Steve Eisman's Masterclass on the 2008 Financial Crisis (Part Two) | The Real Eisman Playbook Ep 39

Hi, Steve Eisman here. On my weekly wrap, I try to both teach and convey information as objectively as possible. I try to make clear what are the facts and what are my opinions. But... In today's media, it's increasingly hard to figure out what are the facts and where the facts are being shaded by opinion. That's why when I look into news events, I first go to ground news.

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There, I immediately saw four tabs, left, center, right, and bias comparison. When I clicked on the center tab, a series of headlines appeared, all from center-leaning sources. I could then click on any of those headlines. and read the story at the source. The same happened when I clicked on the left tab and on the right tab. The bias comparison tab showed Ground News' own analysis of how all

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Wall Street was buried in subprime paper. This was true throughout the industry. The crisis was not just a US event, but global. It brought the global financial system to its knees. The balance sheets of systemically large and important financial institutions became tied together in a web of credit default swaps that was so complicated that no one knew where it started.

and where it ended. And that's why the financial crisis was baked. It was inevitable. And if one large firm went under, the whole system could go under. The only people who were clueless were the executives of Wall Street firms and the federal government.

From a pure justice point of view, every one of those firms should have gone under. But that would have caused a global depression. In my opinion, this was the largest fraud in human history. And the story I just told is no secret. It's a lot. So let's get started.

Hi, this is Steve Eisman, and welcome to another edition of The Real Eisman Playbook. Welcome back to my lecture on the financial crisis. In part one, I discussed the first two of the four causes of the financial crisis. Too much leverage. and a large asset class subprime mortgages that blew up. I ended part one by saying that by the summer of 2007, subprime lending came to a screeching halt because credit data was becoming so horrendous. And I said,

that all this happened by late summer 2007, which meant that the financial crisis was already inevitable. Why? Because of cause number three, which is... Systemically important financial institutions own subprime securitizations in size. Wall Street people are highly educated, and they are also very well paid. And in the 2000s, they were extremely well paid.

The securitization gravy train created massive profits and everyone involved got huge bonuses. And combined with the increasing leverage that I discussed earlier in the first lecture, everyone got paid a lot, especially senior management. Wall Streeters got very arrogant. How could they not? They were getting paid tens of millions of dollars a year. Arrogance breeds stupidity, or as I like to say, incentives trump ethics every time.

I remember having meetings with the heads of securitization departments. I would ask them how they could participate in making these horribly unethical loans. And their response was always, hey, it's legal. When my partners and I would point out... that credit underwriting standards had deteriorated so that eventually these securities would blow up and cause losses to investors, the investors that they had sold these securities to. Their response was, sure.

That's going to happen. And when it does, we will buy back the securitizations from the investors for pennies. After these meetings, I felt like I needed to take a shower. Ironically, those predictions did not happen. Quite the reverse. Here's why. By 2006, the subprime mortgage sector was originating $600 billion annually, and that produced an insane amount of securitizations and CDOs.

Turned out that at that level, it became harder to sell all of those securities to investors. Now, if sanity had prevailed, Wall Street would have realized that there were just too much volume. Maybe they would have told the subprime lenders to tighten underwriting standards so that less volume would be produced. But no, since everyone was compensated on volume, nobody had any incentive to make that decision. The party had to go on.

Since there were not enough investors to sell the product to, the securitization departments convinced their own firms to buy or keep the excess paper on the firm's own balance sheet. After all... How bad could it be? It was rated AAA. Famous last words. So Wall Street was buried in subprime paper, meaning they owned it too. This was true throughout the industry.

Every large investment bank and bank owned way too much. And that's why, by the end of the summer of 2007, the financial crisis was baked. It was inevitable. The only people who were clueless were the executives of Wall Street firms.

and the federal government. And now we turn to cause for derivatives. In almost every financial crisis in history, large financial institutions had too much leverage. A big asset class blew up. and important financial institutions owned the asset class. As we've just seen, the great financial crisis of 2008, the GFC, had those three elements. The only unique aspect of the GFC was derivatives.

And in this case, the unique aspect was credit default swaps, a.k.a. CDS. Now, CDS was invented by JP Morgan sometime in the 90s. It was designed to reduce risk. And it does that. For the investor that owns the CDS, it reduces risk. But systemically, it became a form of massive systemic self-destruction. This requires a bit of a convoluted explanation. Let's say I'm a pension fund.

