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What We Really Learned from Silicon Valley Bank

The Takeaways:

  1. Decentralized finance (DeFi) with smart self-regulations through technologies like blockchains, smart contracts & generative pre-trained transformer GPT inside each financial institute represents the future of efficient risk management.
  2. We can establish interest rates markets to allow different parties with different financial profiles and different needs to trade to their desires rates based on their needs, risk levels, time lengths, credit ratings, insurability, and expected returns from fund investment.
  3. FDIC should raise its coverage cap above $250,000 — partly paid by depositors with an excess amount — because uninsured deposits proved riskier this time than we assumed due to the self-fulfilling prophecy.

Not All Lessons Were Born Equal from SVB

Learning the right lesson is the key for the better future. There are so many potential lessons out there and everyone can and will have a different opinion on what to learn and how to prevent future crisis of financial institutions like banks.

Part of reason is that the case itself is very complicated, making it possible to have many things to say. If someone fell down from his bike, there is one or at most two lessons to learn: Either the road is too slippery or the rider was not focused. But when a bank with billions of dollars of asset fell, having only one or two lessons sounds like a failure in learning. It has to be more involved in it.

Not all lessons were born equal. For one thing, we must focus on risk management more than rescue scheme. The best that a rescue scheme can do is to arrive at a “no-loss + loss” result, while the best of risk management is to achieve a “win + win” for all parties.

Another relevant point is mindset more than demographics. For example, a lesson that I have heard many talking about is to attract a diverse pool of clients and avoiding over-exposure to any single sector, single industry or single type of clients. This is always true and always makes sense. However, I do believe we can do things without for an ideal client base. After all, having a special type of clients is not always a bad thing. For one thing, they allow us to develop the best resources for serving a unique group of people, rather than serving everybody. Imagine such a boring landscape picture, in which all banks have the same customers. I would rather see a more diversified picture in which banks are proud of their unique clients.

It’s an open secret that regional banks always face a bigger challenge in attracting diversified clients than national banks. The way the former compete with the latter is not in size and types of clients but in doing one or two things better than the latter.

Ultimately, the key is not about client type but always about risk management. A good risk management strategy starts with, and grow on, the existing clients, not betting on changing them.

With SVB clients, we can learn to (1) know the existing clients well, especially their demand liquidity; (2) do periodical stress tests and (3) possessing bond funds and/or bond ETF. All these can be done without waiting for a safer diverse client base to come by.

A Deeper & Bigger Lesson

If there is one forward looking lesson out of all lessons, if we must say something fundamentally important, it is this: Stop trusting central human regulators and switch tech enabled decentralized smart regulations, where the word “tech” refers not only to FinTech but all the new technologies in and out of financial world.

We can start from the recent report on Fed’s San Francisco branch that missed the red flag of SVB. More generally, the time of central bank intervention determines everything. Regulators need to allow a time cushion following a quick turn of monetary policy. For example, banks with maturity mismatch should have access to funds to keep liquidity and to avoid “fire sale” of their portfolio with huge losses.

But it is always easier said than done with the current system. We have witnessed the modern bank run this time but there is no guarantee that it will not happen again. Humans are not always smart learners and we do have a tendency of repeating the same mistakes over time. In my last post, I highlighted two lessons from SVB: interest risk and liquidity risk. We have been talking about them since day one in financial world, and yet we are still struggling with them decades later.

How do we truly make progress in financial risk management from now on for the future?

The first thing I want to say is this: Although one of the direct casualties this time was the Signature Bank with strong crypto link, the message that carried by the dead messenger is more relevant than ever: The future lies in decentralized and proactive “smart regulations” that assist each bank, including those led by “zombie leaders” like in the case of SVB whose only strength is to guard self-interest but little else (尸位素餐), to constantly monitor current and future risks.

“Smart” More Than “Decentralized” Regulations

The name “decentralized” may sound exclusive rather than inclusive. In my mind “smart regulations” will reserve a big seat for central banks instead of eliminating them. The SVB case tells us that sometimes only words and resources possessed by central authorities would work, and does so dramatically.  

Here is another example from the insurance industry. According to this commentary of AM Best, the largest credit rating agency in the world for the insurance industry, that had the U.S. government not stepped in to make all depositors whole, underwriters of directors and officers insurance for startups and venture capitalists, as well as the financial institution insureds supporting such entities, could have faced financial distress given that they are operating on very thin capital.

