I am sure you, like me, have been watching the unfolding events in the banks over the last couple of weeks with a level of apprehension. At the heart of the issue is the banking system’s exposure to rising interest rates. There are larger problems than rate exposure at the banks, however it is unclear if these problems would have been exposed without higher rates. By and large, the banking system is well capitalized and lending standards have been high at most banks. This is not a situation like 2008 where banks were stuffed full of bad loans and had a credit quality problem. The quality of the loans at the banks are government securities and are of the highest quality. The problem is that they are holding long duration assets that are sensitive to changes in interest rates.
Take a look at the losses investors experienced in bond portfolios last year. The banks have similar losses in the bonds they are holding. Because of accounting rules, banks don’t have to acknowledge these losses in the held-to-maturity (HTM) portion of their balance sheet. The problem occurs when deposits are removed from banks and those bonds have to be sold at a loss to cover those deposits. A new facility that was enacted by the Treasury will provide help to these banks by allowing them to place these underwater bonds at the Federal Reserve at full price. This is a collateralized loan for a year; it has to be paid back with minor interest.
The bigger issue is that this has become more complicated by Janet Yellen segmenting the small and regional banks. Janet Yellen told senators that uninsured deposits (deposits over the FDIC limit) will only be refunded at banks that pose a systemic risk to the financial system. In essence, she has reinforced a two-tiered banking system that harkens back to the “too big to fail” days of 2008. If your bank is big enough to be deemed systemically important then you will continue to receive government assistance when things get tough. If you are a smaller bank then you must fend for yourself and good luck. As you would expect, this will mean that deposits will be moved from smaller regional banks and move to larger money center banks. This adds a lot of potential uncertainty around banks that operate in rural parts of the country that are not serviced by larger banks.
If you do not have deposits over the FDIC limit, then you don’t have to worry about the security of the deposits even if something were to happen to your bank. Another alternative over the last year that has gained popularity is money market funds. You can buy a government money market fund that is yielding higher than deposit interest rates. While these do not have a guarantee from the FDIC, they are holding US government securities, and therefore, are backed by the same entity that is guaranteeing the deposits through FDIC. At Fidelity, we utilize two separate money market funds and they are both of the government security variety.
I want to provide some insight into how Silicon Valley Bank (SVB) found itself in this situation. If you are not interested in these details, please feel free to stop reading here.
First, it is worth asking how SVB got into this situation. SVB was the banker of choice for numerous Venture Capital and start-up companies. They attracted a number of these businesses with “innovative” (risky) practices. These new companies came in with lots of deposits well over the FDIC limits resulting in the bank having the majority of deposits uninsured. When they took in the deposits from these new businesses, they bought a lot of treasuries and mortgage-backed securities (MBS) while interest rates were low. They held these in a part of the balance sheet called held-to-maturity (HTM). Because these treasuries and MBSs were intended to be held until the bonds matured at par, they did not have to report losses on the bonds when the Federal Reserve started raising rates.
SVB is not alone in this situation, and many banks have seen the value of their HTM bonds decrease in value. SVB was also not one of the 15 largest banks that require stress testing. As a part of that testing, the 15 largest banks are required to disclose how much interest rate risk they have.
When venture-backed companies became concerned, they began withdrawing their deposits quickly, resulting in around $42 billion dollars leaving the bank in a single day. This was a classic run on the bank. Because of who these depositors are, they were able to move a massive amount of money in a short period of time. SVB attempted to find additional capital, but was unsuccessful, leading to the FDIC closing and taking over the bank the following day.
It is unclear how the next events will play out. Government officials have stated the necessity of having a robust small banking system. I expect we will see changes over the coming months that will try and bolster the banking system. It is also unclear if this will change the Federal Reserves interest policy and quantitative tightening policy. I am writing this ahead of the next rate decision, but I suspect that Jerome Powell will have something to say about recent events. This added turmoil does highlight the importance of being diversified and having a plan. As always having a long-term approach, staying diversified, and remaining calm lets you take advantage of uncertainty, not held captive by it.
Please Note: This market review was published on March 24th, 2023 and may not be reflective of current market or investing issues.
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