And I own $1 billion of newly issued five-year GE bonds that pay 6%. And say I buy it at par. That means that the most I can make is 6% per year for five years. And at the end of those five years, GE pays me back my principal amount of $1 billion. However, in the unlikely catastrophic event that GE goes bankrupt, statistics show that in a bankruptcy... my unsecured bond will receive very little. So my upside is only 6% per year for five years, but my downside is enormous. If possible.

I would like to buy some insurance against this potential catastrophe. And that's what a credit default swap is all about. So how does it work? I call Goldman Sachs and I say, I'd like to buy a CDS from you. whose principal amount is $1 billion. How much will that cost me? Since GE is a strong company, the risk of a bankruptcy is quite low. So maybe Goldman says 50 basis points, or half of 1%.

And I agree to the terms. What then happens is that every year GE pays me 6% on $1 billion. And I pay 50 basis points or half of 1% on $1 billion to Goldman. And I sleep at night. Why? Because if GE goes bankrupt, Goldman will pay me $1 billion. In the example I just gave, the pension fund is buying catastrophic insurance risk on a security that it owns.

In that case, GE bonds. But you don't need to own the security to buy insurance on it. If you want, you could just buy the GE CDS from Goldman and not own the GE bonds. In that case, you are betting that maybe GE will go bankrupt. Wall Street sold CDS on corporate bonds and on many other things like subprime mortgage securitizations. That's what I did. Anyway, so if CDS reduces risk for the investor,

had it become a weapon of mass destruction for the financial system. Note, in our GE example, Goldman pays me $1 billion if GE goes bankrupt. Of course, if Goldman goes bankrupt at the same time as GE, I don't get paid. Now, I'm actually simplifying this whole story. It's actually more intricate, but the basic points remain. Now realize...

That while investors used CDS like me, most CDS transactions were between financial institutions, like between AIG and Goldman, or between Bank of America and Morgan Stanley. So increase our one example of a billion CDS. to trillions, and you realize that the balance sheets of systemically large and important financial institutions became tied together in a web.

of credit default swaps that was so complicated that no one knew where it started and where it ended. And if one large firm went under, the whole system could go under. So those are the four causes of the crisis. Too much leverage. A large asset class of prime mortgages blew up. Systemically important financial institutions owned the asset class in size in the tens of billions, and derivatives tied the balance sheets of large firms in a complex, intricate web.

Now let's turn to how the GFC unfolded and what happened afterwards. If you want to read a very detailed account, Andrew Sorkin's Too Big to Fail is probably the best version of what happened. I'll just give a brief summary. By August 2007, subprime credit quality had deteriorated so much that investors no longer would buy subprime securitizations. At that point...

the financial crisis was baked because large firms owned the asset class in size. What followed was inevitable. It just took time for everyone to realize it. In the fall of 2007, the first sign of trouble occurred. when Morgan Stanley announced that an internal hedge fund with capital solely for Morgan Stanley had blown up and cost the firm billions because it bet the wrong way on subprime securities.

Financial stocks swooned for a while, but then began to recover. By the way, the total write-off by Morgan Stanley in 2007 was over $10 billion. That write-off was just a harbinger of what was going to happen. Things were quiet until March 2008. The stock prices of all financial companies had been under pressure as investors began to sniff that problems were looming. The weakest of the large investment banks was Bear Stearns.

Subprime securitizations have been a large part of its business for years, and on Friday, March 14, 2008, Bear Stearns announced that it was receiving an emergency loan from J.P. Morgan because no one else would buy its short-term debt. And the stock collapsed. That event is portrayed nicely in the movie The Big Short, where Steve Carell gives a moving speech about fraud at a conference hosted by Deutsche Bank. And yes, that actually happened.

I did make a speech at that conference while Bear Stearns was imploding. What's not in the movie is that the next speaker was Alan Greenspan, the former head of the Fed, and he spoke largely to an empty room because people were freaking out and ran from the room after my speech.

I had that impact on people back then. That weekend, Secretary of the Treasury Hank Paulson, the former CEO of Goldman Sachs, tried to save Bear Stearns. He managed to get JP Morgan to buy Bear Stearns for $2 per share. But... To get the deal done, he had to have the federal government indemnify JP Morgan against all losses from Bear Stearns. When that announcement was made Sunday night, the market breathed a sigh of relief. However...

