's one way to think about a bank that people don't appreciate I mentioned earlier if you look at the bank's Capital stock meaning the bank is financing assets

with the mix of liabilities deposits and Equity that Equity components about 10 it borrows 90 through deposits that means on average your bank has 10 turns of Leverage a bank is borrowing short they're lending long they're 10 turns 11. so now your securities portfolio goes down 20 percent imagine you've got 50 billion dollars in securities and now that 50 billion employer is worth 45 billion dollars you've lost 5 billion but now you got 10 turns of Leverage

that is why you have this unrealized loss in the Securities portfolio by the way this was known by Regulators regulars have talked about the issues in the HTM portfolio for some time in fact the Federal Reserve has about 1.5 trillion dollar unrealized uh hold to maturity loss the difference is that the Federal Reserve can hold to maturity and The Regulators hope that these other Banks can hold to maturity in which case they'll actually make money on the bond and I just want to clarify for for people who you said um bonds fell 20 in

2022. bonds aren't supposed to fall 20 right that's right unexpected I mean for the crypto listener to be like just 20 and that sounds fantastic sign me up but that this is supposed to be a less of a foundation of the entire Global Financial yeah it's an important asset to not fall and it was obviously a core asset that a Silicon Valley Bank was was betting would not fall by anything close to 20 you nailed it so so bonds prices drop when rates go up they're the same

thing right so we had 14 years of ultra low interest rates we had the Federal Reserve by about nine trillion dollars in treasures and mortgage-backed securities 25 trillion dollars in quantitative easing globally other central banks in fact had negative interest rates think about the banks that bought those negative yielding bonds and holding maturity for a loss so that's the backdrop and then we saw inflation uh increase of course that was partially driven by two trillion dollars in covet stimulus which is multiples of

what we've ever seen in any other recovery package so get inflation and now rates are going up at the fastest rate since 1981 and there is a new regime and that regime is called higher wheel rates which is what as you mentioned Jim Bianco has talked about yeah so we we often talk about this idea of going uh further out on the risk curve and that's actually a really easy thing to um visualize when we talk about bonds and bonds yields and what you said the longest term maturity Bond uh bond

yields I can't remember the actual specific name of the correct asset but just like they are buying the longest dated bonds possible the svb is Silicon Valley Bank is because that's where they get the most return in interest rates but they also take what you said is the highest interest rate risk because they are so far out on the risk curve but that's what you must do in an era of zero interest rates in order to have any margins whatsoever and so one part of this equation is like I think everyone agrees Silicon Valley Bank totally

mismanaged their risk and also we also had the fastest interest rate hikes in history or in in my lifetime and so these two things have collided and and so that's really what I think we're seeing here on this chart and ROM I want to check my understanding of this chart we we're seeing two different lines here one is a line of blue dots and one is a line of yellow dots that are scattered and below the blue the blue line and the blue line is is titled common Equity tier one Capital ratio I don't really know what that means my gut is that this

is what it would have been like if the interest rates hadn't been going to Infinity really really quickly to be hyperbolic and so all of these Bank all of the yellow dots all the bank the banks individual Banks you see JP Morgan there UC Bank of America et cetera you also see a silver God Silicon Valley Bank at the very very bottom the gap between these two lines am I correcting my understanding that that is the interest rate hikes like that and and so people who are further down falling down are people that have taken further risk

than other banks that haven't taken as much risk am I interpreting this track that's exactly right you nailed it cool okay so again so so now we now we've pinned I want to re like go through other conversations so far uh Mobile Banking and and time to uh withdraw is the fastest it's ever been finances moving fast it's ever been so Bank runs are more susceptible regardless of conditions then we have this one Bank Silicon Valley Bank that uh serviced a higher risk end of the Spectrum in terms of financial services which was the Venture world and then

also it happened to just take more risk itself being inside of that milieu that it was and that also interest rates got got jacked up faster than it's ever been before so these are the these are the big parts of this multivariate story I don't think we're done yet uh ROM where should we go from here well let's zoom out for a moment what you're seeing is the unwind of carry trades let me Define what a carry trade is so a carry trade is when you borrow short in a currency it used to be the Japanese Yen low

interest rate of Comedy economy and then you make a loan in a higher interest rate economy and you capture that spread and that hedge fund strategy works so long as the policy rate environment is stable so in this period of ultra low interest rates all sorts of carry trades were created one of them was the grayscale Bitcoin trust trade which you guys have talked about in your short show another is in the convenience your brokerage account you could have borrowed and bought Muni bonds you could have levered Muni bonds and get a nice equity-like return

and that's also taken place across these non-banks that have had issues and that's what's happening now so think about silvergate for example silvergate in a way is a character it's not a critique of the business model they're responding to incentives they paid out zero percent to their depositors and they're earning that spread and that game works in a zero interest rate world but what happens is when you raise rates and you have an inverted yield curve the incentives change so remember we talked about before what banks are doing is