Treasuries: "Risk Free" or "Risk Unlimited"?
The high-profile collapse of Silicon Valley Bank last week is a story about bad debt, just not in the way most people think.
Bank executives didn't issue too many loans to poor quality borrowers. They made what they believed to be conservative investments in the safest of all assets. The bad debt turned out to be U.S. Treasuries - an asset class they assumed to be "risk free."
This assumption was reinforced by regulatory requirements which artificially incentivize bankers to hold U.S. Treasuries as a tier one asset and bulletproof collateral.
Today they are questioning the conventional wisdom about the risks of holding U.S. debt. So are investors and finance executives everywhere.
Rising interest rates led to catastrophic losses in SVB's portfolio of Treasury debt and mortgage backed securities. The losses created a capital shortfall and spawned a good old fashioned bank run. Regulators stepped in and closed the bank Friday.
The trouble is that SVB is not alone. Virtually every bank in the western hemisphere is holding the same debt to a greater or lesser degree, for the same reasons. Until this moment, few outside the community of goldbugs really bothered to reassess whether Treasuries are still risk free.
What does the "full faith and credit of the United States" actually mean these days?
Government backing was a powerful guarantee when America was on the ascension. Unfortunately, somewhere along the line, Congress began perpetual deficit spending and Federal Reserve bankers went nuts, launching Zero Interest Rate Policy, monetizing Treasury debt and inventing other reckless monetary expansions.
The guarantee means a lot less now.
It isn't just banks getting a wakeup call. Insurance companies and pension funds are also stuffed with risky Treasury debt.
So are State reserve accounts, their so-called rainy-day funds. State laws nearly everywhere prevent officials from investing in alternative assets, such as physical bullion. The losses in these funds are now piling up.
For some financial institutions, like SVB, it is already too late to recover. Others still have the chance to adapt, but it will require them to abandon conventional thinking.
Investors must learn to operate in this era of declining confidence. Assets fit loosely into three risk categories when return of capital becomes more important than return on capital.
Some assets are pure paper – backed by nothing but confidence. This list includes U.S. Treasuries and the U.S. dollar.
The collapse of SVB is a byproduct of the artificial bull market in government debt fueled by central bank buying.
In a rising inflation and rising interest rate environment, not only can bonds underperform, they could become worthless if trust is lost.
Treasuries only recently broke downward out of a 40-year bull market, and the full faith and credit of the U.S. isn't worth much these days.]
The next category of assets are derivative instruments which offer some claim against an underlying asset. Stock options in publicly traded companies, ETFs, and futures contracts are examples.
The trouble with many of these paper assets is they also derive much of their value from confidence. Counterparty risk and leverage mean there may be nothing left backing the paper one holds if things go wrong.
Tangible assets owned directly, not in derivative form, carry no counterparty risk. They include real estate, precious metals, and other goods such as diamonds or fine art.
Real estate carries the potential for loss because central bankers have spent decades keeping mortgage rates artificially low, thereby blowing a bubble in prices.
No asset is "risk free." That is a marketing term coined by Wall Street bankers and bureaucrats to peddle debt backed by the "full faith and credit" of our now hopelessly insolvent Uncle Sam.
Today the closest an investor can get to risk free is an investment in tangible assets which offer zero risk of going to zero and no counterparty risk.
Interestingly, one of these assets – physical gold – was designated as a tier one asset alongside US Treasuries several years ago. Unfortunately, bankers and other finance executives took pretty much no action to diversify their balance sheets into gold.
Perhaps those who survive the carnage now begun by SVB's collapse will finally get around to buying some metal.