March 17, 2023
What a difference a week makes!
On Tuesday and Wednesday of last week, Fed Chair Jay Powell stepped out onto his financial tightrope in front of Congress and tried to placate both Wall Street (zero-interest rate fans) and Main Street (low inflation fans).
He was performing a balancing act, caught between the winds of a wobbly stock market and still stubborn inflation. Not an easy feat as it is.
What happened next could only be a plot twist in a movie…
On Thursday last week, literally one day after Powell did his best to assure everyone that everything was alright, the banking sector recorded a 6.0 shock on the financial Richter Scale.
Shares of California-based Silicon Valley Bank (SVB) tanked 60% — the biggest hit it has ever taken since it went public in 1987 — on rumors the bank was experiencing liquidity issues. (The rest of the banking sector lost over $50 billion as well.)
And the $64,000 question is… what happens next?
I want to explore that today. But first let’s take a little deeper look into the fall — and post mortem — of SVB…
Eight Days of Mayhem
By now you’ve most likely heard most of the details about what happened. But just in case you missed something, here’s a quick rundown.
The shakeup in the financial landscape wasn’t caused by some catastrophic failure in the system. Rather, it was sparked by a mid-sized regional bank called Silicon Valley Bank (SVB). SVB catered almost exclusively to the VC / start-up crowd. (Banks usually diversify their lending portfolios.) By doing so, they had put all their “deposit eggs” in one basket so to speak — which made them more vulnerable to any trouble in the tech sector.
Everything was great for SVB during the lockdown-driven tech boom of 2020-21 — they nearly tripled the size of their asset base. And like any bank would, they put a portion of those assets into fixed income securities.
As 2022 rolled around, however, their chosen “sector” began to come under pressure.
During the week, the bank announced plans to increase its balance sheet flexibility by shortening the duration of its asset holdings and raising capital by selling more shares.
Those efforts failed. And when word got out, SVB got caught up in a good old fashioned bank run. Here’s a little deeper look…
Willie Sutton was Wrong…
Gentleman bank robber Willie Sutton supposedly once said “I rob banks because that’s where the money is…”
Today that’s no longer the case.
To paraphrase another (fictional) banker of old, George Bailey, “Your money’s not here… Your money is in Joe’s house, right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others… and they’re gonna pay you back as best they can…”
The absence of money at your local bank is due to something called the fractional reserve system. The idea is because money is fungible, a bank need only keep a small portion of its deposits on hand to satisfy withdrawals. The rest they can lend out.
And the more they lend out, the better. Because it’s how BANKS MAKE MONEY!
For years, banks were required to maintain reserve balances of 10% of deposits. But in March 2020, during the pandemic liquidity fiasco, the Fed suspended any reserve requirement on the part of banks. In other words… Willie would be out of luck.
Of course not all money held by banks is handed out in loans. Some is invested in securities. This is a regular and accepted practice on the part of banks. No one would fault SVB for putting money into government debt.
Except for one detail…
It turned out SVB held some 57% of their $120 billion portfolio in treasuries and mortgage backed securities — longer term securities to be specific. (The average percentage among 74 major US banks is only 24%.) Again, holding these isn’t necessarily irresponsible. Virtually none of them are susceptible to any kind of default risk.
What they are susceptible to is interest rate risk… a rise in interest rates that would push the value of their bonds lower.
And Then the Fed Happened…
Having watched inflation soar to nearly 4 TIMES its target rate, the Fed decided it wasn’t transitory and that it needed to do something to get it under control. So in 2022 it started hiking rates with extreme prejudice. It was the most aggressive rate hiking move since Paul Volcker in the early 80s.
The spike in the fed funds rate took interest rates across the yield curve with them. And when rates rise in the market, the prices of the securities that pay those rates go down.
SVB’s roughly $120 billion portfolio had a 5.6 year duration — meaning they were locked in, long term, on a huge portfolio that had been sinking in value for over a year.
But still, all wasn’t lost because there are two types of bond holdings where banks go…
HTM vs AFS
I frequently talk about the unintended consequences the government thrusts upon those of us trying to get by in the regular economy, by fixing things they undoubtedly broke in the first place. This is a perfect example of that.
