Suddenly and All at Once

The days ahead:

• Fed meeting

This week:

• Silicon Valley Bank broke some cardinal rules of banking…
• …but it doesn’t look like it will spread but the Fed did the right thing
• And so did the Swiss National Bank for Credit Suisse
• Central banks are coordinated on bank problems.
• Bank problems meant Treasuries rallied
• And so did international bonds
• Meanwhile the economic numbers are doing fine

Program note:

This week’s note is a bit shorter (Editor: hooray) because a lot has happened. We’ve tried to cover the important items below. But let us know if you have questions or topics you’d like to see.

Silicon Valley Bank: What Just Happened?

When a bank goes under, journalists quote from Hemmingway’s “The Sun Also Rises” about going bankrupt in two ways, gradually then suddenly. The story of bank failures is as old as, well, banks and comes down to something very simple. Loss of confidence. In the film It’s a Wonderful Life Uncle Billy forgets to make a crucial deposit, and customers start wanting their money back. Call that operational mismanagement followed by a run. In Mary Poppins, it’s a straight demand for money from Michael Banks who starts a riot because he’d rather feed the birds than deposit his two pennies. Call that depositor preference.

Bank regulators know a loss of confidence is fatal to a business that relies on “maturity transformation”. This is just a grand way of saying that a checking deposit to you and I is money conveniently stored for whenever we want it. To a bank it’s a one-day callable liability that can be removed any time. A bank cannot make money if it just sits on the cash, investing it overnight at overnight rates and paying interest out every day*.  So the deposit is turned into a loan with a different maturity. That can be for a 30-year mortgage, a 7-year commercial loan, a 5-year car loan or even rolling credit card debt. But the point is that short-term deposits are turned into long-term loans by “maturity transformation”.

Borrowers pay higher rates of interest than the bank pays to the depositors. The bank collects the difference. This is called a spread or sometimes a net interest margin, and voilà, you now have a profitable operating bank. It’s not that complicated.

Where a bank gets into trouble is when a loan goes bad or depositors take their money out. A loan going bad is simple enough. A borrower misses a payment or goes bankrupt. Then the collateral value against which the bank made a loan goes down. That could be a house, car, factory, inventory or pretty much any sort of hard or financial asset. If a borrower stops paying, the bank collects the collateral, say a car, and sells it for half of the purchase price. The bank has a loss on its hands and takes a charge against its capital. If this happens too much the bank has no more money, calls it quits and asks for help.

If the depositor is fed up with the bank and wants to put her money somewhere else, the bank must raise the money by selling a loan. That loan may be just to the Federal Reserve, which is no problem. But if it’s to a car owner, it must liquidate the loan, which is very inconvenient to the car owner, who may just say “come and get it” or sell the loan to another bank. If lots of depositors do this, the bank has no more money, a bunch of loans that it can’t sell, calls it quits and it asks for help.

Of course, there are a ton of regulations, laws, financial ratios, deposit insurance, liquidity buffers and capital requirements to stop bad loans or anxious depositors to help a bank not call it quits and ask for help all the time. But the basic principle is to find good, sensible depositors and match them with good sensible borrowers. Unfortunately, not all banks do that.

The Silicon Valley Bank (SVB) problems comes down to having bad depositors, bad assets and not following the regulations.

Bad depositors:

The international standards on banking, or the Basel committee, ranks depositors on a score from “stable” to “unsecured wholesale”. A stable depositor is usually a person whose salary is automatically deposited every two weeks, has a checking account and for who changing banks is a hassle. These are given a 95% capital rating on the assumption that only 5% of the deposits will run off. All these depositors would have Federal Deposit Insurance Corporation (FDIC) insurance, which covers deposits up $250,000 per account.  

The ranks go all the way down to the “unsecured wholesale” category of securities firms, other banks and “hot money” which is just using the bank for its high rates. For these guys, changing banks is no hassle at all. They’re given a 0% capital weight on the assumption that they will run off very quickly. None have FDIC insurance. There are about seven categories in between the “good” 95% retail deposits and the flighty corporate 0% deposits.

