In the wake of the 2008 banking failures, lawmakers passed rules requiring banks to undergo regular stress tests for their investment portfolio so we would never have a banking crisis again. However, regulators and bankers agree that the recent bank failures of Silicon Valley Bank (SVB) and Signature Bank weren’t caused by reckless investments, but instead were due to uninsured deposits, arcane accounting rules and lax or incompetent risk management and supervision. According to Michael Barr, the Federal Reserve Vice Chairman for Supervision, SVB’s failure was a “textbook case of mismanagement”.* JP Morgan CEO Jamie Dimon recently opined that, SVB’s problems were “hiding in plain sight”. “It is unlikely that any recent change in regulatory requirements would have made a difference in what followed.”*. Maybe some history will help illuminate the issues.
I started my career in finance in late 1987 as a teller in the management training program at Lincoln Savings. Roughly 2 years later, that institution was closed by the FSLIC (Federal Savings and Loan Insurance Corporation). I went to work as a new account representative at Columbia Savings. At the time it was ranked the best managed savings and loan by Forbes magazine for five consecutive years. In early 1991, Columbia closed as well. I was in the Beverly Hills branch as officers of the FSLIC issued checks for $100,000 (the federal insurance limit at the time) to customers who had deposits exceeding that amount. I also remember when Indymac failed in the banking crisis of 2008 and depositors over the insured limit were only reimbursed up to 100K. Although, according to the FDIC (www.fdic.gov), you can structure your accounts to have insurance coverage for more than 250K in one bank, I’ve typically advised clients to have no more than the insurance limit (currently $250K) in any bank. You never know what can happen.
In light of this history, imagine my surprise when I recently learned that as much as 94% of all deposits at Silicon Valley Bank (SVB) and 89% of Signature Banks deposits were uninsured!*
Why are there so many uninsured deposits in banks?
To stem a potential run on a bank President Franklin D. Roosevelt signed the Banking Act of 1933 to provide a federal guarantee for bank depositors. No longer did customers have to stand in line with the hope of getting some of their money bank. If the funds remained under the insurance limit ($2,500 at the time, but currently $250,000), depositors would get their money back. However, because uninsured deposits do not have that protection, they tend to leave at the first sign of trouble. Apparently, Corporate America (especially large tech) has a cash management problem. According to Carfang Group, “…US companies currently hold about $3.6 trillion in cash on their balance sheets… up from $1 trillion in 2000.*”. While most of this money resides in US Government money market funds and treasuries a good amount is on deposit at banks and is over the insurance limit. Tech giant, Roku had $487 million, about 26% of their cash, at SVB*. In this case, regulators needed to do something fast. In the case of SVB and Signature Bank, the FDIC decided to cover ALL deposits, even those exceeding the FDIC limit!
So how did SVB go broke?
The banking industry was set up to fail by the Federal Reserve Bank. Because the last two banking crisis were caused by bad balance sheets, new regulations encouraged banks to buy long dated US Treasuries and mortgage securities. The thinking was the market for treasuries is so deep, that when a bank experienced withdrawal requests they could sell the treasuries without incurring losses. Unfortunately for banks, quantitative easing kept the yield on these investments low to stimulate the economy and that kept prices of these safe investments high. Money supply exploded, as did bank deposits, especially uninsured deposits. When the Fed subsequently raised interest rates, the result was not surprising. In banking, “…long term interest-sensitive assets are funded by short-term, liquid deposits”. Because the Treasuries were guaranteed to pay par value by the US Government, and because they were designated “hold for maturity”, when the market value declined, there was no corresponding realized loss by the bank. “In 2022, SVB reclassified a chunk of its bonds as “held for maturity”, where they don’t have to be carried at market value.”* This is all well and good until SVB HAD to sell its “hold for maturity” investments to meet withdrawal requests. Historically, deposits are relatively sticky, even during a bank run. Uninsured deposits, however, are a different matter altogether.
Speed Played a Role
In the past, bank failures have occurred over several weeks, if not months. In these cases, social media, and the “…perfect flow of imperfect information…”* accelerated the process and regulators were unable to respond in time. When SVB needed cash to meet withdrawal requests, according to the Wall Street Journal, they “…turned to the San Francisco Federal Home Loan Bank, asking for a $20 billion loan. The FHLB system is nearly 100-year-old network of privately capitalized, government-sponsored banks… Banks leave collateral with FHLB’s in exchange for credit lines… The FHLB’s have to issue debt, which means they can generally only lend when the market is open… The FHLB had to determine how much collateral it needed to hold…time ran out.”*
Out of the woods?
The current banking crisis may be behind us, but there may be another shoe to drop in the future. Analysts are eyeing the maturity of Commercial real estate loans. “U.S. commercial-property loans set to mature in 2023 and 2024 total nearly $900 billion”.* Re-financing those loans may prove to be difficult in an era of higher interest rates and increasing vacancy. “In downtown areas, the office vacancy rate reached 17.6% in the last three months of 2022, up from 13.8% two years earlier, according to CBRE”.* Although Commercial Mortgage Backed Securities (CMBS) make up the lion share of maturing loans in the next couple of years, regional banks are not without their exposure. “In later years… the share of maturing loans is dominated by banks. Bank lenders are behind more than 50% of the loans scheduled to come due in 2026 and 2027”.*
The good news behind the bad news
The irony of this bank crisis is, because the assets being liquidated to meet redemptions are US Treasuries, other banks may experience some relief. When investors panic, they tend to buy, you guessed it, US Treasuries. Because the demand, and subsequently the price, of these investments rose in the wake of this banking crisis, other banks experienced some unrealized gains on that part of their portfolio. The other good news is the tightening of lending standards that is sure to follow will make the Fed’s job of fighting inflation easier. This banking crisis essentially speeds up the Fed’s process, making it more likely we have seen the last of rate hikes in this cycle. In fact, the futures market believes the Fed will begin lowering interest rates, to combat a potential recession, by the end of the year. *
After this banking crisis is over, the hangover will likely last for a while. The increased regulation, capital and liquidity requirements which will surely result, will make it increasingly more difficult for banks to profit. It is very possible that the regulations added to the banking industry will cause them to act like utilities, with regulated profits and regular dividends. Maybe lawmakers will learn from their mistakes. History would suggest otherwise.
- Doug Lagerstrom
· In Today’s Banking Crisis, Echoes of the 80’s, Wall Street Journal March 29, 2023
· Why FDR Limited FDIC Coverage, Wall Street Journal Aprils 10, 2023
· SVB Collapse Creates New Risk for Tech’s Billions in Cash, Barron’s March 20, 2023
· QE Left the Banking System Vulnerable, Barron’s March 20, 2023
· SVB Effort Ran out of Time, Wall Street Journal March 23, 2023
· What Congress Should Ask Regulators in SVB’s Aftermath, Wall Street Journal 3/27/23
· Banks Reclassified Bonds as Rates Rose, Wall Street Journal, March 30, 2023
· Barney Frank and the Demise of Signature Bank, Barron’s April 3, 2023
· Office Vacancies, High Rates Press Property Bonds, Wall Street Journal April 7, 2023
· Things Aren’t Quite Right for These Super-Rich Investors, Barron’s April 10, 2023