The Peter Zeihan Podcast Series - Why I’m Not Worried About the Banks (Yet) || Peter Zeihan

Episode Date: September 7, 2023

The Ukraine War has negatively impacted almost every area of life, but perhaps there's a silver lining beneath all the global disruptions and adverse effects...It may sound like a stretch, but this war may have helped to prevent a financial crisis in the US.Full Newsletter: https://mailchi.mp/zeihan/why-im-not-worried-about-the-banks-yet

Hi, everyone, Peter Zine here coming to you from the Blue Bird Trail in central Colorado, off above Denver. Today we're going to talk about the not banking crisis and the impact of the Ukraine war on finance, which is a weird connection. But hey, work with me here. I'm going to break this into three rough sections. First, talk about what normally causes banks to go bust, what normally causes a financial crisis. Second, talk about why people are legitimately concerned with everything going on in China right now and the banking exposure. and then third, why this time it really is different, or at least the circumstances are mutated enough

that this isn't going to be approximate cause of financial distress in the United States. So first of all, banks. How banks and credit unions normally make most of their money is low. So they give a car loan. There's an interest rate that you have to pay and the differential between the money that is lent and what you pay back is where they make most of their income.

Because, Excuse me, during COVID, everyone got a lot of cash put in their pocket, and near the end of the COVID period, Americans had $2 trillion in spare cash. Not a lot of people are behind on their loans. So there aren't any loans to go bad, really. Normally, when you have a time period of financial downturn, people start missing payments and go into delinquency and maybe even to foreclosure if it's a mortgage. That hasn't happened. Americans are cash flush. Unemployment rates are near historical lows, and arguably,

still dropping. Personal incomes are at highs and are still rising. And a lot of the inflationary issues that the U.S. is struggling with are in part because workers are being paid a lot more. In fact, people are in such a flush financial position that delinquency rates on mortgages are the lowest ever since we started recording the data. So the traditional hits to asset quality that banks suffer just aren't there. The second way that banks can get money in an environment where for whatever reason, loans are not seen as enough, is they can buy someone else's financial assets. So back in the mid-aughts, everyone was getting in on subprime

and buying sub-prime mortgages because the interest rate on them was higher. The income on them was higher than it was on traditional loans. We haven't had an equivalent of that this time around because everyone still has a bad taste from subprime in their mouth. So about the only exposure we're seeing in that regard is like subprime auto loans, which are not insignificant, and there are a number of financial institutions, especially smaller ones, who don't have the personnel to do full due diligence that have just gobbled them up. And now they're facing pressure, but it's not enough to cause a sector-wide problem.

It's an institution-by-institution problem. So we're not looking at a normal pressure that you would see at the beginning of a financial crisis at all unless your bank follows a very non-standard investment model. So if you guys remember earlier this year, four banks of size did, go under, but all of them were linked to Silicon Valley. And in Silicon Valley, the financial model, to be perfectly blunt is very, very different. They don't make money on loans because the money isn't borrowed in the traditional sense. It comes from venture capital. And it gets paid out in a big lump. So your startups will take that big lump and they'll put it in a bank as a deposit.

And then that bank will buy long-term bonds and the interest on those bonds are for their income. And what happened is when we had a scare, people would pull their money. money out, but the maturity of those bonds was pretty long, and so the banks had to cash some in at a loss. You do that enough, the bank fails, and that's exactly what happened. But that is a very specific financial model for a very specific sort of financial institution serving a very specific subsector of the economy. The rest of the banking system is more or less okay. Okay, so that's how it normally works. Number two, let's talk about what the pressure is and where the concern is. China. The Chinese do not run banks like we do. In China, or in the United States and most places,

if you take out a loan, there's an interest rate, there are fees. If you miss a payment, there's delinquency penalties, and ultimately you have to pay it back. And if you don't pay it back, you'll probably lose your collateral. China, in China, capital, cash, is considered a political good, not an economic one. And they splash it at whatever sort of institution will generate not the most income but the most jobs, because they're all about buying social placidity. And that means you get an Enron-style lending policy across the entire economic system, where the emphasis is on throughput and butts in seats, as opposed to actually earning a positive

