A 21st CENTURY BANK RUN
By Mark Ukrainskyj in Trusted Advice
An old Wall Street adage is that the Federal Reserve raises interest rates until it breaks something. With the FDIC’s takeover of Silicon Valley Bank (SVB) last week, it appears we have reached that point. As a preface, at Covenant, our client portfolios have had minimal exposure to bank stocks given their growth characteristics. And what there is, tends to be in the larger money center banks that should eventually benefit from a flight to safety.
On Thursday as word of losses on asset sales and a botched capital raise at SVB spread as fast as the wireless networks could transmit them, depositors frantically worked their cell phones trying to get money out. SVB’s stock price plummeted and by Friday, regulators had taken over the bank. Given the potential for contagion, many investors reacted quickly to minimize losses. This sent the stocks of other regional banks plummeting, some by as much as 85% in only three days. The proceeds from these sales and other funds went in search of safety in the US Treasury market, driving prices up and yields down. It was particularly noticeable in the 2-year Treasury note, as the yield went from 5.07% at the close on Wednesday, March 8th, to a low of 3.8% on Monday, March 15th. An incredible move.
Tuesday, March 14th, brought some stability back to the market and at one point regional banks rallied by as much as 180% from their intraday lows, and 2-year Treasury yields rose by about 30 basis points (bps). It appeared to be a delayed response to the Federal Reserve’s new credit facility for banks and the FDIC’s announcement that all of the depositors at SVB would be made whole, not just those under the $250,000 insurance limit. Investors appeared to take additional comments from federal officials that all US deposits were ‘safe’ as an implicit guarantee for all deposits above $250,000, not just those at SVB. While the blanket coverage of all depositors may introduce a long-term moral hazard, it does appear to have helped calm depositors’ fears and stem other possible bank runs.
While covering all depositors helped restore confidence and calm the markets, the new Federal Reserve borrowing facility helps address the root cause of the loss of confidence, the massive losses on SVB’s balance sheet. Unlike most other bank takeovers, the losses weren’t from bad credits, but from rising interest rates on holdings of safe US Treasuries. During the early phases of Covid in the summer of 2020, interest rates on the 10-year US Treasury bond went as low as 55 bps. All of the stimulus funds deposited in banks had to be invested and where better than safe US Treasuries. This was fine until inflation moved up strongly and the Federal Reserve started raising interest rates to combat it. Rates on the 10-year Treasury hit almost 4.25% in late 2022 and prices went down accordingly. Early last week, the head of the FDIC pointed out that banks were sitting on over $620 billion of paper in losses because of this. While SVB was hit hard because of poor risk and communication management, all banks face this liquidity issue to varying degrees. The new Fed borrowing facility helps banks manage large deposit withdrawals loaning them funds for up to a year using their Treasuries as collateral at full face value. That way, banks can distribute cash to depositors without selling their Treasuries and taking massive losses.
Taken together, these regulatory actions should stabilize the US markets and prevent further bank takeovers. We will have to see how things play out in international markets, as their banks faced similar interest rate increases. In addition, the instability this has caused could give the Federal Reserve reason to slow or even pause their rate hikes and let their lagged affects play out. The resulting period of calm, combined with potentially stable to declining inflation, should be beneficial to both the economy and the markets.