Bank challenges and the markets - Checking in
Normally I’m excited about March Madness this time of year and settling in to watch some games, but it’s been a very full week with things I already had scheduled and then with the banking headlines from this week (and the related market developments) those games have been pushed to the side for now (but congrats to SDSU for those in town fans).
It’s hard to craft a letter trying to make sense of things for you when new news comes out each day. As the situation unfolds, it’s important to keep in mind that we’ve been in volatile market environments in the past, and long-term investors ultimately reaped the rewards of navigating through turbulent times. Despite all the headlines, the markets are actually on track to be positive this week as of Friday mid-morning (the S&P and especially the Nasdaq – the Dow is roughly flat).
With that said, I know these kinds of events can feel scary and confusing, so I wanted to reach out and answer some of the questions you may have about what’s happening.
How It Happened: Silicon Valley Bank was the initial main trigger last week. There were a number of influences that together spelled the downfall of the bank. From 2020 through 2021, Silicon Valley Bank took in incredibly high deposits through PPP loans and through clients that were taking their companies public through a Special Purpose Acquisition Vehicle (SPAC). SVB took those deposits and decided to invest in long-term bonds, such as mortgages and treasuries, while interest rates were low.
2022 was a very different year. Silicon Valley Bank’s unique customer base of private companies started to need cash and, as a result, pull their deposits. In addition, interest rates also increased, which negatively impacted the mark-to-market value of its longer-term bonds. In an effort to appropriately deal with the impacts of its mark-to-market losses, the bank used a legal accounting change to consider those bonds “held to maturity.” (Any bonds that are held to maturity do not need to be updated with the market value but can be held on the books at cost.) Unfortunately, you cannot hedge interest rate risk for bonds in the “held to maturity” category, meaning the bank could not appropriately hedge interest rate risk for these longer-term bonds (of which they had many).
The combination of reducing deposits, too few assets that were marked at the market (or consistent with the current market value), and growing withdrawals forced the bank to sell their held-to-maturity bonds. When they sold these assets, the paper losses became realized, and those losses effectively overwhelmed the bank's equity, causing the bank to fail. All of this happened over the course of a week — and mostly over a two-day period. The stock was worth $267.83 close of business Wednesday and worthless by the close of business Friday.
Did Silicon Valley Bank do anything wrong? SVB did not break any written rules I'm aware of, but they did not effectively hedge their interest rate risk. Poor risk management ultimately spelled their doom. It would have been easy enough to reduce purchases of so many long-term bonds back in 2021, but the appeal for the bank to make a little bit more money on their deposits was likely too strong. It seems they didn't believe the Federal Reserve would raise interest rates so much so quickly. They were unprepared for the shifting market environment.
Some have said it was a “bank run.” Is that right? Yes, there are really three reasons why depositors pulled their money out. Many depositors needed money because their startup businesses were not as successful as anticipated due to the market environment. In addition, some depositors wanted higher interest rates they could achieve with a money market fund (4.5% vs. 1% at many banks). And when depositors realized that the bank’s tangible equity was falling, those with more than the FDIC-insured limit of $250,000 on deposit decided to take their additional savings out to be safe. $42 billion last Thursday alone.
Is the risk the same for the big banks (over $250B in assets)? Shouldn't be. Big banks are stress-tested regularly to ensure they are sufficiently capitalized to absorb losses during stressful conditions while meeting obligations to creditors and counterparties and continuing to be able to lend to households and businesses. Large banks are better positioned to hedge their interest rate risk. As a result, they are not prone to the same degree of risks as Silicon Valley Bank. However, risks remain. The good news is that FDIC covers depositors up to certain limits regardless of a bank’s size.
What about smaller banks? Yes, some smaller banks with more aggressive treasury operations (what they choose to do with the deposits and how they hedge or not) are at risk. Signature Bank of New York has been seized by regulators. Other midsize banks (which have less than $250 billion in assets) seem to have low tangible equity. There have also been issues that popped up this week with First Republic and even Credit Suisse overseas. Banks can be notoriously difficult to analyze, so I expect many who invest for dividends to find greener pastures.
Impact on the market? We’re not sure yet how this will impact the market other than introducing more volatility. Some believe that the Fed must stop raising interest rates immediately to stem the losses of these poorly performing long-term bonds on bank balance sheets, while others think the Fed needs to continue to raise rates to combat inflation. One thing is certain: bond market volatility, as measured by the MOVE Index, is likely to be heading higher. Last year, when the MOVE index increased, financial conditions tightened, the stock market declined, and the economy slowed. A similar scenario could be the case again in 2023.
That said, it’s important to recognize events like this do happen and keep in mind that we invest for long-term returns. Depositors should be okay as FDIC insures deposits up to certain limits, so make sure you are aware of and following those limits if you have that much cash. Equity holders of the banks may not. Being diversified, most funds have small, if any, exposure to the currently affected banks.
I encourage you to follow reputable news sources for more developments – there are a lot of people who try to profit off of fear in times like this and others who will try to say everything is fine. Like many things, the truth is somewhere in the middle. Rest assured, I will be paying careful attention to it myself and will reach out again if needed.