This is because “’startups are by nature much more agile and less risk-averse than other companies, their directors and officers often make decisions quickly,’ said David Blades, associate director, industry research and analytics, AM Best. ‘Therefore, the potential for D&O claims for startups would have been high in the case government had decided not to help the depositors.’”

There will be lawsuits for sure no matter what. According to this report of AP, “A class action lawsuit is being filed against the parent company of Silicon Valley Bank, its CEO and its chief financial officer, saying that company didn’t disclose the risks that future interest rate increases would have on its business.”

“It is looking for unspecified damages to be awarded to those who invested in SVB between June 16, 2021 and March 10, 2023.

“In particular, the lawsuit said that annual reports for 2020 through 2022, “understated the risks posed to the company by not disclosing that likely interest rate hikes, as outlined by the Fed, had the potential to cause irrevocable damage to the company,” the lawsuit stated.”

“It also claims that the company “failed to disclose that, if its investments were negatively affected by rising interest rates, it was particularly susceptible to a bank run.”

With the above being said, let’s go back to remedies and we can do two big things toward smart regulation.

Decentralized, Flexible FDIC Caps

We have already seen solutions include raising FDIC insurance coverage cap above the current $250,000 line. Lawmakers all seem to be open on this idea, with the focus on how much the new cap should be.

This is a good idea because we have learned this time that non-FDIC insured deposits can post a big risk. It directly triggered the bank run of SVB, and explains why the share price for the First Republic Bank has been down by 70%. Uninsured deposits prove riskier this time than we assumed due to the self-fulfilling prophecy.

However, unlike the old cap of $250k, this time we probably do not want to have a fixed, nationwide new cap of FDIC coverage. Instead, we want FDIC’s new coverage cap determined through a negotiation process by individuals, and to be paid partly by depositors with an excess amount, sort of like copayments in the healthcare business. This way, depositors will share the responsibility and will be given personalized choices in determining how much risk they want to take.

The range of caps can go from 100% to 0% theoretically, and it’s up to the depositors to decide. Those who choose 0% extra coverage can always take advantage of the existing cap of $250k by having multiple accounts across financial institutions for excessive amount of money, not leaving all eggs in a single basket.

Depositors can either spread fund across banks or using Certificate of Deposit Account Registry Service CDARS, opening a cash management account, relying on MaxSafe by Wintrust or finally using Depositors Insurance Fund (DIF).

Either way, each depositor will sign a legally binding contract with FDIC and the bank where they deposit their money, stating that they fully understand the risk and in case of bankruptcy, only the amount they have purchased will be covered by the program.

Establishing National and Regional Interest Rates Markets

This is a bigger deal and of course will be subject to discussions and debates. But the basic idea is simple and interest rate swaps already exist and are an important component of the fixed-income market according to a Smartasset.com article. We just need to expand it to make market interest rate floating rather than fixed and to allow variation

The first thing about interest rate swap is that they are financial derivatives traded over the counter, where investors will typically exchange a fixed-interest payment for a floating-rate interest payment, which is known as vanilla swaps. Investors use these contracts to hedge or to manage their risk exposure.

But we do more than vanilla swaps, including allowing parties with different needs and profiles to trade directly among themselves.

The basic driver of an interest rate market or markets is different needs and different financial profiles of different parties. On the profile side, entities with low credit rating are willing to offer higher interest rates to attract buyers of their products, while the opposite holds true for the high credit rating entities.

The other profiling factor is time of economy. During a booming economy, parties don’t mind paying a higher interest rate because their returns from the fund are expected to be higher. On the other hand, when a future project does not have big expected return the owner of the project is only willing to pay lower rated fund. To the extent that a region is growing fast, many investment projects can expect high return, which push up a higher interest rate in that region.

At the end, we just need to calculate the average bidding interest rate in a region to come up with a region specific & time specific interest rate as the “going rate” for all.

On the need side, some entities are willing to pay a higher interest rate when getting funds quickly matters more than higher interest rates. Other entities do not have any urgent need for fund and will only pay low rated funds. The average of the ongoing highest price a fund buyer (the bid price) is willing to pay will be the “going bidding rate” of interest. The average of the ongoing lowest price fund sellers (the ask price) are willing to accept will be the “going asking rate” of interest. The average of the going bidding interest and going asking interest will be the market going interest rate.