Secretary Paulson received a lot of political criticism for bailing out Wall Street. And in response, he promised that he would never bail out a Wall Street firm ever again. And that promise would come back to haunt him. Many things happened between March and September.

More and more investors realized that the financial system was at risk. And on September 7, 2008, the federal government took over Fannie Mae and Freddie Mac. But the real crisis unfolded a week later, when the second weakest firm after Bear Stearns, Lehman, got into trouble. No one wanted to buy its short-term debt, and that is death for a financial institution. So on the weekend of September 13th, Secretary Paulson tried to find a buyer for Lehman. Barclays said they would do it.

But they wanted the same sweetheart deal that J.P. Morgan got for buying Bear Stearns. Secretary Paulson refused because he had made that promise. So Lehman went under on Sunday, September 14, 2008. That same weekend, the government facilitated a merger between Bank of America and Merrill Lynch. Things stabilized for two days.

But on Tuesday night, September 16th, it was reported that AIG, the largest insurance company in the world, was also in trouble. AIG had sold about $80 billion of credit default swaps on all kinds of subprime paper. As the price of subprime paper kept eroding, AIG might have to pay the buyers of the CDS. And with the world imploding, everyone started to worry that AIG would be unable to pay and would become insolvent. Once again, the federal government stepped in.

But this time, Secretary Paulson bailed out AIG by essentially taking it over. He felt like he had no choice because financial institutions all over the world had CDS transactions with AIG. He worried that if AIG fell... It would have a domino effect. AIG really was too big to fail. At this point, Secretary Paulson realized that the entire global financial system was on the edge and a new global Great Depression loomed. I'll skip over the details.

But essentially, he got the federal government to bail out Wall Street. He bailed out the guys who brought planet Earth to the brink. Now, from a pure justice point of view, every one of those firms should have gone under. But that would have caused a global depression. Paulson felt that he had no choice. The crisis did not end until the spring of 2009. Obama was now president, and Tim Geithner was now secretary of the Treasury. Geithner announced a bank stress test.

All the banks would be subject to a very draconian test to see how undercapitalized they were. Each bank would then be forced to raise the necessary amount of capital that the test indicated. The test was in fact quite draconian, and it forced banks to raise a lot of capital. But it ended the crisis because investors realized that after raising the capital, the banks would in fact be adequately capitalized and the system would survive. So that's the crisis.

But before discussing what happened after the financial crisis and the changes that were made, I'd like to discuss a very important point. In my opinion, One of the biggest mistakes the Obama administration made was the lack of any prosecutions of Wall Street executives. From a purely political perspective, this lack of prosecutions had terrible consequences. The perception was...

that a massive fraud and crime had been perpetrated. Some people said that the crimes were just too complicated to prosecute. But regardless, the conclusion many voters reached was that the fix for rich people was in. The Tea Party grew from this one event. And it also exacerbated a longstanding trend of loss of faith in political institutions. Now, my take on this issue is that, in fact, there was a massive fraud and it was not complicated. Here is where the fraud is clearest.

When a Wall Street firm buys subprime loans from a lender, it buys them blind. What do I mean by that? A Wall Street firm develops a relationship with an originator, an AmeriQuest, or a new century. It creates an underwriting grid. and tells the lender that it will buy any loans from them that fit this criterion, like a loan to value of X, a debt to income of Y, an employment history of Z. It will buy, let's say, $1 billion of loans.

from an originator, but it will do so blind. Meaning, at the time of sale, it has no idea what is in the loan files. The lender sends the files to the Wall Street buyer, and now, after having bought the loans, the Wall Street firm can do its due diligence. It does its due diligence after it buys the loans, not before. Contractually, the Wall Street buyer has the right to put back to the lender any loans.

that do not fall into the underwriting grid parameters. But checking files is time-consuming and expensive. The average size of a subprime loan was around $200,000. A purchase. of 1 billion of loans means something like 5,000 mortgages. That's 5,000 files. Almost every Wall Street firm hired a due diligence firm called Clayton Mortgage. And Clayton Mortgage was given the same marching orders.

