QUOTE OF THE WEEK
“If a man can control his mind he can find the way to Enlightenment, and all wisdom and virtue will naturally come to him.” – Buddha
Last week was especially tough for the equity markets. Most of the gains accumulated in January and February have all but disappeared. Last week the Dow was down -3.24%, the S&P 500 was down -4.51% and the Nasdaq was down -4.68%. Year to date the Dow is down -3.24%, the S&P 500 is up just +0.91% and the Nasdaq is up +6.63%.
The big news last week on Friday was the collapse of Silicon Valley Bank (SVB). SVB was the 19th largest bank in the U.S. with their corporate customers primarily consisting of Silicon Valley tech firms and startups. This was due to their unique understanding of the tech industry and they provided banking services and funding for those firms but this relationship required that they do all their banking with SVB.
As a side note, this failure is going to create a big void for the Silicon Valley tech industry because those firms will have to start a new banking relationship elsewhere.
Banks enjoy a very favorable accounting regime. Post the Great Financial Crisis (GFC) of 2008 commercial banks were asked to keep a Liquidity Coverage Ratio (LCR) above 100%. This means they must always have enough High Quality Liquid Assets (HQLA) to meet deposit outflows in a stressed scenario. This effectively means that banks around the world are forced to keep around 10-15% of the asset side of their balance sheet invested in HQLA assets.
What exactly Qualifies for HQLA? The answer is reserves at the Fed and bonds. Effectively banks are asked to own a large amount of liquid assets and were told bonds were the only game in town due to the regulations.
What types of bonds qualify? Mostly government bonds, but be aware that corporate bonds and mortgage backed bonds also qualify.
When regulators force you to own tons of bonds, they also force you to swallow a lot of profit and loss (P&L) volatility and the banks don’t like that. Remember when interest rates change the value of the bonds change. That’s why regulators allow bank treasuries to park the bonds in two accounting friendly books: Available-For-Sale (AFS) and Held-to-Maturity (HTM).
In both cases, if Treasuries, corporate, or mortgaged backed bonds lose value the bank’s P&L does not record the loss immediately. The unrealized gains and losses of the bonds held in AFS hit the capital position of the bank, not its P&L. However, the bonds booked in Held-to Maturity are reported at their current value, or basically, the unrealized gains or losses. This creates an incentive to park as many bonds as possible in these accounting categories because over time as the banks earn interest they don’t face as much P&L volatility.
The flip side is when you need liquidity to meet depositor’s demands for withdrawals. The banks can only sell a small portion of HTM bonds before being “tainted” as non-compliant from regulators.
Remember that when interest rates go up, bond prices go down. Also, bonds of longer duration are more volatile than bonds of shorter duration. The mistake that SVB made was to buy bonds of longer duration rather than shorter duration. Their portfolio of HTM bonds were bought at an interest rate of 1.81% and current rates are around 3.50%. Their thought was to get more interest on the longer term bonds vs bonds of shorter duration.
If interest rates don’t rise, this is a smart move because longer term bonds pay more interest. Unfortunately, the Fed has aggressively raised interest rates thus causing the HTM bonds to lose a lot of value. Silicon Valley Bank realized that they didn’t have enough value in the HTM bonds to meet their reserve requirements so they tried to do a capital raise which brought to light their predicament. This caused depositors to wonder if the bank was in trouble so SVB sold some of the devalued HTM bonds at a loss to meet withdrawals. This made the situation worse to the depositor’s eyes which then led to them transferring their money to other banks.
It is important to understand that people or companies with a computer can wire money from one bank to another in minutes. Even though I am not a large corporation I have the ability to do a bank transfer from my bank account in minutes via a wire transfer.
What Silicon Valley Bank then had was a classic “run on the bank”. Depositors started to withdraw their money, many of which had accounts far in excess of the FDIC $250,000 guarantee so they wanted to get the money out of SVB as fast as possible. The Federal Deposit Insurance Corporation saw what was happening and they closed the bank before it got worse and created a contagion to other banks. The FDIC, to further stop the possibility of a contagion, is now guaranteeing “ALL” bank deposits at “ALL” banks in the U.S. above the current guaranteed $250,000 level.
It is way too early to tell how this is going to affect the markets but it is going to create interesting theater for economic nerds like me.
Sources: Washington Post, New York Times, The Macro Compass, Yahoo Finance and Omega2