The Tide Goes Out
The financial crisis in 2008 was essentially caused by trillions worth of debt going bad. In its aftermath, Dodd Frank legislation and the Federal Reserve placed an emphasis on the creditworthiness of the assets banks held and incentivized them to own what regulators considered “very safe,” liquid government securities. Because regulators considered these securities essentially riskless, they required banks to have relatively nominal levels of regulatory capital when owning them. However, the legislative emphasis on credit risk and the Fed’s use of risk-weighted capital to judge a bank’s health do not take into consideration the risk of potential investment losses that can result from increases in interest rates. Treasury securities are only free from credit risk when held to maturity. As rates rise, even assets that are safe in credit quality will fall in price, resulting in a loss if sold.
After interest rates fell to zero during the early stages of the Covid pandemic, many banks became accustomed to having a base of deposits that did not pay depositors any interest. Concurrently, many of these banks invested sizable amounts of the capital provided by these “free” deposits in long-term, “safe” government securities that were yielding around 2%. To some banks the 2% spread being made from these deposits was viewed as a form of riskless financial alchemy and according to the Fed, U.S. banks bought trillions worth of treasury and agency securities during the past few years.
When inflation reached levels not experienced in over 40 years, the Fed was forced to start aggressively raising interest rates during 2022. This rapid increase in interest rates caused bond prices to plunge and while this risk is implicit in every bond purchase, accounting and regulatory frameworks can obscure this risk and distort economic reality. While the intelligence of many bank CEOs is debatable, most were smart enough to counter the potentially negative impact falling bond prices would have on their balance sheets by employing a relatively basic accounting change that also provided the added benefit of keeping billions of unrealized losses on their bond holdings from impacting reported earnings. This “acceptable” accounting maneuver involves simply declaring an intent to hold bond investments until they mature rather than classifying them as being available for sale. After making this reclassification, the prices of these bonds become “frozen” regardless of how far in market value they may fall. The ability to make this accounting change falls well within approved accounting guidelines but has helped enable many banks to report robust levels of capital when the current economic reality of the assets they hold are worth significantly less.
This is the playbook that Silicon Valley Bank (SVB) followed. SVB bought long-dated Treasury bonds and declared an intention to hold them until maturity. The unrealized losses of these bonds were initially ignored because they will pay the bank their par value at maturity but the income generated by these bonds went straight to the bank’s income statement, adding to SVB’s reported profitability. SVB held about $90 billion of its $120 billion bond portfolio as held to maturity investments and did next to nothing to hedge against its exposure to an increase in interest rates. Almost all of these bonds were rated “risk-free” or “low-risk” from a credit perspective but they were ladened with interest rate risk. Today’s digital technology makes everything move faster and when withdrawals happen fast, liquidity and solvency (or the lack-there-of) can become synonymous. After a few tweets by Peter Thiel raising the issue of SVB’s potential lack of liquidity, withdrawals snowballed as depositors instantly moved their funds in mass from SVB to other financial institutions simply via the touch of an app or the click of a mouse. When SVB’s depositors in mass demanded their funds, the bank had far less in assets based on the current market value of the bonds they owned versus their par value if held to maturity and could not make their depositors whole. Silicon Valley Bank quickly ran out of capital and was seized by federal regulators and arguably became the first victim of a digital bank run (albeit largely self-imposed).
After reading numerous annual reports of small and regional banks, it’s nearly impossible to predict how broad this problem could become but what’s certain is that many of these banks locked up their capital in bonds and mortgages at what could prove to be well below market rates for a long time. According to the Fed, these holdings had collective unrealized losses of more than $600 billion at the end of 2022. To paraphrase Warren Buffett, the tide of low interest rates has gone out and we are starting to learn who has been swimming naked. As savers continue to seek higher rates of return on their deposits and become more mindful of the FDIC’s $250,000 insurance limit on their deposits, capital has been moving from smaller and regional banks to larger banks that are more heavily regulated, have stronger capital ratios and are too important systemically to be permitted to fail. Post SVB’s collapse, JP Morgan, Bank of America, Citigroup and Wells Fargo have not been able to open new accounts fast enough.
Throughout history, the United States has seemed to careen from crisis to crisis. Investors will never run out of things to worry about but over time, the world gets wealthier, new scientific advances improve health and the quality of life while creative people and businesses bring innovations to market that delight us and improve our lives. In time, this too shall pass.
Ted E. Furniss, CFA – April 2023
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