BSW has been closely following the banking issues that started to unfold last week. While it is unnerving to see banks fail, we feel that the combination of recent swift actions by both the FDIC and Federal Reserve will stem any further contagion.
What caused these bank failures?
Two things generally cause a bank failure – bank assets become impaired, either due to loan defaults or falling values, or there is a run on the bank whereby too many depositors ask for their money back. In the case of Silicon Valley Bank and Silvergate Bank, they appear to have experienced the double whammy of both happening at the same time.
When banks take deposits, they typically turn around and either make loans with those deposits or invest the deposits in “safe” bonds – usually treasuries or mortgage-backed securities. Because banks operate on a “fractional reserve” system, they are only required to keep a fraction of their deposits in liquid cash. Generally, the rest is invested at higher rates than what they pay the depositors, earning them a spread called a net interest margin. Pretty simple business model really.
What we are seeing is that the issue with most banks right now is that the value of a portion of their assets in which they parked depositor’s cash – namely treasuries and mortgage bonds – are worth less than when they bought them. Not unlike what we saw in certain bond portfolios last year, when market interest rates go higher (due to Fed rate hikes) the value of bond holdings bought at lower rates goes down.
Banks can hold these bonds in a “Held to Maturity” (HTM) classification on their books, which conveniently values them at cost, or they can hold them in an “Available for Sale” (AFS) classification, where they are valued at market pricing. You might be wondering why all banks don’t just hold all bonds in the HTM bucket if bond prices have fallen. Good question.
The issue arises when depositors want their cash back, either all at once or slowly over time. Bonds need to be moved from the HTM bucket to the AFS bucket to be sold to get cash back to depositors. When they move between the HTM and AFS buckets, the value drops in today’s interest rate environment.
To some extent, we feel banks have brought this on themselves. While money market fund yields have skyrocketed, banks have been hesitant to raise deposit rates. Cash has been leaving banks paying 0.25% – 0.50% on deposits for money market funds that currently pay over 4%.
In the case of Silicon Valley bank, they had bond losses and a deposit base that was concentrated in a certain type of depositor – private equity and startups. When it comes to depositors, the more diverse the better. This is because the odds of a diverse depositor base being affected by the same business dynamic or economic issue goes way down. When all the private equity firms wanted their money at the same time, this caused a classic “run on the bank.” Not at all unlike the scene in “It’s a Wonderful Life.”
Why we don’t think this will unfold into a larger banking crisis
The Federal Reserve has just created a Bank Term Funding Program. This fancy sounding solution is nothing more than a lending facility for banks. It solves the problem of having to sell bonds at a loss to pay depositors.
Banks can send their underwater treasury and mortgage bonds to the Fed and in return the Fed will lend them money on the par amount of the bonds for up to 1 year. This avoids the dynamic explained above where a bank must realize losses on bonds to pay depositors.
The FDIC has also acted swiftly to make depositors whole in the recent bank failures. In a strong show of support for depositors, it has taken the step to not only make insured depositors (those with balances up to $250k), but also uninsured depositors 100% whole. Unlike a bank bailout, taxpayers are not on the hook. Rather, to the extent the FDIC comes up short after liquidating these bank’s assets, all banks will have to come up with a special assessment to shore up the FDIC insurance pot.
What now?
BSW will remain diligent in following this rapidly unfolding banking situation. We do not have any current concerns around the brokerage firms that we custody assets with, nor with any of the larger money center banks that are considered SIFIs (Systemically Important Financial Institution). We also do not have any concerns around the many local Colorado banks with which our clients do business. Most have very diverse depositor bases, strong balance sheets, and are conservative with their lending and business practices.
Could more banks fail? If history is any guide, unfortunately, yes. Our financial system is more intertwined than ever before.
Between 2008 and 2014, 500 banks failed for a multitude of reasons. However, the regulatory backstops and systems worked to a point that I would wager many of you reading this did not even notice.
The U.S. economy will get through this. At the heart of the banking industry is a simple concept. Trust. If trust is maintained and cooler heads prevail, this recent dust up in the banking industry may be chocked up as a wakeup call – that taking rates from 0% to almost 5% in the span of a year does has consequences.
BSW is here and ready to address your questions.
We are all accustomed to addressing the risks of stocks and other investments. You shouldn’t have to worry about the safety of your cash.