Back in 2009, as the economy was digging itself out from under the massive liquidity freeze that nearly tanked the world, US regulators suspended the mark to market rule for financial institutions. Instead, they let banks segment their assets into two buckets: Available for Sale (AFS) and Held to Maturity (HTM).
Anything in the AFS bucket would be marked to market daily but could be sold to raise capital and bolster liquidity if necessary. Anything in the HTM bucket had to be held to maturity BUT could be reflected on their balance sheets at cost. In other words, they wouldn’t reflect any losses the assets might have incurred due to changes in the market.
This was an idiosyncratic accounting solution to a more systemic problem faced by banks. It made them look better on paper, but their realities were much worse.
According to Vivek Ramaswamy in the Wall Street Journal:
SVB booked $91 billion out of $120 billion in the most favorable HTM category, and only $26 billion as AFS.
Last November the Wall Street Journal reported on the impact rising interest rates were having on banks’ bond holdings — they even mentioned SVB by name!
SVB Financial Group, the parent of Silicon Valley Bank, said the market value of its held-to-maturity bonds was $15.9 billion less than their balance-sheet value, as of Sept. 30.
What that is basically saying is the bank’s HTM securities had lost nearly $16 billion dollars in value…
That gap was slightly more than SVB’s $15.8 billion of total equity.
…a loss which exceeded the total equity held by the bank.
SVB’s chief financial officer, Dan Beck, said in an email, “There are no implications for SVB because, as we said in our Q3 earnings call, we do not intend to sell our HTM [held to maturity] securities.”
Which didn’t matter because they didn’t intend to sell them… until they had to sell.
To increase its balance sheet flexibility, the bank sold $21 billion of its AFS securities in the market (hoping to reinvest the proceeds in shorter term treasuries) but lost $1.8 billion in the process which basically indicated to the market how far under water the rest of their holdings were.
As an ironic side note: The bank had just been audited and given a clean bill of health by KPMG. Auditors are supposed to highlight excessive risks a financial company may be facing. How the $16 billion got overlooked I’m not sure, but there was another warning bell that should have been sounded…
Silicon Valley Bank’s deposits peaked at the end of the first quarter of 2022 and fell $25 billion, or 13%, during the final nine months of the year. That means deposits were declining during the period of KPMG’s audit. If the decline was affecting the bank’s liquidity when KPMG signed off on the audit report, that information likely should have been included. Since it wasn’t, the question becomes, did KPMG know or should it have known what was going on?
After the $1.8 billion in losses had been made public, venture capitalists Peter Thiel and Garry Tan both advised companies to limit their exposure to the bank.
And that was pretty much all it took to create a good old fashioned bank run. As news of the mass withdrawals spread, the bank’s stock tanked 60%. According to ZeroHedge:
…shortly after the Bank announced a loss of approximately $1.8 billion from a sale of investments and was conducting a capital raise (which we now know failed), and despite the bank being in sound financial condition prior to March 9, 2023, “investors and depositors reacted by initiating withdrawals of $42 billion in deposits from the Bank on March 9, 2023, causing a run on the Bank.”
As a result of this furious drain, as of the close of business on Thursday, March 9, “the bank had a negative cash balance of approximately $958 million.”
By midday Friday, it was all over but the shouting…
Stupid Government Bailout Tricks
The government wasted no time in doing everything in (and beyond) its power to calm the markets before Monday’s open. By Sunday the Treasury indicated that ALL deposits at SVB bank would be covered above and beyond the FDIC’s $250K limit. (Which is a joke because there’s less than $130 billion in the deposit insurance fund.)
On Monday President Biden was in front of the cameras taking full credit for saving the world.
“Thanks to the quick action of my administration over the past few days, Americans can have confidence that the banking system is safe.”
He of course blamed “the last administration” for loosening banking regulations and causing the current crisis.