The idea is to replace the single nationwide interest rate set by central banks to a diversified and decentralized, market determined interest rates, in which central banks can still set basic rates but anything beyond is subject to market forces.

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Life insurance

Is Annuity a Good Idea with Inflation?

The Takeaways:

  1. Investing in a time of inflation is essentially buying the best physical and financial products to preserve the value or the purchasing power of your money. The goal is to invest so that your rate of return on investment will beat the inflation rate.
  2. An annuity is mostly a retirement product offered by insurance companies to provide protected, reliable income for life after retirement. It can help bridge the income gap between the savings you’ve accumulated over time, traditional sources of retirement income, like Social Security and the goal of living a comfortable retirement life.
  3. The chain of reactions: Inflation entices fed to raise interest rates, which in turn push bond yield high, and potentially lead to higher annuity income. Bond yield is the rate of return earned by an investor who buys a bond and holds it until maturity (i.e., Annual Interest Payment / Face Value x 100.).
  4. The higher the interest rate, the more money you earn on your annuity. When you’re ready to retire, you’ll have more wealth in your account as a result of earning higher interest, also with regular payment that is inflation adjusted to keep the same purchasing power for your retirement money.

A Common Question People Ask

I’m not sure about you but in my experience one of the most common questions people have asked is what the best investment is today. We can be curious for different reasons — sometimes just for the sake of striking a conversation, other times deadly serious about investing and making money.

Of course, you do not need me to tell you that one of the biggest concerns for today is inflation. Thus, the above question becomes what investment tool we should choose that can beat inflation.

Let’s find out first what ChatGPT has to say. Below is the heavily edited answer, as the original version was too “plain vanilla” for lacking a better word. My hope is to make the explanation easier and livelier.

Inflation means price hikes for goods (e.g., gas, eggs, meat) and/or services (e.g., ridesharing price), which lowers down how much goods you can buy with the same amount of money (e.g., $10).

Sometimes people ignored the fact that inflation must be sustainable for a period of time rather than a short-term phenomenon. You may also hear people saying inflation is “general” price hike, although inflation can be “sectorized,” meaning different sectors of an economy can receive different impacts rather than all sectors move together.

In a farming economy, food price can be a major driver of inflation, but in an energy or natural resource centered economy like Russia, oil price change plays a big role.

A simple, hypothetic example is $1 buys 3 eggs now, compared with 4 eggs before inflation. The value of your $1 decreased and it took one egg away from you (or 25% of its original value was “eaten” by inflation.)

Formally, we say the value of your money decreases, even though a $10 bill will always be $10 on the face value, no matter how long it sits in your wallet. Another way to say the same thing is consumer’s “purchasing power” goes down when inflation goes up. Note value of money comes from its purchasing power, in addition to other factors like its intrinsic value (e.g., gold or silver), acceptance, scarcity, stability, government backing.

General Principle of Investment During Inflation

Regarding what investment is the best for inflation, the idea is this: During inflation most if not all goods are getting more expensive or priced higher. This is the time to ask yourself what specific goods you should buy so that not only your initial investment will not be washed away or severely reduced by inflation, but you make money beyond the invested money — despite inflation.

Let me use an example to illustrate the point. If you believe the price of pork will be significantly higher one year from today, it will be a good idea for you to buy piglets and raise them so that one year later you can not only get your investment money back but with a large profit margin.

The pig example involves physical property. Another example of physical property is real estate. For those not know yet, real estate is known for its value in fighting inflation because housing price and rental income both tend to go up during inflation.

They are like boats: When the water level is up, boats go up with that.

As you can see from the above example, the key to fight inflation is to compare two rates. The first is inflation rate, typically measured by Consumer Price Index (CPI). The CPI is a measure of the average change in the prices paid by urban consumers for a basket of goods and services over time.

The second is your rate of return on investment. Say one year later the inflation rate hits 5%, but selling pigs gets you 10% of return, you win because your return is twice the inflation rate. On the other hand, with the same 5% inflation rate but your pig sales only offered you 4% of return, you know your real return is actually 4% – 5% = -1% or negative 1%, because real return must be adjusted against inflation.  

Note sometimes you hear people mixing up “rate of return on investment” and “profit margin.” They are related but not the same. Briefly, profit margin focuses on measuring the efficiency of a company’s operations, while the rate of return on investment is on evaluating the performance of a particular investment, although both are percentage figures.