Pull a statistically significant sample of files and check to see how many loans fall outside the scope of the underwriting requirements or the underwriting grid. A statistically significant sample was generally around 10% of all the files. So in a pool of 1 billion, 10% is 100 million. Or, out of 5,000 total files, that's 500 files.

So Clayton Mortgage checked the files. And in 2006, when underwriting standards went to hell, the reports that Clayton Mortgage made to Wall Street on 2006 securitizations... started to come in very bad. Reports showed anywhere from 10% to 40% of the 10% was outside the grid. That is terrible quality control. Since the sample was statistically significant, it stood to reason that the remaining 90% had an equally bad amount. Here's the punchline.

I'll say that again. No Wall Street firm ever ordered due diligence on the remaining 90%. Instead, they put back the bad loans from the sample to the lender. and securitized the rest and sold it to investors as if nothing was wrong. In the risk section of the offering document, it stated something like, there might be loans in this securitization that do not adhere to our underwriting requirements.

Think of the math. The sample of the $1 billion was 10%, so $100 million of loans was checked. If 30% was bad, then $30 million was sent back to the lender, and the Wall Street firm got a refund. The remaining $970 million was securitized and sold to investors all over the world. In my opinion, this was the largest fraud in human history. And the story I just told is no secret. It was detailed extensively by the Financial Crisis Commission that President Obama created.

The commission, in fact, referred this entire story to the Justice Department to be criminally investigated and, wait for it, nothing happened. And no one knows why. And there are a lot of theories. Some people say... that Geithner got the Justice Department to kill any investigation because he worried that any investigation would somehow cause another crisis. But that's just a theory. No one has any facts to prove that at all.

Books have been written about this, but no one has an adequate answer. This episode is brought to you by Marketo. When it comes to your payments provider, you can't afford to compromise. Marketo's modern payment solutions flex with your business. Without the trade-offs, stable and agile, secure and innovative, scalable and configurable. If they say you can't have it all, don't believe them. Your business demands more. Choose a payments provider that delivers more. Choose Marketo.

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And now we're going to talk about what happened after the financial crisis. By mid-2009, the crisis had ended. The stress test had restored enough confidence such that the system functioned again. Wall Street had a ban a year in 2009 trading bonds. and the stock market had a huge rally. But in 2010, Congress passed Dodd-Frank as a means of reforming the banks and the financial system. The bill was not perfect.

The rating agencies emerged mostly unscathed. But large financial institutions did not emerge unscathed. The most important thing the bill did was create a new position in the Fed. vice chair of financial supervision, which is a fancy term for chief bank regulator. It's an amazing statement that prior to Dodd-Frank, the U.S. never had a head bank regulator. Instead,

Our bank regulatory system had an alphabet soup of regulators, and the banks played them off one another. If someone was too tough, banks would change regulators. This actually happened all the time. Dodd-Frank ended most of that and made the Fed the regulator of all the large banks and investment banks. Now, President Obama never appointed anyone officially to the position of vice chair of financial supervision.

But de facto, the job was performed by Fed Governor Daniel Turullo from 2011 till the spring of 2016. Now, I never had much respect for bank regulators. I always felt they were captured regulators more interested in protecting banks from consumer lawsuits than protecting consumers. They thought that large banks were run by geniuses so that those executives understood their risks better than anyone.

Wrong. Daniel Tarula was the first bank regular that, in my opinion, did a really good job. Under his watch, he forced banks to massively de-lever. For example, before the crisis, Citigroup was levered around 35 to 1. But when he was done, it was levered only 10 to 1. A massive difference. Also, even with that lowered leverage, he forced banks to reduce the risk they took. Thus, leverage was lower and risk was reduced as well.

He also forced banks to improve their risk systems, and the annual stress test forced banks to better understand their risks as well. He did a great job. And now I'm going to go on a bit of a tangent.

and discuss why Silicon Valley failed in 2023, and was it ever a systemic risk problem? Or was that just so much hype? One of the weaknesses of the new financial rules was that the most stringent rules only applied to the large banks. the annual stress test only applied to banks with assets above $250 billion. Also, the large banks had more stringent capital requirements and liquidity requirements than the mid and smaller banks. In principle,

That might have made some amount of sense, but Silicon Valley made that conclusion ridiculous. Silicon Valley's assets were below $250 billion, so it escaped the stricter liquidity rules. So what happened? Silicon Valley was a surprise to most people. Tarullo did his work from 2011 through April 2016, and there were no crises on his watch. And then COVID hit, and the Fed cut rates to zero.

and this eventually caused a massive problem for banks, and therein requires a somewhat extended conversation. Banks take in deposits, some checking, some savings, and some in CDs. Checking pays nothing. and savings and CDs pay something. And that something is based off of short-term rates. When the Fed cut rates to zero during COVID, depositors got paid nothing or almost nothing on their deposits. Sounds good, until you think about what banks did with that money.

