A Helpful Q&A on the Bank Crisis

March 16, 2023  |  Michael Reilly

And here’s the price paid…

Last weekend’s fallout from the Silicon Valley Bank’s (SVB) failure has dominated market news.

So I want to address some of the questions and concerns surrounding what’s happening in the banking sector. Let’s dig in…

Last Friday, Silicon Valley Bank (the 16th largest bank in the U.S.) failed and was seized by the FDIC, marking the largest bank failure in the U.S. since Washington Mutual during the 2008 financial crisis. 

If that wasn’t scary enough, on Sunday, Signature Bank of New York (SBNY) also failed and was taken over by the FDIC.

The obvious concern for most savers and investors is: What’s next? Is this going to act like the flu infecting all banks? Is my money safe?

Right now, this challenge appears to be isolated to regional banks. And the Fed is stepping in to protect funds held on deposit with the banks. 

And in an effort to keep this from spreading to other banks, large and small, the Fed is stepping in to protect funds held on deposit with the banks. 

Silvergate Capital, SVB, and SBNY all had some things in common – poor management of their respective bond portfolios. 

That’s not the case for all banks, but I wouldn’t be surprised if we hear more banks come forward with liquidity problems in the coming days – it’s a wait-and-see. 

I’m getting a lot of calls and questions asking if this is 2008 all over again. It’s natural to make that comparison – 2008 is firmly and forever etched into our collective memories.

However, let’s be clear: This is not 2008. 

In 2008, there were all kinds of shenanigans going on at all levels of banking and real estate.

What we’re seeing in the regional bank space today is more similar to the Savings & Loan (S&L) crisis of the late 1980s and early 1990s than to the Great Financial Crisis of 2008. 

Back then, S&L Associations made risky investment decisions that caused many S&Ls to fail – ultimately requiring a government bailout. That crisis was isolated to S&Ls and never threatened the broader banking system. 

Today’s challenge remains isolated to regional banks and not likely to find its way to the big banks as was the case in 2008.

Can other, bigger banks get exposed? Sure, we’re just not aware of them as of this writing.

The biggest problem regional banks are facing today is the result of rising interest rates. 

Yes, some of the aforementioned banks had far too much exposure to digital assets. 

But for the most part, banks are investing in the U.S. Treasuries markets and Mortgage Backed Securities – considered safe.

So it isn’t that these banks made risky investments with their depositors’ funds, as they did leading into the Great Financial Crisis of 2008.

The mistake many of these banks made was in how they managed – or didn’t manage – the potential changes in interest rates would have on their bond holdings.

It looks like many regional banks simply were not prepared for the unprecedented rise in interest rates we experienced over the last year. 

I’d bet most of the bond managers at these regionals have never had to navigate a rising interest rate environment and have little to no experience in managing interest rate and duration risk… and it shows. 

This will be a costly lesson for many.

But let’s not just blame the banks… the Fed has raised interest rates by 5% in 14 months. The speed with which rates have risen is unprecedented, and the fact that something finally broke should come as no surprise.

Here’s what happened… 

Banks, take in deposits and buy bonds of varying maturity. Many of the bonds in bank portfolios right now were purchased over the past several years when rates were significantly lower. 

So, as rates rose dramatically over the past year, those longer-dated bonds that the bank purchased years before dropped in value a lot.

Why? Bonds have an inverse relationship to price – as rates rise, price falls, and vice-versa. 

Think about it… if you own a bond paying 1.5%–2.0% but new bonds are paying 4%–5%, who wants your 1.5% yielding bond?

Nobody. That’s why in order to sell your bond to raise cash, you’d have to sell it at a deep discount to its original price. 

And that’s what’s happened. Banks were woefully unprepared.

When depositors started withdrawing large sums of money, banks like SVB had to sell bonds at a loss to provide cash to depositors. 

They were taking incredibly large and unsustainable losses. You take enough losses and you become insolvent.

Enter the Fed.

U.S. authorities took extraordinary measures to shore up confidence in the financial system after the collapse of SVB to avoid a run on the banks.

They also introduced a new backstop for banks that Federal Reserve officials said was big enough to protect the entire nation’s deposits.

In the case of SVB and SBNY, the Fed immediately stepped in, fired the management, and took control of the respective banks.

They announced that all depositors at SVB and SBNY, including FDIC-insured and non-insured, will be made whole. 

And to avoid further stress on the banking system, the Fed created a new lending program called the Bank Term Funding Program (BTFP).

Without too much detail,  here’s how the BTFP works: It’s designed to help provide additional liquidity to banks, so they don’t have to liquidate bond holdings at large losses to meet depositor requests. BTFP makes loans to banks in need.

So the announcement that FDIC will cover insured and non-insured deposits and the creation of BTFP should go a long way to reducing the likelihood of a run on the big banks.

My guess is this will likely become a moving target as more banks find themselves in trouble – and more programs will be coming down the road.

To summarize… 

We’re seeing that the Fed’s aggressive rate raise has uncovered or exacerbated a problem with regional banks’ bond management, in which their bond portfolios have lost tremendous value – risking the banks’ solvency and their ability to return depositors’ funds.

The FDIC and Fed have worked out a plan to protect depositors’ funds that protect both FDIC-insured deposits and funds in excess of $250,000. 

And in an effort to protect the integrity of the financial system a special program has been established (BTFP) to help provide banks liquidity to meet depositors’ needs without the need to liquidate bond positions that have seen their value cut in half.

It’s a loan program. 

The Fed is basically saying, “We know the bonds in your portfolio will mature at full value as long as you don’t have to sell them prior to maturity, so here’s a loan to provide funds for depositor redemptions.” 

That’s obviously a simplified version of the program, but it gives you an idea of what it is meant to do.

Will it be enough? Right now, it looks like the Fed and FDIC have a plan in place and got out in front of this the best they can. 

However, they may need to stand ready to do more if necessary.

And because aggressive Fed rate policy has been at the heart of this problem, there’ll be a lot of questions moving into next week’s Fed meeting around the likelihood of additional rate hikes.

The implications of the future of Fed policy won’t just impact regional banks, it will impact broader asset classes across the globe.

So we’ll be paying close attention to Fed action…

If you’d like to talk more about how Avalon’s Relative Strength-based strategies and investment models can help you navigate the markets with ease, schedule a free 1-hour consultation with me or one of our other advisors today. 

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