Investing in Financial Products

Investing in physical properties (pigs, real estate) sometimes is not the most convenient thing to do to earn a high return. To raise pigs you will need the piglets, the feed, the pig farm, the labor and the veterinary, to name just a few. To invest in rental income you must do a good job in maintaining the properties and also in dealing with dishonest renters.

Is there anything else that allows profit but is easy and fast to operate?

You bet. They have a special name “financial products” to differentiate from physical property. The former possess ideal features and should be among your first consideration for investing.

Speaking of investable financial products, in the old days gold came first but not anymore, as there are financial products that do better nowadays. I won’t get into the list of all the investment portfolio options for inflation purpose here. Let’s just consider one financial product that will benefit from inflation: annuity.

A Sideline Story of Eggs

Before proceeding, let me tell you a side story to lighten up the reading a little bit.

Assuming my previous hypothetic example of egg price in inflation is real, does it mean we should all stop buying eggs because their prices are so high and $1 now only gets you 3 eggs instead of 4?

I actually asked ChatGPT this egg question just for fun. Interestingly, although the database of ChatGPT does not cover the latest news, WebChatGPT, a free Google Chrome extension, does that. Every time you ask a question, the app will search three pieces of latest news related to the inquiry and then ask ChatGPT to present a conversational answer drawing from these reference.

Perhaps you already know the answer but formally, no, we don’t want to stop buying eggs if they are important to us. WebChatGPT also correctly points out that “the increase in egg prices is not directly caused by inflation, but rather as a result of various market factors.”

We need to separate consumption from investment, as well as separating segments of consumers. For some people eating eggs is a daily necessity and eggs are their staple food that nothing else can substitute. Others however will be happy to explore alternative sources of protein that are more affordable, such as beans, lentils, and canned fish.

Now let’s switch to the topic of “Annuity and Inflation.”

Nature of Annuity

Let’s begin from ChatGPT again. The following is an edited version of the answer.

An annuity is a financial product that provides regular payments to the owner over a certain period, often for the rest of their life. This means you won’t be too far off if you link annuities to retirement, as they are frequently retirement related investments products.

I say “not far off” because some annuity like immediate annuity provides regular income payments right away for a set period of time or for life, and you don’t have to wait until retirement. Instead, you can begin receiving payments immediately after purchasing the annuity with deposited fund.

Similarly with deferred annuity you may or may not have to wait until retirement — as long as you wait long enough to enter annuity’s “annuitization” phase (i.e., time to receive annuity payment).

You may hear some people calling annuity “annuity insurance” but that is not exactly right — even though annuity is a type of insurance contracts between insurance company and the person receiving annuity payment, or “annuitant” as they are called.

For one thing, insurance, especially life insurance, is designed to benefit one’s loved ones (i.e., spouse or children or any designated party), while annuities are mostly for oneself.

Secondly, annuities usually do not need a particular “trigger event” to start the payout, as long as enough money has been accumulated to pay. Life insurance however always requires that (most likely death but also terminal or chronical illness) to start the payout. In other words, you can’t start receiving insurance payment just because you feel like it. You must convince the insurance company that it’s time for them to pay you according to terms of the insurance policy. Annuity does not need you to do anything in particular, as everything is in the contract and is predetermined.

Finally, most annuity features regular payouts over a fixed interval, while life insurance can have a lump-sum payment to the beneficiaries.

Parties in the Annuity Contract

The typical parties listed on an annuity contract are:

  1. Annuity owner: The person who buy the annuity either in a lump sum payment or more typically through a series of regular contributions in order to receive regular payments either immediately or wait for a period of accumulation.
  2. Annuity issuer: The company or institution that issues the annuity and is responsible for making the payments to the annuity owner. This is generally an insurance carrier but can also include other financial service firms.
  3. Annuitant: The person whose life expectancy is used to calculate the annuity payments. The annuitant can be the same person as the annuity owner or a different person. This is why I say annuity is mostly designed to protect oneself.
  4. Beneficiary: The person or persons who will receive any remaining funds in the annuity upon the death of the annuity owner or annuitant. However, unlike a life insurance policy there is no guarantee for annuity beneficiary to receive money. It all depends on whether there is fund left in the annuity account when the annuitant died.

Let’s use a hypothetic example to show how annuity works on the high end. I made the human characters up, but the rest of story is reasonably realistic.