Banks make loans, but they take their excess liquidity and generally buy short-term bonds. With short-term rates at zero, buying short-term treasuries meant that the spread between what banks paid depositors and what it earned on its short-term liquidity was very narrow, almost nothing. Thus, during COVID, the net interest margins of banks suffered. Now, some banks decided to take some of their excess liquidity and buy...

Long-term bonds, because long-term bonds have higher yields than short-term bonds, which would then help their net interest margins. This is called taking duration risk. You take short-term funding. deposits and you buy long-term bonds. And when the yield curve is positively sloped, that will mean a better net interest margin. But what happens when the Fed starts raising rates? When the Fed raises rates,

banks pass on some of that increase to depositors. Eventually, if the Fed raises rates enough, the interest rate on deposits could exceed the interest rate on the long-term bonds that the banks bought when rates were zero. So on those bonds, the bank will be earning a negative spread. Moreover, and this is key, when rates go up, the price of existing bonds go down. So a bank that loaded up on long-term bonds...

when rates were zero, would eventually have large mark-to-market losses on its balance sheet. The way the accounting works, when a bank has mark-to-market losses but does not sell those bonds, Those unrealized losses are deducted from equity or book value, but do not show up on the income statement. They only appear as losses on the income statement when the bonds are sold.

The Silicon Valley story is an example of why rules matter. During COVID, all banks were faced with this net interest margin conundrum. There was a huge temptation to buy long-term bonds so as to generate some net interest income. But... This temptation was reduced for large banks. The large banks have stiff liquidity requirements imposed upon them by the Fed. Medium and small banks have much more lenient liquidity requirements.

Some large banks such as J.P. Morgan decided not to chase yield out of fear of what would happen when rates went up. Other large banks such as Bank of America decided to surf the curve. When rates went up... Bank of America had large unrealized losses, but those losses were manageable because the Fed's liquidity rules only allowed them to make so much of a bet. They had to put most of their excess liquidity in short-term bonds.

Silicon Valley was another story. Now, just because a bank has large unrealized losses is not necessarily a reason for panic. As long as depositors stick with the bank, the bank is not forced to sell its bonds. Eventually, the long-term bonds will mature and the bank will get its money back. So normally, if a bank surfs the curve and rates go up and the bank has large unrealized losses, that only amounts to an income problem.

but not a solvency problem, meaning it has unrealized losses and its net interest margin weakness and therefore income suffers. But... For there to be a solvency problem, depositors have to make massive withdrawals, thereby forcing the bank to sell its bonds so as to pay off its depositors. Normally, that never happens.

Generally, banks have very diversified deposit bases. Some are rich consumers, some are middle class consumers, some are small businesses, and some are large businesses. These deposits have little in common, so it would be highly unusual for them all to act in concert. Silicon Valley, unfortunately, was different. Silicon Valley Bank had a very unique business model. It was the bank to the venture capital industry. When venture capital funds raise money,

they would park the cash in Silicon Valley until they funded companies. But even when those companies were funded, these VC-owned companies would also park their money with Silicon Valley and gradually pull that money out. as they funded their cash flow needs. Prior to 2022, venture capital boomed. More and more money was raised and more companies were created and funded. As VC growth exploded,

The money raised caused a massive growth in Silicon Valley's deposits. Silicon Valley Bank did not make a lot of loans. Mostly, it took all those deposits and bought riskless treasury bonds. Now, when the Fed cut rates to zero during COVID, Civ B was faced with a conundrum. If it bought short-term treasury bonds, its net interest margin would suffer, and its earnings would also suffer, and it would disappoint Wall Street.

