Welcome to the Global Financial Crisis of 2023 (Part Four)

The financial contagion that began with the failure of SVB was never going to be contained to the US. Just as the meltdown virus had jumped from the crypto world to mainstream banking with the failure of Silvergate Bank, the meltdown quickly spread from the US to the international banking system.

The first major overseas victim (but not the last) was Credit Suisse. This bank was founded in 1856 and was one of the two biggest banks in Switzerland (along with UBS).

After long struggles with loan losses, customer frauds, and poor risk management, Credit Suisse received a bridge loan of 50 billion Swiss francs (about US$54 billion) from the Swiss National Bank (SNB) on 16 March 2023 to provide liquidity while other measures were considered.

Finally, on Sunday 19 March, SNB announced a shotgun wedding between UBS and Credit Suisse. UBS acquired Credit Suisse for only 1% of its peak share price. Shareholders of Credit Suisse were largely wiped out but did receive a US$3 billion sliver of proceeds from UBS.

The financial damage of the Credit Suisse failure ran far deeper than stockholder losses, which, after all, are expected in a failure of this type. A certain kind of bank capital called AT1 was also wiped out. These consisted largely of so-called ‘CoCo’ bonds, short for contingent convertible.

CoCos do get bailed in

CoCo bonds are high-yield debt that is automatically converted into equity when a bank is in distress. That might be an acceptable outcome when the bank survives. But when the bank fails, the CoCos get wiped out along with the rest of the equity.

CoCo bondholders in Credit Suisse lost US$17 billion, but mark-to-market losses in the larger world of AT1 credits were more than US$275 billion as investors lost confidence in the entire asset class.

The biggest losers in the Credit Suisse CoCo wipeout were PIMCO (US$870 million) and Invesco (US$370 billion). Losses on the Credit Suisse CoCos were a hybrid of a bail-in approach (because taxpayer money was not involved) and a bailout approach (because shareholders were not wiped out completely before the CoCos were crushed).

This mixed bail-in/bailout result just adds to the confusion about what happens when the next bank fails. The ripple effects of the huge losses and uncertain outcomes are still spreading through the international banking system.

The crypto connection

SVB is itself the victim of financial contagion in addition to being the source of more contagion. SVB can be thought of as the result of an ongoing contagion from Silvergate Bank. Of course, these matters are complex, but here’s a high-level perspective…

This meltdown arguably began with Bitcoin [BTC] in November 2021 when it proceeded to crash by 70% by November 2022. That caused what crypto cultists called the Crypto Winter, and it triggered a cascade of failures in crypto land. These failures included Three Arrows (a crypto hedge fund), Genesis (a crypto exchange and custodian), FTX (another crypto exchange and custodian), and Alameda (a crypto hedge fund associated with FTX).

As these failures cascaded, the issue I weighed was whether the crypto contagion would spill over into mainstream banking. If the financial virus remained in crypto land, it could cause a lot of damage but not a full-scale financial panic. If the virus spreads into mainstream financial channels, things could get a lot worse.

On 8 March, we got the answer to that question. Silvergate Bank announced it was filing for bankruptcy protection. Silvergate Bank was the bridge that carried the virus from crypto land to the mainstream banks. Silvergate Bank was a mainstream bank with FDIC insurance and bank regulation. But it was also knee-deep in crypto transactions, including crypto loans and funds on deposit with failing crypto exchanges.

Silvergate Bank closed its doors and announced an ‘orderly liquidation’. Now the crypto contagion had spread to conventional banking. SVB was Silvergate Bank’s first victim in the mainstream banking system.

Even worse is that the so-called crypto ‘stablecoin’ kept large cash balances in SVB. Those balances were seen to be at risk, so the stablecoins started melting down.

Unstablecoins

A stablecoin is a cryptocurrency that claims to maintain a constant value of US$1 per coin. The sponsors do this by taking proceeds from buyers, issuing the coins, and investing the proceeds in bank deposits, US Treasury bills, or other high-quality cash equivalents. The two most popular stablecoins are Tether and USDC.

Stablecoins are a US$200 billion market and the backbone of the entire crypto world. About 70% of bitcoin purchasers buy Tether first and then buy bitcoin with Tether. If bitcoin holders want to bail out, they have to sell Tether for bitcoin and then redeem the bitcoin. The bitcoin crash becomes a Tether crash. That’s contagion in action.

The difficulties begin with the fact that stablecoin issuers have never been transparent about where they actually invest their dollar sales proceeds. There have been no audited financial statements or detailed disclosures.

One partial disclosure from Tether showed that almost half of the dollar assets were in ‘commercial paper’ (an unsecured corporate IOU) with no detail about the name or quality of the commercial paper issuer. This leaves open the possibility that the issuer could be affiliated with the sponsor or even that billions of dollars of funds may have been improperly diverted.

Now those stablecoin concerns have become more acute. USDC had more than US$3 billion of its cash reserves on deposit with SVB. That money was at risk. By Saturday, 11 May, USDC was trading around 85 US cents. That’s an extreme meltdown considering the token is promised to always be worth US$1.

The potential is not only that these stablecoins meltdown, but that they take bitcoin with it because of a mad dash for the exit to dollar liquidity. Exchanges, hedge funds, and crypto banks will fail alongside the coins themselves.

There has not been a bank failure of the magnitude of SVB since 2008. There has never been a crypto-crisis side-by-side with a banking crisis. Regulators don’t know what they’re doing. They’re fighting the last war about depositor bailouts without realising they are actually fighting a new war of tech-firm failures and crypto-panic.

Regards,

Jim Rickards,
Strategist, The Daily Reckoning Australia