By Steven K. lewis
The week ended with the unusual mid-day Friday FDIC takeover of SVB (usually these happen at closing time), followed by the weekend closure of another large institution, Signature Bank in New York (with over $100 bil. in assets), which had significant exposure to the crypto market. Treasury Secretary Janet Yellen went on the weekend news circuit to reassure the public. It appeared a good deal of work was occurring in the background along with the FDIC to get to the bottom of the damage, negotiate with a possible buyer for the bank, and/or provide a backstop of sorts. However, any type of solution was downplayed until late Sunday, when it was announced the U.S. government would guarantee all depositor funds beyond bank assets, using the ‘systematic risk exception’ (SRE). In fact, a new Fed facility, the Bank Term Funding Program (BTFP), was created to help banks with liquidity problems by offering short term loans by posting high quality (Treasury or agency MBS) collateral at par value. It was also communicated that taxpayers would not bear the brunt of any losses—which appeared to be an important part of the government’s message. There is some precedent to this, such as the Bank of New England failure in 1991, where the FDIC insured deposits above the then-lower $100k limit. Such an outcome provides a soft landing for depositors and puts a stop on run risk for other regional banks, but stockholders are still likely wiped out.
The speed of SVB’s collapse was unsettling to financial markets, to put it mildly, especially to the financial/banking sector, which saw sharp stock price declines. While the SVB failure is the second largest in history (behind WaMu in 2008), the consensus at this point is that it was a one-off of sorts due to the nature of the bank’s clientele, sector concentration, and financing.
There are a variety of concerns that raised the stakes of this bank’s failure in particular:
It was a preferred bank of the U.S. technology and biotech sectors, with both private and public companies as clients, as well as venture capital. These have been obvious key drivers of American innovation and catalysts for economic growth. As such, there’s little political will to inflict long-term damage there, particularly as the global technological competition with China has been continually ramping up, in one of the only areas of broad bi-partisan support.
Because of this concentration in tech, and large balances held by certain firms (which could be more of a corporate finance diversification issue to be further probed), payrolls and routine corporate liquidity were at risk.
The problem was exacerbated by SVB’s large loan and securities portfolio as a percentage of deposits. The sensitivity of those assets to rising interest rates and realized trading losses to shore up capital requirements based on how these were accounted for on the books, were the impetus of last week’s sudden insolvency.
Retail depositors only represented about 10% of the total (per JPMorgan data). While this is the group that typically falls under FDIC insurance limits, it represented a small part of the problem in this case. For the average large U.S. bank, that insured number has fallen in the 40-60% range.
That means corporate investors represented approximately 90% of the remainder and are far less likely to fall under the FDIC umbrella. In theory, all uninsured assets were at risk of loss, beyond what can be recovered from the bank’s assets, where the Treasury Dept. did not make an exception.
The Fed and Treasury acted relatively quickly, at least as quickly as conditions at SVB fell apart. The announcement of a backstop for other banks using collateralized loans or swap-type tools isn’t unusual in these situations since the quality of collateral isn’t the problem. So, it isn’t a ‘bailout’ as much as it is an ‘extension’ of sorts. The treasury and agency MBS debt is expected to mature at par—the failing banks just can’t wait that long for market prices to recover, while another more liquid bank (or the government) can.
Regulators have been careful to walk a tightrope here. Excessive help can flip the positive sentiment to negative due to the classic ‘moral hazard’ problem. As discussed widely during the 2008 financial crisis, routinely bailing out every problem bank takes away the responsibility for banks to act prudently. In fact, it could give the impression of a ‘put option’ in place potentially allowing a bank to take on a variety of extra risks since much of the downside is removed (other than wiping out jobs and stockholders). This creates more instability in the system. While ‘creative destruction’ is painful, it’s also necessary to ensure risk is handled in a responsible way. Of course, a line is drawn when it comes to depositors, who are considered the innocent victims of such bank management problems. Trust in the banking system is the most important factor to its proper function, above all else, which is often echoed by the Treasury, Federal Reserve, and FDIC in their comments when reassuring the public and creating these new facilities.
At the same time, the problem appears to not be one of improper or missing regulation. Bank rules have often been put into place in response to the most recent crisis. After 2008, it was about bank capital but also classifying various types of capital into ‘tiers’. This was intended to guard against problems with taking excessive credit risk. However, with fixed-income securities (a key bank asset), credit is only half the equation—the other half is interest rate risk. Credit wasn’t an issue with SVB, as the assets appeared to be treasuries and agency mortgage-backed securities, which are considered top-tier, due to their lack of default risk. Instead, rising rates pushed down the value of long-maturity bonds, turning this more into a duration risk issue.
What happens now? After the Treasury Dept. and FDIC guaranteed all depositor funds, they appear to be seeking to broker a merger of some sort behind the scenes to absorb SVB’s assets for a low price (insolvent banks have been sold for as little as $1). It might even involve a foreign bank.
What are the wider ramifications of SVB’s failure? There had been some push in social media over recent days (before the government stepped in) to pull funds from regional banks in favor of the ‘big 4’ banks (by assets, considered to be JPMorgan, Citibank, Bank of America, and Wells Fargo—the ‘too big to fail’ group). This gets to a breakdown in trust, again a concern for the Treasury Dept. and Fed, potentially creates consolidation risk, and reduces competition, which many policymakers also want to avoid. This is the primary reason why a structured and targeted ‘bailout’, coupled with a merger/absorption, fortifies trust in the banking system, while not giving the impression the bank is off the hook completely.
Will this have an impact on Federal Reserve policy? While the Fed has held steadfast to beating inflation by raising rates, with more tough talk last week, this episode is a powerful example of the byproducts of sharply rising rates and the banking system problems caused by an inverted yield curve, which ultimately can put a dent in financial stability. The dilemma of balancing those two goals is being closely monitored by financial markets (on a weekly, if not hourly basis these days).
The Fed met in March and raised interest rates by another 25 basis points, bringing it to a 6-year high. In fact, the June probabilities are already back to showing a possible rate cut, and several again priced in by December. This reflects the view that the Fed has finally ‘broken’ something, which has often happened at some point historically during the tightening process.
Sources: FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Citigroup, CME Group, Deutsche Bank, FactSet, FDIC, Financial Times, First Trust, Goldman Sachs, Invesco, JPMorgan Asset Management, Marketfield Asset Management, Morgan Stanley, MSCI, Morningstar, Northern Trust, PIMCO, Standard & Poor’s, Seeking Alpha, StockCharts.com, The Conference Board, Thomson Reuters, T. Rowe Price, Univ. of Michigan, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wall Journal, The Washington Post. Index performance is shown as total return, which includes dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor. The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.