Which is also pretty funny considering Barney Frank, retired Democrat Congressman, co-author of the Dodd-Frank bill and (former) board member of (the now defunct) Signature Bank — it went into receivership on Sunday — had been arguing for a loosening of the regulatory standards as well.
Regardless, if relaxing banking regulations is the problem, rewarding bad behavior by banks is certainly not the solution.
The media trumpeted Biden’s triumph…
As part of his solution…
[Biden] said he would ask Congress and banking regulators to strengthen the rules for banks, to “make it less likely this kind of bank failure would happen again.”
The sound byte version from the administration, that the loosening of regulations led directly to the current crisis we are experiencing, sounded fine on its face. But ZeroHedge notes the reality that’s rarely mentioned :
The 2018 law did not excuse mid-sized banks from performing quarterly liquidity stress tests to ensure they could withstand “adverse market conditions,” and “combined market and idiosyncratic stresses,” such as interest-rate shocks. Mid-sized banks must also maintain a liquidity buffer of “highly liquid assets” such as Treasurys and MBS.
In other words, easing regulations doesn’t give a bank leave to act like a financial idiot.
In addition to all this, on Sunday evening, the Fed introduced just a tiny bit of QE back into the banking system. According to the Fed:
The additional funding will be made available through the creation of a new Bank Term Funding Program (BTFP), offering loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. These assets will be valued at par.
Valuing these assets “at par” basically means the Fed’s covering any (unrealized) losses banks may have taken on the securities they hold.
Ordinarily I wouldn’t look for this to be a hugely popular program. No bank wants to step up to the borrowing window and effectively admit their portfolio is in the tank. But the Fed has already thought that much through… ZeroHedge reports that “the Fed won’t disclose names of banks using it for two years.”
The trough is back open!
Other Factors Come to Light
Other factors beyond the bank’s lack of liquidity, which may or may not have helped determine the bank’s fate, came to light in the days that followed.
The bank was a big supporter of the green energy movement. From its own press release:
SANTA CLARA, CALIF. – January 10, 2022—Silicon Valley Bank, the bank of the world’s most innovative companies and their investors, today announced it has committed to provide at least $5 billion by 2027 in loans, investments and other financing to support sustainability efforts and the company has set a goal to achieve carbon neutral operations by 2025.
It also maintained a major focus on DEI issues evidenced in a July 2022 investor call:
SVB was boasting about its diversity, equity and inclusion (DEI) progress and a Pride Month forum, as J.P. Morgan official Steve Alexopoulos pressed for answers on an investor call about why its investments had lost 8% of value in a single quarter, according to the transcript of the meeting.
It was a darling among the ESG crowd:
The now-failed bank had an A rating for its Environmental, Social and Governance policies according to the MSCI index after creating its own initiatives to ‘advance inclusion and opportunity in the innovation economy’ and investing in clean energy solutions over the past few years.
And it was missing a key employee for the better part of a year…
Laura Izurieta, the former head of risk at Silicon Valley Bank, left the bank in April 2022. She wasn’t replaced until January 2023 when the bank hired Kim Olson.
I’ve warned in the past that excessive, blind investment in green technology is risky because it’s not ready for prime time. And that focusing on your ESG score is a red herring because those demanding you do it aren’t doing it themselves.
And I’ve never thought it was a good idea to go without a chief risk officer for 9 months…
The Fallout
Despite the government’s best efforts, by mid-week the fear of further trouble spread throughout the entire regional bank market which took a hit. On Wednesday, First Republic was downgraded by S&P from A- to BB+ (that’s four notches to basically “junk” status).
The chaos sent investors rushing to the safety of the treasury market, spiking volatility, crushing yields and creating even more chaos there.
And then with SVB and Signature Bank of New York’s failures on the books, Credit Suisse — a global bank classified as a “systemically important financial institution” under international banking rules — came under scrutiny when: “the bank said it found material weaknesses in its financial reporting.”
The Swiss National Bank finally came to their rescue with a backstop of $54 billion to “pre-emptively strengthen its liquidity.”
All in all, it was an exciting week.
So exciting, most of the critical economic news of the week was pretty much ignored.
