First Major Banking Collapse Since 2009 – What Does it Mean?
March 11, 2023
By Mitchell Anthony
Silicon Valley Bank (SVB) collapsed yesterday as depositors withdrew cash! This is the first major banking collapse since the great financial crisis of 2008. While the crisis and details of this takeover are still unfolding the early visibility we have reveals that this failure is not part of a systemic problem within the US economy and we are unlikely to see other banks fail in a similar manner. The problems and circumstances that led to the default seem unique to this highly specialized regional bank that worked almost exclusively with the start-up tech industry in Silicon Valley. At first blush it would appear that the majority of major banks are sound and not subject to the unique circumstances that brought down this highly specialized bank. The problem that we have is the fact that banks are not required to disclose or mark to market their bond portfolios that are being held to maturity or they hope to hold to maturity. There could be significant unrealized losses on these portfolios. This crisis may force banks to reveal their bond portfolio status and it could certainly require them to start paying higher returns on cash deposits. Investors are obviously bracing for the worst and the stock prices for almost all banks plunged by as much as 20 to 30% over the last few days as the crisis unfolded. We believe the crisis and the plunge in bank stock prices likely represents a value opportunity. We have been underweight banks in our portfolio since the pandemic began for reasons such as this!
SVB was seized by FDIC regulators and depositors have been unable to with draw cash temporarily. This occurred because the bank was unable to meet demands for cash that were coming from depositors. The bank became insolvent as the value of the bank’s asset portfolio shrunk significantly just as depositors were in need of their capital. The start-up tech industry became rich with cash in the 2020- 2021 equity market run and deposited much of their capital at this highly favored Silicon Valley Bank. Last year interest rates rose significantly and the entire landscape changed for the start-up tech industry as well as for the banking industry. The start-up tech industry was no longer the beneficiary of new money and hence needed the existing money that they had deposited in the bank in previous years when interest rates were near zero. Unfortunately the bank invested this cash in longer term government bonds that had yields of 2% or less. Now the yields on the securities the bank owns are 5% or more and the value of the banks bond portfolio has declined by as much as 50%. The bank was incurring huge losses when it had to sell large chunks of their portfolio to meet the run-on assets that was occurring from depositors. The bank became insolvent just last week and regulators stepped in and took over the bank.
Silicon Valley Bank had over 200 billion in deposits making it a relatively large bank. What is unique about this banking problem is that depositors needed their cash just as the wrong time for the bank. The bank unfortunately made a poor decision to put so much of their capital into long-term treasuries and mortgage bonds when interest rates were at historical lows. The bank had hoped to ride out this bad decision over time but they were not given this opportunity because these start-up companies needed their cash and started withdrawing deposits at a significant rate over the last six months.
No comment yet from bank regulators
There has been no comments yet from Bank regulators on how the collapse will be handled and who might lose money. Stockholders, bondholders and bank depositors, are all at risk. The regulators are trying to size up whether the bad decisions made by the bank in investing in long-term bonds at an inopportune time have been made by other banks and whether there are problems brewing within the banking industry as a whole?
Who might lose money?
It would seem almost a given that the shareholders of SVB will lose all or some of their equity in the bank. The bank will likely be taken over by another bank and existing shareholders will get some minor position in the stock of the new bank. Bondholders will be subject to something similar. The real question is what will happen with depositors. Generally the rules are that bank deposits are only insured up to 250,000. However most of these Silicon Valley companies had hundred’s of multi-million dollar deposits that were not insured. Historically Congress and or the Federal Reserve has stepped in and made depositors whole most of the time particularly when the banking problem was systemic. However this time, the banking problem does not appear to be widespread, and may be limited to just this bank or regional banks that deal with start-up tech companies. Given this it would only seem right and just to hold the CFOs of these tech companies accountable for investing funds in uninsured deposit accounts. The democratic regime we have today will probably not be able to stomach losses by bank depositors so it is likely depositors will be made whole.
Are there similar problems brewing within the banking industry similar to SVB?
Interest rates have been near zero for over a decade until the inflation problem developed in 2021 which changed the landscape significantly. Banks got comfortable paying 0.1% on deposits and investing the deposits in 10 year or longer treasuries yielding 2 percent or more. The banks were making 10 to 20 times the return that they were paying on their capital. Seemed easy! However Banks got overly comfortable with long-term treasuries and significant amounts of interest rate risk and now they are paying the price for their decision. So it’s hard to believe that there are not significant losses in the held to maturity bond portfolios of other major banks. Banks sell at very modest valuations because investors don’t have good visibility of the quality of their bond portfolios and hence discount the stock price accordingly. If banks are force to sell and realize significant losses on their bond portfolios it could bring about a default by the bank particularly if there is a run on their deposits. If not it will just be a significant headwind for earnings as they are forced to pay more on deposits in the current environment than what they are returning on their bond portfolio. Again this crisis will likely force banks to pull down their pants and show us the condition of their bond portfolios and the extent of the losses in their portfolios.
How big might the asset quality problem be?
Silicon Valley bank’s bond portfolio was approximately 125 billion in size and represents about 62% of their 200 billion of total deposits. This is very large for any bank. As a comparison Bank of America’s held to maturity bond portfolio is about 630 billion in size out of approximately 3 trillion in assets or 20%. J.P. Morgan’s bond portfolio is approximate 425 billion in size out of approximately 3.7 trillion in assets or 11%. Charles Schwab’s Held to Maturity bond portfolio is approximately 173 billion in size out of 550 billion in assets or approximately 31% of deposits. There are many regional banks where their held to maturity bond portfolio is over 50% of deposits putting them near the crisis level of SVB.
What other banks might have problems with sudden outflow of deposits
Regional banks seem to be the most at risk as many times they have the majority of deposits from an industry that they have nurtured business from. It would seem that most of our large major banks would be insulated from a run on deposits or from a major outflow of assets because of liquidity problems that might exist with their customers.
What does this mean for the Broader economy?
This bond portfolio problem is rooted in the sudden rise in interest rates that we have had over the last year due to the inflation cycle that unfolded because of Covid. The rise in interest rates appears to have damaged the balance sheets of both regional banks and national banks. The American banks are largely healthy due to firm regulations on lending but who would’ve thought that investments in treasuries and government bonds might be such a problem for a bank? What this means for the economy is that banks will get more careful with lending as a result of weaker balance sheets and their earnings will be compromised as long as interest rates stay high. Currently rates are five times what most of these banks are earning on their bond portfolios. Banks are hoping rates will come down and these bond portfolios will appreciate in value and become profitable again. This seems unlikely over the next few years. As a result of this crisis the banking industry will lose some of the trust that they have worked so hard to regain with investors and the public since 2008.
There will be some fruit born from this crisis and that investors will likely start to real realize much higher returns on cash deposits at banks. Currently most banks pay less than 1% on cash and clearly have the ability to pay as much as 4% or more and still make a nice margin on your money. As investors realize this they will start to move money out of poor paying banks and a price war will occur between banks forcing them all to raise rates on their deposits.
We are optimistic but we will be monitoring and reacting as needed to the developing story around this banking crisis. Inflation will continue to give this economy and the markets distress but we believe the equity markets will perform well as inflation ultimately falls to the pressure of higher rates and concerned consumers. We remain under-weight bonds and overweight cash and stocks.