Silicon Valley Bank had more in common with George Bailey’s Building and Loan in It’s a Wonderful Life than it did with Lehman Brothers. The bank wasn’t full of bad loans, it was full of deposit customers that all knew each other.
As the residents of Bedford Falls rushed to Bailey Brothers Building and Loan to demand their deposits back, George (Jimmy Stewart) pleadingly explains to them “You’re thinking of this place all wrong, as if I have the money back in a safe! The money’s not here, well your money’s in Joe’s house, that’s right next to yours, and in the Kennedy’s house and the Macleans house and a hundred others…”
When consumers and businesses deposit their money in a bank, the bank lends some out, invests some safely, and keeps some in reserve to meet liquidity needs. That’s what Bailey Brothers did and that’s what Silicon Valley Bank did. That’s what the economy needs banks to do.
Sometimes, banks make bad loans which reduces the amount of capital they have to return to their depositors. That’s sort of what happened to Lehman Brothers. That was not the case here. The problem with SIVB and Bailey Brothers is that all their customers wanted their deposits back at once. And the money just wasn’t there.
In the case of Silicon Valley Bank, much of the money was invested in long-term Treasury bonds and mortgage-backed bonds. The creditworthiness of these investments was and is impeccable. Unfortunately, most of the bonds were issued in the last few years with near-zero percent interest rates. As the Federal Reserve pushed short-term interest rates from 0% to 4.75% in the last year, those bonds issued with lower rates have become less attractive. And worth much less. Over the past year, Treasury bonds with 20+ year maturities have declined by more than 25% in value. This has been the worst bond market in history, and in fact, would rank in the top 5 worst stock market declines.
When the executives at Silicon Valley Bank tried to shore up their balance sheet by selling some of these bonds and raising equity capital, they effectively sounded the fire alarm. Depositors, most of whom were Silicon Valley startups or investors began demanding their cash back. Since most were in the same geographic area and industry, word spread like a wildfire and there was a run on the bank’s deposits. Unlike the kind-hearted folks of Bedford Falls, they did not relent and the Federal Reserve and Treasury had to step in. In an ironic case of “You break it, you buy it”, the Fed who caused the bond market decline by pushing rates up has stepped in and guaranteed depositors’ assets, even above the FDIC limit.
So, what now?
Could there be more bank failures? Of course. But that is true almost any time depositors gang together and all demand their money back at once. SIVB was more susceptible to this as their deposit base was so concentrated. Community banks and smaller institutions are more susceptible than larger banks as their deposit bases are smaller and less diverse. Most at risk are niche banks like SIVB and Signature Bank (which were concentrated in cryptocurrencies). While it is too early to say if there will be any more failures, the average consumer should not be worried. In fact, deposits are actually safer now than they were before the weekend thanks to the new safety nets installed by the Federal Reserve.
There is an old Wall Street adage that says the Fed will raise rates until they break something. Well, they just did. This has dramatically changed the outlook for additional rate hikes. Last week we were debating whether they would raise rates by 0.25% or 0.5% at their upcoming meeting. That discussion has now shifted to 0% or 0.25%. Additionally, the chances of lower rates by the end of the year were off the table a few days ago. It is now firmly back in the conversation.
We think the selling in the regional bank sector was overdone yesterday. We don’t see a large failure contagion coming. Although it will remain a tough banking environment as deposit rates will need to increase and loans will be tougher to get. There are also other industries that depend on bond portfolios. Insurance companies and pension plans all have significant exposure to lower bond prices. These companies are much less likely to face a “run on deposits” but we are thinking about the impact in our analysis of investments.
It will be interesting to see how these events play out over the days and weeks ahead. Any hint of instability in the financial system is never good for stock prices. However, the market has been eagerly awaiting less aggressive interest rate hikes. Thanks to SIVB, it may just get its wish. ~Compliments of StreamSong Advisors, LLC