So, instead, it decided to buy a great deal of long-term bonds. Because its liquidity requirements were more lenient than large banks, it could serve the curve mainly to its heart's content. And then the Fed raised rates in 2022. SIVB had massive mark-to-market losses to such a degree that its equity went to zero, and there were times when it was even negative. But as I said before,

Just because a bank has mark-to-market losses isn't necessarily calamitous. But SIVB had a unique deposit base. It was all venture capital related. In other words, it had many depositors, but they were all basically the same. And the VC industry started to have problems as the Fed raised rates. Here's why.

What are the characteristics of a company created and owned by a venture capitalist fund? It has high revenue growth and negative cash flow because it's an early stage. It takes a startup years before it can generate positive cash flow. Such a company has an insatiable need to raise capital. And because positive cash flow is many years away, the valuation of these companies is highly, highly sensitive to interest rates because they are all valued.

on a future cash flow analysis that is discounted back with an interest rate. Plus, an increase in rates will have very negative implications on this discounted cash flow analysis and vice versa. Partially because of the long bull market. Many companies that went public were VC-created companies with these characteristics. And when rates were cut to zero during COVID, these public VC companies soared. But in 2022, the Fed reversed and began to raise rates.

And in 2022, the S&P declined by 18% and NASDAQ was down by 33%. Experience a membership that backs your business journey with American Express Business Platinum. When you pay with membership rewards points for all or part of an eligible flight booked with a qualifying airline through Amex Travel, you can get 35% of those points back, up to 1 million points back per calendar year. American Express Business Platinum.

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And critics say it's one of the best superhero movies of all time. Marvel Studios' The Fantastic Four First Steps. Now streaming on Disney+. Rated PG-13. What time has it been? It's Covertime! Many of these high-growth negative cash flow companies declined by over 75%. Think of these public companies as proxies for the valuation of privately held VC companies. Valuations collapsed here too, but these companies still had constant needs for capital and cash flow.

Let's say a VC startup is hot and raises capital at a billion valuation and gets investors. And then three years later, the space it is in is even hotter and the valuation soars to 10 billion. And everyone wants to invest. As long as valuations go up in the VC world, investors flock. But let's say now we are approaching round three and valuations have collapsed like they did in 2023.

Our VC company might now have a potential valuation of only $500 million, and now no one is interested. 2022 was a disastrous year for the VC industry, something it is still recovering from. It became impossible for VC companies to raise any money, but they were all still generating negative cash flow. So they kept tapping their deposits at Silicon Valley Bank to fund their businesses. And they all banked at CivB.

Since the VC industry could no longer raise capital, there was no replacement for these deposits. And Civ B's deposits started to go down. The problem for Silicon Valley was that it's extremely... High concentration of deposits from venture capitalists meant that it lacked any diversification. The correlation of the actions of its depositors was one.

Because of SIVB's decision to surf the curve, by the end of 2022, on a market-to-market basis, Silicon Valley had no equity. But again, banks can survive that. if they don't have to sell their bonds at a loss, thereby crystallizing the loss. They can wait it out, but not SIVB. Because of the decline in posits, Silicon Valley was forced to sell its bonds so as to raise the cash necessary to pay the VC depositors that were pulling their money to fund their negative cash flow.

And so in March 2023, Silicon Valley announced that it had sold the bonds and realized $2 billion in losses and needed to raise capital. The stock tanked. The company could not raise capital. And on Sunday of that weekend, the federal government took it over. Prior to 2022, Silicon Valley had been one of the best-performing bank stocks for years. It was an investor darling, and then it was gone.

One of the major reasons why Silicon Valley was able to surf the curve so aggressively was that the strict liquidity rules that large banks had to follow did not apply to it. It's not that large banks were necessarily smarter, they were just more restricted. Think Bank of America, for example. They also surf the curve and have about $100 billion of unrealized losses from buying long-term bonds when rates were low. Not a small sum. But Bank of America has a highly diversified deposit base.

So it was not a forced seller. They had bad long-term bond positions, and those positions will weigh on the companies at interest margin for years. But for Bank of America, this is only an earnings problem, not a solvency problem. On the March weekend when Silicon Valley went under, prominent members of the venture capital community begged the Fed, literally begged the Fed to bail Silicon Valley out, arguing...

hysterically, that the system was at risk. Believe me, the system was not at risk. Venture capital money was at risk as venture capital depositors would become unsecured creditors of a seized Silicon Valley. Venture capital funds and venture capital companies would certainly have had serious problems. The system would have been fine. Once the Silicon Valley bank panic ended, regulators looked around to try and figure out what went wrong.