SVB had a lot of corporate deposits and people with very large, non-FDIC insured deposits. By the end of 2022, the bank had total deposits of $193 billion of which $156 billion were in accounts greater than $250,000 and so not FDIC insured. They also had a lot of deposits in that last category of “unsecured wholesale”. Many of them were tech companies just holding cash to meet payroll. Roku, the streaming service, for example, had $487 million at SVB, which was 25% of its cash. They could move that money any time and frequently did. If you have a lot of Rokus as your deposit base, you’re at risk of a run. In all, only 3% of SVB’s deposits were FDIC insured.

Bad assets:

This is where it gets tricky. SVB did not have bad loans like we described above. There was almost no credit risk, where borrowers suddenly could not pay. What SVB did have was interest rate risk. The bank took 37 years, from 1983 to 2020, to grow to $100 billion in assets. The next $120 billion took about a year. But there wasn’t a lot of loan demand in the pandemic, so SVB bought U.S. Treasuries and mortgage securities instead. They paid depositors 0%, earned around 2% on the securities and life was good. They picked up a 2% margin, minus expenses, and didn’t have to worry about bad borrowers.

The stock went from $140 to $750. To be fair, a lot of banks bought securities in 2021. Here:

The blue line shows the spike in Treasury and mortgage securities as a percent of bank assets. Note the increase from 16% to 19%. That was a direct result of high cash deposits and low loan demand. They’ve since come down to 17% based on the lower market value of the securities.

SVB bought a lot of Treasuries and mortgages. By the end of 2022, it held $120 billion in them or over half its balance sheet. That’s quite a lot more than the 17% shown in the graph. It bought most of these when the 10-Year Treasury yielded less than 2%. Rates went up in 2022 and the value of the securities fell by around 15%. SVB didn’t have to mark all of those to market but the losses were there and regulators told them to raise capital to cover the loss. But they never got round to raising more capital.

Regulations:

Banks operate under numerous regulations and ratios. But the one that matters to SVB is the “Liquidity Coverage Ratio” or LCR. It says that a bank must have high quality assets equivalent to 100% of 30 days of expected cash outflows under stress conditions. Basically, it requires banks to be able to fund any short-term run off in deposits. The minimum standard is 100%. But SVB said, “Ha, those rules aren’t for us. They’re for big banks. We have [checks screen], er, less than $250 billion and we’re America’s 16^th largest bank so we don’t have to meet LCR rules.” They phrased it differently:

Because we are a Category IV organization with less than $250 billion in average total consolidated assets…we currently are not subject to the Federal Reserve’s LCR or NSFR requirements, either on a full or reduced basis.

– SVB Financial Group (via the United States Securities and Exchange Commission Form 10-K filing)

In other words, they didn’t have to play by the same rules as other banks. No one’s quite sure what SVB’s LCR was because it didn’t have to calculate one but it was probably at best around 70%. Even if it was, it couldn’t have met the $42 billion of withdrawal requests it had over a few days last week.

SVB was gradually getting into trouble. They had big, but twitchy depositors and a bond portfolio that was seriously underwater. The final straw, the “all at once” for Papa Hemingway, was the sudden rush of withdrawals by its depositors.

We haven’t mentioned the SVB’s clientele of tech firms, venture capitalists (VC) and funds in this story, because we think it’s mostly irrelevant. Sure, the VC folk tend to herd. After all, they all come out in sync on AI/Web 3.0/multiverse/big data/fin tech/cloud/block idea. Just watch any documentary about sheep farming in the Shetlands and you’ll get a good idea of how they act. It looks like someone on a VC WhatsApp/Substack group said “Take your money” out, so, just to show how independent they are, they did.

But they didn’t run the bank and they didn’t force the bank to take deposits or buy securities. It’s just a bank that grew too quickly, attracted the wrong kind of depositors, operated a sizeable funding mismatch and jumped through a giant regulatory loophole.

In a final piece of outstanding opportunist marketing in this fast-breaking story, the new CEO of SVB put this ad out:

That’s a cunning plan. “We’re a bust bank and the government is bailing us out, so come join us and have all your deposits fully guaranteed.” I dunno, maybe I’m getting old. Still, land of second chances, eh?

The Fed Steps In

We have a new acronym at the Fed! It’s BTFP or and the Bank Term Funding Program. The Fed, the U.S. Treasury and the FDIC stepped in over the weekend to buy any Treasuries, agency debt (meaning GNMA, FNMA etc.) and Mortgage Backed Securities (MBS) (also any security on this long list) from any bank at par. That last bit is key. It means the securities we mentioned above can be sold to the Fed 15% to 20% above where they currently trade. The BFTP will run for a year and is limited to $25 billion. The Fed will no doubt increase the amount if necessary.  

