An Anatomy Of The Banking Crisis

Last Friday (March 10), seemingly out of the blue, the financial world was rocked with the failure of Silicon Valley Bank (SVB
VB
), then Signature Bank
SBNY
. This week we saw the contagion spread to Europe (Credit Suisse). The chart above shows the rapid plunge this past week in the S&P Regional Bank Index, not a pretty picture.

We did have a CPI report; it was released on Tuesday (March 14) and was nearly identical to market expectations, with Y/Y inflation falling back to 6.0%. Then on Wednesday, the Producer Price Index showed an actual fall of -0.1% for February, with the services sub-index also showing up as -0.1% for the second month in a row, something we haven’t seen for more than 7 years. The Fed meets next week, with markets now indicating that a 50-basis point rate hike is now off the table. The sentiment appears to be tilting toward between no rate hike, but 25 basis points is still a clear possibility with this Fed.

The financial world is still reeling from this turbulence. The U.S. Regulators tried to make this a one-off event. But clearly nobody bought that, as many U.S. Regional Banks had silent deposit runs on them and we just had similar drama with Credit Suisse in Europe (with the Swiss National Bank ending the drama with a 50 billion franc ($54 billion) cash loan. Then on Thursday (March 16) we learned that there is a discussion led by JPMorgan and other large money center banks to make a deposit of $30 billion into First Republic, which is the latest bank experiencing this assault of deposit runs. This gives First Republic $30 billion of liquidity to help them survive any deposit withdrawals from clients who have lost confidence.

Back to SVB. Last Friday, because they were a lender to the tech sector, especially tech start-ups, some commentators said that this was a one-off event. Relevant here is the level of uninsured deposits. As of 12/31/22, of the $175 billion of deposits, 94% were not insured (i.e., over the $250K limit).

SVB was a niche bank – it catered to technology company start-ups. Note its name and location – in the heart of Silicon Valley. When a start-up gets capital from its sponsors, its new shareholders, those sums are usually in millions of dollars. They deposit these funds into their bank account – and since SVB was the niche bank for such start-ups, the deposits were all way over the $250K FDIC insurance limit.

Let us digress here and explain the banking process. In order for a bank to make a profit, it must have investments – either it makes loans to businesses and individuals, or it buys assets like bonds. It does that with a portion of the deposits it takes in. So, because they make loans or buy bonds, a bank doesn’t have enough cash on hand to pay back all the depositors at once. And, in normal times, they don’t have to. On a daily basis, new deposits come into a bank even as owners of existing deposits make withdrawals, usually by writing checks. This is the normal way the system works – until, that is, the public loses confidence in a particular bank, and everybody wants their deposits at the same time – that’s called a bank run. These are very rare – the last time we saw anything near to what is currently going on was in the 1930s, before FDIC insurance, although we did have some issues back in 2008.

There are sources of liquidity for a bank. They normally have lines of credit with the Federal Reserve Bank or other government agencies like the Federal Home Loan Bank. However, when those are exhausted, the bank must sell its other liquid assets, its bonds.

Prior to March 2022, bond yields were miniscule and had been so since the end of the Great Recession. The Fed had kept interest rates near zero and kept creating money until it decided to go on the fastest hiking spree since the early 1980s. Because of the length of time interest rates were low (2008 to 2022), in order to garner any sort of yield, some banks bought long duration (time to maturity) bonds. When rates rise, longer duration bonds suffer much higher price depreciation than do shorter ones. And when rates rise spectacularly fast, the bond prices fall rapidly.

It is pretty certain that SVB is not a loner when it comes to the value of their bond portfolios. It’s been a year since the Fed began hiking. So, the question becomes: If some banks have this bond problem, why aren’t there more bank solvency issues? This is what the regulators feared the weekend that SVB and Signature Bank failed.

To protect bank earnings and capital from tumbling when interest rates rise, thirty or so years ago, the accounting profession and the bank regulators set up a “Held to Maturity” classification for bank bond portfolios. Bankers could elect to put bonds in that designation, or into a separate pool called “Available for Sale.” Bonds in the “Held to Maturity” classification don’t have to be marked to market (i.e., from the purchase price, these bonds amortize or accrete toward the maturity value). The logic is, since they are “Held to Maturity,” market prices do not matter (our comment: until they do). Bonds in the “Available for Sale” account are regularly marked to market prices. The one caveat is that a bank cannot just “sell” a single bond from the “Held to Maturity” account. If it did, the entire “Held to Maturity” pool would have to be immediately marked to market.

As noted, because of the minuscule rates from the Great Recession till last March, most of the bonds in the “Held to Maturity” classification are likely to be longer-term in nature (because they had some yield when purchased during the Fed’s zero interest rate regime). As rates have dramatically risen over the past year, the market value of those bonds tanked. Clearly, in SVB’s case, the losses in the “Held to Maturity” portfolio were enough to deplete its capital and cause its insolvency.

In today’s world, some banks would suffer a significant depletion of capital if their “Held to Maturity” bond portfolios were marked to market. As a result of the SVB and Signature Bank failures, in the immediate aftermath of those failures, the regulators set up some new rules to persuade the public that their money is safe in their current banks:

  • They guaranteed 100% of the deposits at both SVB and Signature bank. We suspect they would extend this to any other large bank that fails in the near future. But, apparently not to small banks because, on Thursday (March 16), Treasury Secretary Janet Yellen, when asked by Oklahoma Senator Lankford if the deposits in all banks, regardless of their size, are now 100% insured, she responded: Uninsured deposits would only be covered in the event that a “failure to protect uninsured depositors would create systemic risk and significant economic and financial consequences.” [Translating that into plain English: 100% of the deposits of the large banks are now covered, but if you are a small bank, probably not. Thankfully, the media isn’t pushing this declaration.]
  • The regulators also set up a new lending facility for banks in which they would loan 100% of the face value of the “Held to Maturity” bonds. As a result, if that portfolio is worth, say 15% less than what it was purchased for, the bank could get 100% of their investment using those bonds as collateral. They won’t have to sell them and take a loss on their financial statements. This protects the capital position shown on the financial statements, and, at the same time, satisfies the regulators.

Like any corporation, a bank will survive if it has enough liquidity to continue operations. That’s what those new lending facilities are designed to accomplish, i.e., the provision of adequate liquidity to survive any storm.

Final Thoughts

Of course, the burning question is: Have we seen the end of this crisis? As we write, we don’t think this is over quite yet – we still have to get through the First Republic issue, and there may be other targets over the near term.

Nevertheless, this is what poor Fed policy (both keeping interest rate too low for too long, and then spiking them) has done to the banking system. This is what happens when there is a singular goal (2% inflation) that is pursued without regard to the health of the entire system, which, by the way, is clearly a responsibility of the Fed.

As we have discussed in prior blogs, there is a Recession coming:

  • Via the lagged impacts of the Fed tightening moves that have already occurred;
  • Via the inevitable tightening of bank lending in the wake of the current instability in the banking system;
  • As indicated by the fall of the Leading Economic Indicators over the past year;
  • Because retail sales are soft;
  • Because corporate profits are falling;
  • ……. The list goes on.

Prior to last week’s banking sector instability, markets were braced for a 50-basis point hike in interest rates at the Fed’s March 21-22 meeting. The consensus now is a toss-up between no hike and 25 basis points. In our view, given the instability in the banking system (which the Fed is supposed to be concerned with), and the fact that the recent Producer Price Index was -0.1% for February, any rate hike appears to us to be overkill. We are very firmly in the rate reduction camp. That’s because we think the Recession will break other things in the economy – we just don’t know what or when!

(Joshua Barone contributed to this blog)

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