We Are
By Matt Freund, CFA
Last week, questions about a California bank, Silicon Valley Bank (SVB) (SIVB), quickly developed into the country’s first electronic bank run. In a panic, accelerated by social media, SVB lost close to 25% of its deposits in a single day (well in excess of what we saw in the Great Financial Crisis or GFC). The speed of the withdrawals exceeded the bank’s ability to react and access its ample liquidity. By Friday morning, regulators had seized the bank. Information is very fluid and changing quickly, but this is what we know today.
Investors are rattled because the implosion of the bank came with so little warning. Unlike the GFC when weak balance sheets and undercapitalized banks were at the epicenter of the crisis, a week ago SVB carried investment-grade ratings from Moody’s and Standard & Poor’s and was considered to be well capitalized with a high-quality balance sheet. Nevertheless, this was insufficient to stem the electronic bank run.
Over the weekend, the Federal Reserve stepped in and committed to backstopping all depositors, even those with uninsured balances (that is, those above $250,000). Although the Fed’s move alleviated some anxiety, markets remain highly unsettled because the Fed has made an implicit rather than an explicit guarantee. As such, fears of contagion haven’t been entirely erased.
To understand why this happened, we have to look back a few years. SVB, like many banks, was flooded with deposits during 2020 as the US government sought to fight the Covid lockdowns with massive stimulus on many fronts. Much of these dollars landed in bank accounts. At the same time, the government provided support to businesses, and there was a significant reduction in bank borrowings from those businesses. SVB had a supply-demand imbalance—more deposits than loans. In response, the bank invested customer deposits in high-quality government securities.
As interest rates rose dramatically in 2022, high-quality government bonds fell in price; some high-quality sectors of the bond market were down more than 20% for the year. This meant that SVB, like many other investors, was carrying unrealized losses on its positions.
From here, we need to take a closer look at the accounting treatments banks are allowed to use. Two accounting treatments are available for banks to report their portfolio holdings. These are “available for sale” and “held to maturity.” Under the held-to-maturity treatment, which the bank chose, investments are carried at book value (the value of the debt when the bank purchased it) on the balance sheet. We believe this treatment is entirely appropriate for long-term capital investments. However, when held-to-maturity securities must be sold to meet the requirements of an electronic bank run, those losses must be recognized, thereby reducing the bank’s capital. The immediate demands on the bank’s liquidity coupled with uncertainty around the bank’s capital level were too much for SVB to overcome.
The markets are continuing to digest the data and understand the potential impacts on stock and bond markets. At the time of this writing, we’ve seen Treasury rates decline sharply as the market reevaluates the Fed’s willingness to continue increasing short-term rates. The Fed has addressed the held-to-maturity problem by creating a new facility that will accept high-quality securities at book value rather than at current market values, thereby eliminating the recognition of the losses that led to SVB’s collapse. Stocks are currently rallying, only partially offsetting the losses of last week. Bank investors are now expanding their focus from banks’ balance sheet quality and capital requirements to a more detailed analysis of banks’ deposits and their susceptibility to another electronic bank run.
The situation is very fluid, and we must be prepared for increased volatility over the days ahead. We encourage investors to remember:
- In rapidly changing situations, investors’ first reads can often be wrong—and turning to unreliable online sources for investment advice can be dangerous.
- Bond math is straightforward: Unlike credit losses which are permanent, mark-to-market losses of high-quality securities disappear as those securities approach their maturity dates.
- We continue to believe that short-term volatility sows the seeds for long-term opportunities.
- Decades of experience investing through crises affirms our conviction that investors who can stay calm and focused on the long term are better served than those who make emotional decisions based on headlines.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.