One could argue this just disguises the bank’s losses. But rescues are about keeping an orderly flow of money and preventing runs. Whether the bank loses money is a secondary issue for now. The Fed does not lose money. It buys a Treasury/MBS/Exim Bank loan at par and holds it to maturity.

The Fed also confirmed that the discount window remains open. This allows banks to borrow from the Fed for up to 90 days using a wide range of collateral and loans. A bank can pretty much turn any part of its balance sheet into cash.

This is simple as “I have a $10,000 loan against a boat. Please lend me $10,000 for 90 days at a rate of 4.75%. Oh, we think the boat’s only worth $5,000 because it has a hole in it. Is that ok?”

And the Fed will say, “Sure….here you go…see you in 90 days.”

That’s it. The bank and depositors both get their money. The size of loans at the discount window are less than $10 billion right now but they went to $544 billion in 2008 so the Fed can make these loans all day long if it must.

You’ll notice in the discount window case, the bank gets the loan back at $10,000 and will eventually have to recognize with its accountants that the boat is only worth $5,000. Shareholders may be sad but depositors, the Fed and the people concerned about the orderly functioning of markets will be happy.

The Swiss National Bank Steps In

You’ll remember from school there was always one kid that always seemed to be in trouble. They weren’t bad. They just seemed to be around whenever a window was broken, a fire alarm went off, or a homework assignment was late. That’s Credit Suisse. This is what its long-suffering shareholders have had to put up with:

For a brief shining moment in 2008, when nearly all bank share prices peaked, Credit Suisse was worth over $100 billion but is now worth around $7 billion. At one point it had assets of over $1 trillion but today they’re down 35% in the last two years to $530 billion. It’s made money in only three out of the last seven years and, in a good year makes about a 5% return on equity.

Along the way it has lost money in investment banking, been fined by U.S., German, Swiss, Singaporean, UK and EU authorities for, well, just about anything you can imagine, backing hedge funds that blew up and breaking several sanctions on Russian oligarchs.

A tanking stock cannot sink a bank. But if a counterparty bank starts refusing your line of credit, things unravel quickly. Credit Suisse is a very different bank to SVB. Credit Suisse is not only twice the size but is far more interconnected to the global financial system. The contagion risk is higher.

The recent collapse in Credit Suisse’s share price is about a fear of a bank run. The ECB asked several banks about their exposure to Credit Suisse and then did not put out any statement, which is not a good sign. Finally on March 15^th, 2023, the Swiss National Bank (SNB), equivalent to the Fed, stepped in and said Credit Suisse met all its conditions for liquidity and there were “no indications of a direct risk of contagion for Swiss institutions…”

This is a very Swiss way of backstopping a bank! We don’t know if the SNB will find a buyer, lend money, buy securities or increase insurance coverage but that doesn’t matter at this point. In the short-term, it provided a $54bn loan facility and offered to buy back some securities. It may do more. What is clear is that the SNB, and other central banks who joined in on Wednesday, will restore calm to the markets.

So, What do all These Bank Scares Mean?

Will the Fed ease back on raising interest rates at its March 22^nd, 2023 meeting?

Probably. A few weeks ago, there was ample talk of a 0.50% increase in the Fed Funds rate range from 4.5% to 4.75% to 5.0% to 5.25%. It’s now likely to be 0.25% and it may well be zero, depending on how confidence changes in the next week.

Will SVB’s problems cause more bank failures?

Not at the large banks. They have fundamentally different balance sheets and are held to tighter regulations and ratios.

Fine, what about regional banks?

Probably not, although the share prices of many regional bank indexes are down this year. The KBW Nasdaq Regional Bank Index is down 23% this year:

As mentioned above, SVB’s insured deposits were around 3% of all deposits and securities were more than 55% of all assets. But some of the biggest names in the index have insured deposits ranging from 20% to 50% and securities portfolios of 15% to 25% of assets. SVB looks very much the outlier.

Will SVB hurt the economy?

Not directly because SVB did not have a lot of corporate loans. There is a chance that it hurts consumer confidence, especially in the Bay Area of California, but there’s no sign of that yet.  The good news is that the bank was in the hands of the FDIC within 48 hours of running into problems. The Fed’s actions help.