The problem at Silicon Valley was not a lack of capital. It was a unique situation where a company had massive mark-to-market losses and a highly concentrated deposit base. that Silicon Valley was surfing the curve when they were doing it. And the regulators did nothing to stop it. A rational analysis would have concluded that stricter liquidity requirements should be imposed on more banks. But generals always fight the last war.

So regulators took out the old post-GFC playbook and argued that all banks, especially large banks, need more capital. This conclusion was just weird. There had been no problems at the large banks, but that did not seem to matter to the regulators at the Fed. Led by the Biden-appointed Vice Chair of Supervision, Michael Barr, the Fed began to prepare even more stringent capital requirements for the large banks and a process that became to be known as the Basel IV endgame.

This time, the banks pushed back and got a lot of support. During the Tarula years, the banks constantly pushed back on his moves to force him to delever and de-risk. And back then, I felt the banking industry was just plain wrong. I thought Tarillo was right, and when I could, I said so. Today, I think if you ask those same bank CEOs who are critical of Tarillo, they would admit they were wrong, and Tarillo accomplished a great deal. Tarillo really is an unsung hero.

But post-Civ B, the move to force the large banks to hold even more capital just seemed wrong to me. And eventually Michael Barr backed off. And that brings us to 2025. But first, a few conclusions. It's almost 17 years since the onset of the GSC. A lot has changed. Banks are much safer. I no longer worry about the systemic health of the financial system of the United States. But as always...

There were unforeseen consequences, and I'll just discuss two. Number one, by forcing banks to deliver and de-risk, banks made fewer types of loans. Private capital stepped in, and its growth soared. That's why private equity companies devoted to making loans like Apollo have seen explosive growth. This, of course, means that a high percentage of debt financing occurs outside of the banking system and is unregulated.

Some critics have argued for years that the next crisis will occur in this private debt area. But so far, we really have not seen any significant problems. We will just have to wait and see. And the second unforeseen... consequence is that the big got bigger. Yes, banks de-levered and de-risked, but Dodd-Frank and its resulting regulations increased the costs of regulatory compliance. For years, compliance departments grew.

Large banks can bear these costs more easily. Also, new technologies began to have a real impact on banking. From online banking to payments, etc., the cost of creating a good banking experience via the new technologies soared. Large banks could provide these services more easily because they can bear the costs. As a result, the large banks have taken deposit share. The big got bigger. For example, in 2008...

JP Morgan's deposit share was at 7.4%. Today, it is in excess of 12%. And now some predictions. Fundamentals for banks should be good during the next few years. The economy is strong. So barring a trade war, loan growth should improve. The Fed will not be cutting rates aggressively, so the pressure on net interest margins should abate. And the credit cycle still looks fairly benign. So the earnings backdrop is good.

The Trump administration will probably take a kinder view of M&A, and we could see an increase in M&A activity, and that should help the investment banks. Finally, the regulatory environment should and is actually getting better as we speak. Michael Barr resigned as vice chair of financial supervision, and President Trump appointed Michelle Bowman to replace him. She is more friendly to banks. Now, we are never going back to a pre-Dodd Frank world.

But the stress test will almost certainly become a bit more lenient, and the cost of regulatory compliance might be reduced a bit. In fact, the stress test results that were announced on Friday, June 27th, prove this point already. For me... The wild card revolves around bank mergers. Since the GFC, bank regulators have frowned on bank M&A. Very large bank M&A activity is actually completely prohibited.

But even mergers below the very large banks are frowned upon, and I think that is wrong. Because of the increasing costs of bank-related technology, only the large banks can comfortably afford to keep spending. Everyone else is struggling, and that means that the large banks will keep taking deposit share. This is something I have changed my mind about, but I now believe that we need many bank mergers so that there will be more banks that can afford

this cost of technology. We have not seen a large bank merger wave in decades. Maybe that is about to change. I hope you've enjoyed this lecture and learned something from it. We will do more financial literacy lectures. And if you have any suggestions as to topics, please email me at info at steveisman.com. Thanks for listening.

This podcast is for informational purposes only and does not constitute investment advice. A host and guests may hold positions in stocks discussed. Opinions expressed on their own and not recommendations. Please do your own due diligence and consult a licensed financial advisor before making any investment decisions.