Last week market sentiment swung from expectations that the Fed and European Central Bank would continue hiking interest rates to worries about financial stability and liquidity concerns. This change was a result of the failures of Silicon Valley Bank (SVB), Signature Bank (SBNY), and to a lesser extent, Silvergate Capital (S.I.). The stress in the U.S. domestic banking sector has led to a sharp short-term bond rally (yields down and prices up), with U.S. 2-year yields registering the largest 3-day decline since the Great Financial Crises (GFC) and significant declines in bank stocks, primarily regional banks. To prevent possible contagion, the Treasury and Federal Reserve took swift action over the past weekend to ensure all bank depositors could access their cash. Furthermore, the Fed also announced a new lending facility for banks providing one-year loans against their bond portfolios.
SVB, which focuses on lending to technology startups, announced sizeable losses on investments last week. After a failed bid to raise capital, it was placed into FDIC receivership on Friday. This event followed the announced liquidation of Silvergate Capital (SI), which focused on providing banking services for the cryptocurrency industry. A third bank, Signature Bank, was also placed in receivership on Sunday.
During the last year, the Federal Reserve raised interest rates at the fastest pace in over four decades. These banks made the classic mistake of using their customers’ short-term deposits to buy long-term bonds (10-year maturities or so). The rise in interest rates caused the market value of the banks’ assets (bonds) to decline in value. This event would not necessarily be a problem as many assets were marked as “held to maturity” on their books. Then the banks started to experience pressure on their ability to fund their customers’ desire to withdraw funds. These deposit outflows forced the banks to sell their long-term bonds at losses. Once this information became widely known, through social media, the floodgates of withdrawals were opened, and the banks were left insolvent.
We believe these events highlight one side effect stemming from central banks’ rapid increase in short-term interest rates after a lengthy period of low rates. Treasury bonds and agency mortgage-backed securities (MBS) comprised a significant share of SVB’s balance sheet and have been under pressure as interest rates increased. Like many banks, SVB had accumulated significant MBS holdings given what were, at the time, attractive yields and risk/liquidity treatment. As interest rates increased and MBS durations extended (i.e., refinancing on mortgages stalled as most who could refinance at lower rates did), mark-to-market losses became significant, especially for SVB, who did not re-hedge the interest rate risk. The circumstances around SVB appear more extreme than most banks will face. Other banks tend to have a smaller concentration in securities and a more diversified deposit base, and many are better hedged against rising rates.
How Do These Events Compare to 2008?
Unlike in 2008, this is not about assets with opaque valuations clogging bank balance sheets. The assets at the heart of the current bank troubles, such as U.S. Treasuries, are among the most liquid and transparent – and losses can be easily assessed. In the case of SVB, savers, investors, corporations, and venture capital funds opted to move their deposits slowly and then all at once, as calls on social media instructed depositors to do so. While that choice may have initially been to seek higher cash yields or improve their liquidity position, it quickly became a bank-run flight to safety.
What Are the Implications for the U.S. Economy?
Banks across the board will likely tighten lending standards even more, restricting credit availability and raising business costs. The actions by the Government do nothing to address nonbank lending has been growing in importance given that the Fed’s umbrella does not protect this activity. As a result, economic growth is likely to be sluggish, increasing the odds of heading for recession later this year or early next year. Some analysts claim SVB was a special case because of its Tech and V.C. ties. But that misses the broader point. SVB would not have grown into the 16th largest bank without free money, which allowed Tech, PE, V.C., and private credit to thrive. With higher yields, investors have a broader opportunity to earn reasonable returns with less risk.
The current debate is whether the Fed will increase or pause rates at next week’s meeting. Markets have now priced a rapid re-think of monetary policy. As of this writing, two-year yields (a proxy for the policy rate one year from now) trade at 4.31%. They closed on Wednesday (3/8/23) at 5.07%, the most significant three-day drop since Black Monday. Phrased differently, after Chair Powell’s testimony to the House last week, markets priced Fed Funds at 5.691% for the November meeting. That meeting price is now 4.50% to 4.75%, with the terminal rate in June of 4.75% to 5.0%. Pricing for the meeting due in 8 days is only for a 75% chance of a 25 bps hike and a 25% chance of no change.
The bottom line is that we do not believe a general banking crisis will affect many banks. The events since last Thursday appear to be isolated, and U.S. Government institutions have taken steps to protect depositors. The stock and bondholders of these banks will likely suffer significant losses, if not complete losses. The overall economic impact will be slow growth and a likely reduction of inflation. That will allow the Federal Reserve to reduce its rate of interest rate increases significantly.
Dated March 14, 2023
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