The Big Picture – March 13th 2023

Published Mar 13, 2023

A few weeks ago, I remarked that it was strange that after a 300+ basis point increase in rates, nothing had “broken.” There were no hedge fund blow-ups, no huge trading losses, and no failed banks. I wondered if it was a matter of time, or if the industry and regulators had learned from past mistakes. Well, the collapse of Silicon Valley Bank last week answered my question. And the big picture questions now are, why did this happen, and can it spread?

Assets – Liabilities = Equity; this simple equation is the key to understanding how a $209 billion bank could fail because of losses on Treasury securities. It’s strange that we measure banks on the size of their assets, since for every $1.00 of assets a bank holds, they have roughly $.90 of liabilities which would be like someone saying they are rich because they own a $1MM house purchased with a 90% LTV mortgage. But regardless of size, if the value of a bank’s assets falls below the value of its liabilities, equity goes negative and the bank “fails.” And here’s the interesting thing, a big part of banks’ liabilities are deposits, and if depositors ask for their money all at once, banks need to sell assets to pay them back and keep the equation in balance. And selling lots of assets at once can cause the prices of the same assets to decline which causes a dangerous spiral. Banking crises are usually liquidity crises and liquidity crises are crises of confidence.

SVB was the go-to bank for technology companies and venture capitalists. Its assets included loans to tech companies and money it couldn’t lend was parked in longer-term Treasuries. It’s liabilities (deposits) came mostly from the tech companies flush with IPO cash and venture capitalists with more cash than good investments. When the Fed began raising rates, SVB got punched in both sides of the balance sheet. First, reeling from a slowdown in business and unable to raise more cash in the equity markets, many tech companies were forced to draw-down deposits to pay their bills which caused SVB to sell assets to raise the cash to cover those withdrawals. But when it went to sell its Treasury securities, SVB was forced to recognize losses in its securities portfolio that arose after higher rates pushed bond values lower. Trying to plug the nearly $2 billion hole it would recognize, SVB failed to raise $2.25 billion in a stock sale. Once SVB’s very savvy depositors saw the smoke, they began withdrawing money so fast that there could be no way for SVB to sell enough assets without failing. The FDIC – which provides bank supervision and insurance on some deposits – placed SVB in receivership Friday morning.

As future industry leaders the question you need to ask is, how likely is it that there are other banks that could be forced to sell assets at a loss? The FDIC estimates roughly $680 billion of mark-to-market losses on securities held on bank balance sheets (see below). To be clear, $680 billion is not an alarming number when compared to the roughly $2 trillion in total equity in the banking system. But this is another case where averages don’t matter; depositors don’t wonder if the banking system is safe, they ask, “is my bank safe?” and that’s a tougher question for the public to answer. The result being that it doesn’t take the whole system to fail to spark a liquidity crunch for all. Similarly, we might want to know how many other banks have concentrated exposure to rate-sensitive sectors of the economy. One would think the banking regulators know the answer, but once again, the average depositor does not have this information which undermines confidence. Moreover, specific circumstances become less relevant when the news is full of headlines foretelling a broader recession. This is why all bank stocks, particularly regional bank stocks, traded lower in sympathy with SVB on Friday.

Whether we’re talking about a single bank or the entire system, bank runs occur when confidence is called into question and the answers are delayed or equivocal. I seriously doubt that policy makers at the Fed, FDIC, OCC, and Treasury will let this get to that point, but what began Thursday as a run on a very poorly managed bank by “hot” depositors has the potential to sow doubt in the broader system unless the public gets clear and useful information, tomorrow.

And one of the questions we all have is, how did the regulators miss this? A fast-growing regulated bank with highly concentrated credit exposure to a very volatile industry and funding a large portfolio of long-dated Treasuries with hot deposits during one of the most severe selloffs in the history of rates…that doesn’t seem like a problem that was hiding in the “shadows!” And the next question we all have is, what happens if the problem spreads? To their credit, the FDIC and the Fed (the regulatory side of the Fed) are meeting this weekend to discuss creating a fund to insure deposits in failed banks for more than the current limit ($250,000). This would effectively complete the nationalization of the banking system with more implications than we can discuss here.

Finally, will this cause the FOMC side of the Fed to change course on rates? I think that depends on how depositors and markets react next week. But any sign that the Fed is willing to change course due to risky bank behavior when it has said repeatedly that it will stay the course even if/when employment drops would turn this into a complicated political mess at a time when clarity of communication and coordinated action are paramount. If history hasn’t taught us much about fire prevention, hopefully we’ve learned all we need to know about putting them out.

It should be an interesting week.

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