The Downfall of Banks: A Greek Tragedy Unfolding in Modern Risk Management — Part1

Let me tell you a story about the world of banks and their rollercoaster ride of failures. In this story, we’re gonna dive deep into why some banks have been biting the dust lately. I mean, it’s like they’re stepping into a UFC octagon, and they’re getting knocked out left and right.

Now, before we jump into the nitty-gritty of bank failures, we gotta get some groundwork laid out. So, I’m gonna break down the basics for you, like how an US dollar is created — it’s like the lifeblood of the economy, man. Then, we’ll explore how high Fed rates can mess with bond prices, making them go haywire.

We’ll also touch on the mysterious inverted yield curve. It’s like an economic fortune-teller. And to top it all off, we’ll dissect a recent case where a tech bank met its doom — and maybe, just maybe, we’ll figure out what they could have done to dodge knockout punch.

So, buckle up, and get ready to dive headfirst into the financial octagon, where banks battle it out for survival. Let’s get this show on the road!

How an US$ is created?
For instance, let us consider a scenario in which the U.S. government requires $100 to purchase ammunition for an AR-15 or a lithium-ion battery for a drone to be deployed in Ukraine. The government then issues a tender to obtain a one-year loan for this amount. Upon the loan’s maturity, precisely one year later, the government will repay the principal amount of $100 along with an additional dollar, totaling $101. This process, in essence, illustrates the creation of a single new U.S. dollar.

The fascinating aspect of this borrowing process is adaptability of the interest rate. If U.S. government cannot scure a lender at a 1% annual interest rate, they have option to increase the rate to 2%. By doing so, the loan becomes more attractive to potential lenders. Consequently, instead of receiving a repayment of $101, the lender would now receive $102 upon the loan’s maturity. This flexibility in interest rates enables the government to secure the necessary funding by adjusting the return on investment to suit market conditions and lenders’ expectations.

That’s basically the nuts and bolts of how U.S. bond market operates. Oh, and check this out — let’s say the lender suddenly needs cash, like, six months into the loan. That’s ok! There’s this whole bond market where they can sell that loan for, say, $100.75. Why $100.75? Who knows, man! But there are some smart people who’ve done PhDs, winning Nobel Prizes, and even tanking companies like LTCM, all while trying to crack the code on time value of money and option pricing. It’s a crazy financial jungle out there!

How an increase in interest rates impact bond prices?

Alright, so imagine the Fed, which is like the big boss of money, decides to raise interest rates, right? This can really shake things up for bonds.
So, here’s the deal. Bonds pay you a fixed interest, called a coupon, and this rate is locked in when the bond is first issued. Now, when the Fed raises interest rates, new bonds coming into the market will have higher interest rates than the old ones. This makes the old bonds less attractive because they pay less interest. So, the price of old bonds to drop to make them appealing to investors again.

And then, there’s this thing called the discount rate. It’s like a number you use to figure out what the bond is worth today, based on all interest payments and final payout when the bond matures. Interest rates go up along with discount rate. The higher the discount rate, the lower the value of the bond.
Another thng to consider is yield to maturity. This is like the total return you’d get if you hold onto the bond until it matures. When interest rates go up, the yield on new bonds goes up too. To make the old bonds competitive, their prices have to drop to boost their yield to maturity.

And finally, there’s this idea of interest rate risk. It’s like how much a bond’s price could change because of interest rate flctuations. The longer bond has until it matures, the riskier it is, because it’s more sensitive to changes in interest rates. So, when the Fed raises rates, those long-term bonds will see bigger price drops compared to short-term bonds.

To summarize when Fed raises rates, it’s bad news for bond prices.