What about the bond market?

Any credit problems tend to send investors straight to U.S. Treasuries and this time was no different. The 2-Year Treasury, which is a rough proxy for the Fed Funds rate, dropped from 5.1% to 3.9% in a week. The yield curve moved sharply down:

The blue line is the curve on Tuesday and the green line from last week. The difference between the 2-Year and the 10-Year Treasury was around 108bps. It’s now around 44bps. A move like that usually signals the Fed will cut, or at least stop raising rates, sooner than was expected a week ago.

What about international bonds?

Same story. The Japanese 10-Year Government bond yield nearly halved from around 0.5% to 0.27%. The German 10-year Bund yield fell 0.60% to 2.12%. The price of the 30-year bond rose 17%.

So, are all central banks likely to be wary of the banks, and stop rate increases?

Yes to the first but not necessarily to the second. There are many things central banks can do to help banks while increasing rates, as the actions of the Fed and the SNB have shown.

And in Other News…

It was a busy week for inflation, retail sales and the small business survey. In the inflation numbers, the airlines fares component rose a whopping 6.4%. We wrote about the jet fuel shortage last week but the quick version is that prices have not fallen nearly as much as gasoline prices so airfares remain high.

Rent prices went sideways but we’d again look at the new rent prices tracked by Zillow. Rent growth tracked by Zillow has fallen from 18% in the first half of last year to 6.8%, while the shelter component of the CPI has been flat for nearly all that time. The difference is because Zillow tracks new rents while the official CPI tracks all rents. Eventually the two will converge again.

The five themes to slower inflation are lower margins, energy and food costs, rents and wages. All those are trending lower. We also saw the Real Earnings report last week. Here it is:

Real weekly and hourly wages, which adjust earnings for changes in the CPI, have fallen nearly every month since May 2020. They’re down 2% and 1.3% from last February. As we’ve said before, it’s hard to see a price and inflation spiral when one half isn’t moving.

Inflation is not moving down as quickly as the Fed wants. But it’s getting there.

Debt Ceiling Update

Again, this is our list of things we’re watching.

1. Thursday Bill auctions
2. 10-Year Treasury
3. US dollar
4. Rise of safe haven assets
5. Treasury short positions
6. Bonds, Bills, and Notes maturing in June and July
7. Stock performance of companies with 90% of revenues from the government
8. Credit Default Swap (CDS) prices

There’s very little to add from last week as the banks pushed any debt ceiling worries off the front-page. We continue to track the debt-sensitive indicators. The price of CDS increased this week but that is probably due to the worry about a weaker economy rather than default. The longer-term CDS, which are barely impacted by any debt ceiling problems in 2023, did not move.

The Bottom Line

It’s never fun to see banks get into trouble. While it’s a healthy morality tale for management, who are usually shown the door, it’s very upsetting for small depositors.

Here at Cerity Partners, we’ve seen our fair share of bank runs, going back to Continental Illinois in 1984, when the precedent of the FDIC guaranteeing all depositors was set and has stuck ever since. In Europe, bank bailouts used to be closed door events with management, creditors and regulators all hammering out a deal. That still works and we have the added confidence that the ECB knows what it’s doing with trouble banks.

This one feels different to us. We can’t say with 100% confidence that there won’t be another “bank in trouble” story at some time. We can’t say that because banks are opaque and depositors can turn nervous with little warning. But we do feel sure that this is not about bad, highly leveraged loans with a lot of borrowers defaulting. That makes it easier to manage for the Fed and other central banks. And, for the record, the Fed, the U.S. Treasury and the FDIC played this very well.

As of the time of writing on midday Thursday March 16, 2023, stocks are up for the week and remain 2.5% higher from the opening January levels. European stock markets eased last week. They have a high financial weighting of around 20% compared to 14% for the S&P 500. But they are still holding on to gains of 8% to 10% for the year. Bonds were up around 2% and the 10-Year Treasury up 3%. We’d expect that in anxious times. There’s a risk at these times, that we hit send, and events roll right over all that we’ve written. But we’ll continue to update our thoughts as news breaks.

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[i] Sometimes it can if overnight rates are very high but banks have branches to open, loan officers to pay, advertising costs or deposit insurance premiums due, so it’s not a sustainable business model.

Art: Elaine de Kooning (1918 – 1989)