rate of return on capital. And that means arguably by Western standards almost every loan in the entire Chinese system is bust, but they just keep throwing more capital at it in order to keep the companies afloat because it's a social management system. Now, just as with subprime real estate or subprime loans, a lot of American companies gone out and bought assets or shares in Chinese companies,

and I would argue that all of this stuff was ultimately going to go to zero. And everyone who put money into it, if they couldn't get it out in time, was going to lose everything, because this is not the United States. United States. In the U.S., when a bank goes under, you send in your auditors and your investors, and you go through the books and you find out what can be salvaged. And some of those have to be sold off at pennies on the dollar, 80% on the dollar, whatever it happens to be, in order to make at least some people whole. That'll never happen in China. Even at the height of things,

when the Chinese were keeping everything liquid, they made it very difficult for foreign investors to ever get a good look under the hood. And in the today's cult of personality investment, in China, simply the collection of the data in many cases has become flat out illegal. In fact, due diligence firms that are not headquartered in China are being shut down to prevent people from understanding what's really going on. The Chinese are even starting to not collect the data on things like COVID deaths or youth unemployment because they're concerned with the ongoing effect that that will have on investment decisions.

And as a result, everyone's pulling out. And if you were exposed to a Chinese financial institution, well, the hour is getting pretty late and that time where you're going to lose absolutely everything is approaching, ergo the concern. But we've had a couple things happen because of the Russians, of all things, that have softened the blow and maybe even removed it completely. When the Ukraine war started, one of the first things the Biden administration did was put in place a number of financial sanctions, limiting their ability to use the dollar

in trade and stores of value, making this Russian central bank persona non-Groids. and international markets. And while the banking system in Russia was never exactly robust, it's never been the targeted outside investment in the way that China has been, those companies in the West, more in Europe than the United States, who were invested directly or indirectly in Russian financial assets, discovered that if they didn't get out, they were going to lose everything, either to sanctions or to Russian retaliation.

And we saw a general liquidation of the Western presence in the Russian financial system within just the first few months of the war. Well, remember that China is now run by a cult of personality. The collection and dissemination and analysis of accurate data in a timely matter in many cases is now illegal.

Also, in a cult of personality, countries are capable of making decisions very quickly because only one man's in charge, but they have limited the information that can reach them, which means that they often make very bad decisions, and that's what we're seeing in the case of Russia, with the Chinese doubling, tripling, and quadrupling down on the commitment to Russia.

If you look at the Russians, pretty much everything that they have attempted or tried or imagined in getting around Western sanctions has used the Chinese financial institutions and banks in some way as intermediaries. So, if you are an American smaller, mid-sized bank, you don't have the personnel and the experience to look at second, third, and fourth order exposures. So you cut out anything you have that's Russia exposed, and you dramatically slim down anything you have that's internationally exposed. And if you're a large bank and you do have the bandwidth to go down two, three, four layers into the shell companies, you're finding Chinese exposure. And if your concern is very accurately that the Chinese are the next target of Ukraine-related sanctions, well, then you absolutely reduce your exposure. It's now been a year and a half since the war started, a year and a half since the financial sanctions on Russia started,

which means the companies have had a year and a half to reduce their exposure to what is ultimately going to happen. And that means that we no longer have that exposure to sanctions and or risk in most of American banks and credit unions. There's still certainly some more traditional exposure in terms of equities, but those people have a better idea of the risk that they're getting into. So we're not looking at something like a subprime crash. We're not looking at the degree of exposure where all these assets go to zero, or more than the point they will go to zero. There aren't a lot of Americans holding them anymore.

One of the best things that the Russians have done is spook this sector into reducing what was arguably its single biggest point of exposure moving forward. So does this mean that a financial crisis can't happen? Nah. There will always be issues. but with unemployment low, with growth high, with personal incomes high, and with the international exposure at the lowest it's been in years, we're in a pretty good spot. It's going to take

a pretty significant shock from something we haven't seen yet to generate anything like we have seen in every other financial crisis we have seen in the modern era. So take that for what it is. All right, that's it. See you guys next time.