Inflation numbers came out on Tuesday with headline CPI printing at 6% — down from last month’s 6.4% print but still way above the Fed’s target. The core number came in at 5.5%, barely down from last month’s 5.6%.
Wholesale prices were posted on Wednesday and showed a little more promise. The PPI was 4.6%, surprisingly lower than last month’s print of 5.7%. Just as encouraging was the PPI core number which came in at 4.4% vs 5%.
The one number the Fed has liked hanging its hat on to show the economy’s resilience, Retail Sales, came in at an anemic 5.4%, down from 7.7% last month. (I’ve written before about how misleading retail sales actually is. Maybe this indicator is finally starting to catch up with reality.)
And Meta announced it was laying off another 10,000 employees.
Now What?
Here’s a quick summary of the past two years… Years of artificially cheap money led to a generally inflated asset market… An economic shutdown by the government crippled the global supply chain and set inflation soaring… A government giveaway stimulus program dumped fuel on that fire… And now the Fed’s aggressive move to fix that problem has caused yet another unintended consequence.
Frankly, while there’ll probably be more aftershocks from this episode as smaller and mid-sized banks are scrutinized, I don’t believe anything systemic is threatening the economy. There was no massive loan fraud that fueled a bubble. Leverage hadn’t become out of control. This debacle had one, and only one cause…
The Fed.
Sure, there are other factors that could be to blame in part. KPMG missing a plummeting deposit rate and signing off on a clean audit. A too-preoccupied focus on equity, diversity and all things green instead of on hedging interest rate exposure. Not replacing your chief risk officer for three-quarters of a year!
But by hiking rates the way they did, this one is on the Fed. It has potentially put a number of its member banks underwater.
I’m not saying that it wasn’t a necessary evil. The Fed HAD TO address the inflation situation. (And let a little air out of the fake economy.)
Some will say this could’ve been avoided if they would have started tightening more modestly in early 2021 instead of insisting inflation was transitory.
Maybe. But there’s absolutely no way to know that. Back in early ‘21, the supply chain was still in shambles and people were still flush with stimulus money.
The response by the government was telling as well.
No matter what they say in Washington, its guarantee of all depositors was a de facto bailout. Investors may end up with nothing, but the G basically made the bank whole again. Ignore, for a moment, the fact that most of those depositors were into green technology (not to mention Democrat donors), the simple fact that they have agreed to guarantee all deposits has set a precedent.
It has effectively rewritten the law by fiat. There is no more $250,000 limit on FDIC deposit insurance. (Not that most people have more than $250K in the bank.) The Deposit Insurance Fund (theoretically paid into by banks) is now a bottomless pit — and an empty symbol. Basically it’s bailouts for everyone from now on.
Another point to take note of: The Fed “Blinked.”
For all their hawkish talk, the Fed opened the QE tap ever so quietly when it launched its term funding program accepting all qualified securities as collateral at par — and not disclosing borrowers’ identities for two years.
It’s certainly not buying $125 billion in treasuries and mortgage-backed securities every month, but it showed that the Fed definitely has its own stress limits.
Where inflation goes, I’ve been harping that monetary tools won’t get the job done. That it’ll likely take a recession to get inflation numbers back in line with Fed targets. The Fed says there is a lag when it comes to the impact of their rate hikes.
Most of the market was expecting the impact of higher rates to show up directly in inflation numbers. Looks like it showed up in the banking sector. And this could well be the tipping point that (officially) pushes the economy into a recession.
The final question is what will the Fed do now at next week’s FOMC meeting. Well, they’re still squarely facing a rock on one side and a hard place on the other. A headline from the WSJ sums it up…
So far banks’ estimates are split. Goldman says the Fed stands pat. JP Morgan is still looking for 25 basis points.
Last week I said I thought the Fed would take a pause in early 2023.
With inflation at least heading in the right direction, producer prices surprisingly lower and retail sales possibly reflecting some softness building in the economy, it might be a good time for JPow to hit the pause button and reflect on what they all have done to the economy…
Make the trend your friend,
Bob Byrne
Editor, Streetlight Confidential