Have you ever reflected on the foundation of the financial system? What comes to mind? Banks, investors, the stock market, the bond market, or the credit markets? That’s partially true.
They are the underpinnings, but the foundation of the financial system is confidence. Without confidence, we are left in a very precarious situation.
We have full confidence that when we withdraw cash from a bank account or money market fund, or for that matter, close out an account, we will have immediate access to those funds.
But bank vaults aren’t filled with cash that can be easily returned to depositors if, by an incredible long shot, everyone shows up one day to close their account. Our deposits are invested in high-quality bonds, Treasury bills, and loans.
What happened at Silicon Valley Bank (SVB) last month was simply and old-fashioned bank run. Why? Confidence quickly evaporated.
But the root cause of its demise had many regulators, investors, and Fed officials scratching their heads because nearly everyone was caught off guard.
A far cry from 2008
Unlike 2008, when major banks were saddled bad real estate loans, SVB invested heavily in a portfolio of high-quality, longer-term Treasury bonds. From a credit standpoint, these are super-safe investments. What could go wrong?
Well, nothing if the bonds were held to maturity or if interest rates had remained stable.
Bond prices and bond yields move in the opposite direction. When yields rose, the bonds fell in value, creating a paper loss.
But its customer base of venture capital investors had been drawing down on their deposits as more traditional sources of funding were drying up.
With deposits being drawn down, SVB was forced to sell bonds and the bank took a nearly $2.0 billion loss. SVB’s hastily announced plan to raise capital was quickly scuttled when it stock tumbled, and depositors quickly began to withdraw cash, since a large majority of the bank’s deposits were above the FDIC limit.
Less than two days after the bank revealed its loss on the sale of Treasuries, regulators were forced to shut the bank.
Time to failure: less than 48 hours from a late March 8th announcement of its plans to raise capital and a morning shuttering on March 10th.
Moreover, Signature Bank, which was heavily into the cryptocurrency space, was closed on Sunday, March 12th.
Regulators did not have the time to line up buyers, and the FDIC moved to guarantee all bank deposits of the two-failed banks.
As controversial as it was, Treasury and Fed officials fretted over the potential of massive bank runs when markets opened on Monday.
It’s difficult to estimate the carnage we might have seen on Monday morning, but the plan to ring-fence the banks with deposit guarantees and a new lending facility from the Federal Reserve helped contain the crisis and prevent contagion.
The Fed broke something
The epicenter of 2008 financial crisis was subprime lending. Today, the failure of some banks to properly manage the duration of their assets (loans and bonds) and liabilities (deposits), coupled with sharp rate hikes and regulatory missteps, are the primary causes of today’s problem. Banks such as SVB piled into high-quality, long-term bonds but didn’t hedge against the possibility of a rapid rise in interest rates. Rising interest rates exposed a fatal flaw in its portfolio.
The Fed was probably on track to boost the fed funds rate by 50 basis points (bp, 1 bp =0.01%) to 5.00%- 5.25% at its March meeting.
Inflation remains stubbornly high, but the Fed wisely chose to defer to banking stability, and opted for a smaller increase of 25 bps. It gives the appearance that inflation remains a priority, while focusing on the banking system.
It also puts the Fed in a difficult position, as it hopes to tackle two conflicting goals: fighting inflation with rate hikes, which would put added stress on banks, or concentrating on financial stability.
The crisis might do the Fed’s job for it, as tighter lending standards slow economic growth.
How much? No one knows.
We continue to advise a cautious approach with the uncertainty we are experiencing economically. As we have expressed numerous times, the “silver lining” in this ongoing drama has been higher rates on high quality short term vehicles: Money markets, Short term treasury bonds and fixed annuities.
Please don’t hesitate to reach out to our team if you have any questions or concerns, this is exactly what we are here for.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Investing involves risk including loss of principal.