Time to Read: 6 Minutes
During my career spanning 25+ years in the financial services industry, I’ve noticed the risks you don’t see coming are always the ones that seem to have the biggest impact on the financial markets. One such risk appeared last week: Three US banks collapsed because of the fastest central bank rate-hiking program since the early 1980s. It started with Silvergate Capital, which shut down mainly due to the pressure it had been under since FTX went bankrupt in November. Just two days after the collapse of Silvergate, SVB Financial Group (Silicon Valley Bank), one of the most popular lenders to Silicon Valley technology and growth startups, failed after a run on the bank. Signature Bank, one of the most popular banking destinations for crypto companies, was shut down by regulators on Sunday, March 12th to round out the worst week for banks since the global financial crisis, as shown below.
So what happened?
While both Silvergate and Signature Bank were tied to crypto to some extent, SVB was the 16th largest American bank with just shy of $210 billion in assets under management going into 2023. Here we’ll focus on the issues that got SVB quickly into trouble, as these issues relate to other regional banks. SVB was very successful at raising money and gathering deposits, especially from 2020 to 2021 when COVID-related fiscal and monetary stimulus was combined with the technology boom. The result: large amounts of deposits that needed to be invested.
One main issue (among many that are now evident) was that SVB invested many of its short-term deposits into long-dated mortgage-backed securities and US Treasury bonds. While these investments are usually considered very safe and liquid, the massive rise in interest rates during 2022 due to hikes implemented by the Federal Reserve (Fed) caused the bonds to trade at significant losses relative to their purchase prices. Remarkably, by classifying these investments as “held-to-maturity securities,” banks can continue to hold these securities without “marking them to market” or showing the losses on paper.
This is not a phenomenon unique to SVB. As shown below, the total amount of unrealized bond losses across the financial services sector is greater than $600 billion!
The panic was precipitated by SVB’s announcement of a $1.8 billion loss on the sale of just a portion of its bond portfolio. In an effort to replenish capital, SVB then tried to raise equity but failed. The very next day, regulators stepped in to shut the bank down after withdrawal requests exceeded SVB’s available liquidity. It was a classic run on the bank with customers racing for the exits. As shown below, depositors attempted to withdraw $42 billion from SVB in a single day on March 9th. A key reason for the massive withdrawals: More than 90% of SVB’s deposits were uninsured by the Federal Deposit Insurance Corporation (FDIC), which limits insurance to $250,000 per account holder.
To prevent contagion, the Fed created a new Bank Term Funding Program (BTFP) which offers one-year loans to banks in need of liquidity. Banks can collateralize these loans with the very same securities SVB was forced to sell at a loss—and the securities will be valued at par even if their current market value shows a significant decline. In addition, the government said it will fully protect both insured and uninsured depositors of SVB and Signature Bank. While not implicit for other regional banks (yet), the thought is the new program will be available to them as well, should they get into a capital crunch. At BWM, we believe this should (hopefully!) be made clear in the coming days.
All of this has wreaked havoc on the financial markets over the last week as fears of another banking crisis have emerged.
What happens next?
As the time of writing, volatility in the market still persists. Share prices of regional banks initially dropped on Monday, March 13th following the Fed’s announcement but have since recovered some of their losses. Broader markets have also recovered some of their losses. While it might be too soon to tell if we are out of the woods, we think the Fed’s quick actions helped to calm the situation for now.
We have often said that, in our opinion, overtightening by the Fed has caused more than 70% of the recessions since WW2. While we have had our eye on a potential soft landing for the US economy, it is possible the Fed might have “broken” something in the banking industry and we’ll need to assess the ensuing damage. Perhaps this will be short lived, in which case SVB will have a buyer come in and salvage the assets, keep all the VCs and startups in growth mode, and restore confidence to the regional banks. Even in this best-case scenario, we believe bank earnings are at risk as they will need to attract depositors by paying higher interest rates on their cash reserves and regulations will be tightened.
If you are of the mindset that the Fed was moving too quickly and too far with its interest rate hikes, then there is one potential silver lining. The futures market has completely reversed course regarding expectations for interest rate increases. As shown below, markets were pricing in a higher-for-longer scenario just two weeks ago: Markets expected the Fed would hike almost 100 bps (1%) over the next six months to almost 5.5% and then leave the key rate relatively high (>5%) for the rest of the year. The lowest dark blue line shows the Fed is now projected to hike only one more time and then dramatically reduce interest rates. What a difference just two weeks makes!
What to do?
At BWM, we believe there is currently not enough information to make a decisive move in the portfolios. We remain slightly overweight equities and have some excess holdings in short term T-bills to take advantage of an opportunity that might arise, assuming we have confidence in the opportunity. If it appears the economy might take another leg down because of these recent events, we will likely remove the overweight to equities. If, however, we see this as a bump in the road and perhaps enough to slow inflation and allow a soft landing to materialize, we will use cash to increase our stock holdings. For now, we are watching our objective indicators to help guide the decision-making process amid a lot of external noise.