Owning a Luxurious Shipboard Condo

Beth is in her 50s and has never married with no child. As a company executive, her personal assets are in the millions. One day she received a phone call from her friend Gloria who is also in her 50s and a female executive in another firm. Gloria suggested Beth to check out the sales materials she received and invited Beth to own one of the “private residential yacht” apartment rooms next to her, in the world’s largest residential ship called MS The World with 12 decks, 165 luxurious shipboard condos built 13 years ago and equipped with every possible modern convenience in each apartment, costing from $825,000 to $7.3 million. Beth and Gloria each must prove a net worth of at least $5 million, then add another 10 to 15 percent for annual maintenance and other fees based on your apartment size.  

Beth and Gloria have no problem with provable net worth, the concern is with the regular annual payment for maintenance and other fees. They both want to set up a way to take care of the money. Beth has a Farmers insurance agent friend named Tiffany who heard the issue and offered to help. Tiffany told Beth, and through her to Gloria, that since they both will own the shipboard condos after retirement, annuity would make sense for them.

How Annuity Works

The steps are listed below:

  • You make either a lump sum payment or a series of payments into an annuity account. For Beth and Gloria, a one-time only, lump-sum investment makes sense.
  • The annuity provider (or issuers, in this case, Farmers insurance) invests money from Beth and Gloria in a portfolio of assets such as stocks, bonds, and other securities.
  • The investments generate interest, dividends, or capital gains, which accumulate in the annuity account and are tax-deferred until you withdraw them. Here “tax deferred” means taxpayers owe IRS taxes on investments, revenues, or profits but they don’t have to pay now and can be “delayed” or “postponed” to the future. (If you know the concept of “time value of money,” you know $1 today carries more value than $1 next year, so delayed tax payment is a good thing.)  
  • Depending on the type of annuity, you may receive payments immediately — if you made a lump sum investment into the annuity like Gloria and Beth will do, or at a future date, either for a fixed period or for the rest of your life. Most people will choose not to receive a lump sum payment. The whole reason they invest in annuity is to get a stream of regular payments month to month, quarter to quarter and year to year. In that case, the annuity issuer (i.e., Farmers in Beth and Gloria case) will write you a check on a regular basis and it’s worry free.  
  • The amount of the payments depends on several factors, such as the size of the initial payment, the duration of the annuity, and the interest rate or returns generated by the investments.

An important thing to know is that sometimes an annuity can pay you (the annuitant, like Beth and Gloria) more money than you initially invested because the earnings from stock and/or interest rate from bonds are higher than expected.

Beth and Gloria each will invest $500,000, but Beth picks a “Single Premium Immediate Annuity (SPIA)” that provides a guaranteed income stream for life (or a specified period). This annuity is ideal for those who want to convert a lump sum into a guaranteed income stream. It is possible that Beth’s $500,000 may turn out to be $550,000 in the end, due to good marketing performance of the investment by the annuity issuer.

Gloria on the other hand decides to invest in a variable annuity, which is for annuitant with a higher risk tolerance and wants to invest in a range of mutual funds or other investment options within the annuity. Variable annuities can offer potentially higher returns but come with more risk and fees.

Why Is Annuity More Attractive During Inflation?

When price increases during inflation, annuities become a more attractive investment option because it provides a fixed income stream that is immune to inflation. For others without owning annuity, inflation lowers their purchasing power of money. An annuity, however, can provide a guaranteed income stream that is typically linked to inflation, meaning that the income increases along with inflation. This can help protect annuity owners from the negative effects of inflation on their purchasing power.

For example, say an investor (not Beth nor Gloria) purchases an annuity that promises to pay her $1,000 per month and inflation is 3%, the annuity may increase the payout to $1,030 per month to keep up with inflation. This has a special name for it: cost-of-living adjustments (COLAs), which helps her payments keep pace with inflation and keep her purchasing power over time, even if the general cost of living goes up.

Of course, money does not fall from the sky. The reason annuities can afford to pay COLA is because the insurer (or annuity issuer) will invest the annuity premiums in assets that will provide a higher return to offset the impact of inflation. According to this report, “In general, insurance companies earn more in bond yields when the Federal Reserve raises interest rates. As a result, they can offer their customers higher rates.”

Remember the “boat” metaphor I used earlier for real estate? When price level goes up, rental income and housing price goes up as well. This applies to annuity which is guaranteed income to annuitant.