Banking Crisis Update

Banking Crisis Update

Executive Summary

• Banks that lent money when rates were extremely low are facing losses as interest rates go up. Remember mortgages at 2.5%? CDs yielding over 4.5% are now available through us! When banks must pay depositors more than what they are charging their borrowers their business models breakdown. 
• Several banks over the past week have either failed or needed government assistance to continue operating.
• The banks that failed did so because a huge portion of their depositors all asked for their money back at once. 
• The failed banks were forced to quickly sell their low yielding loan portfolios at huge losses to raise the cash for their depositors’ withdrawals. (Because who wants to buy a portfolio of mortgages yielding 2.5% for another 28 years when they could invest in new mortgages yielding over 7%?)
• The circumstances that led to a huge portion of depositors all asking for their money back at once were relatively unique. Except for highly specialized, poorly managed, or small regional banks, the overall banking sector is unlikely to experience a bank run. 
• For good measure, the Fed stepped in to avert panic by making all depositors at the failed banks whole and creating a new lending facility called the “Bank Term Funding Program.” This will give banks a means to raise cash for their depositors without being forced to sell their low yielding loan portfolios at huge losses. 
• The Feds quick actions, and the unique circumstances of the failed banks, likely mean we are not facing a systemic banking failure. Therefore, there is no need to panic!
• While widespread bank failures are unlikely, the profitability of the banking sector is expected to be impaired for some time due to the mismatch between what they will be forced to pay depositors and what they are charging their legacy borrowers. 
• As a result, your team of investment managers at Mersberger Financial Group is monitoring the situation closely and is prepared act if we determine it necessary.

What Happened

Last week Tuesday started with investors focused firmly on Fed rate increases and Fed Chair Jerome Powell’s testimony to Congress. Then, late Wednesday, the crypto-focused bank Silvergate Capital Corp. said it would voluntarily shut down, and Silicon Valley Bank (SVB) said it needed to raise emergency cash. By Friday, SVB became the second-biggest bank failure in US history. On Sunday, Signature Bank, a New York financial institution that had recently made a play to win cryptocurrency deposits, became the third biggest bank failure in American history. Then Sunday evening First Republic bank announced that they had received additional liquidity from the Federal Reserve and JPMorgan Chase.

What happened? This recipe for disaster took two main ingredients and a pinch of “crypto.”

The first ingredient was huge investments in long-dated treasury bonds and mortgage-backed securities and a spike in interest rates. Unlike in the 08 crisis, the banks didn’t lower their lending standards leading to massive defaults. What they did do was take trillions of dollars in depositors’ money and invest them in what is often considered the absolute least risky place, bonds back by the United States Treasury.

Ok, so what’s the problem? SVB purchased treasury bonds that do not mature for another 10 to 30 years, and they were only yielding roughly 1.5%. Now 30-year treasury bonds are offering a yield of almost 4%. This means, even though no one is questioning the creditworthiness of the US Government, those banks stuck with bonds yielding 2.5% less than the going rate for another 28 years has experienced significant losses. (This same principle is true for banks that issued mortgages at 2.5% for 30 years now that the going rate is over 7%.)

The second ingredient was a non-diversified base of depositors that all wanted to pull their money out at the same time. SVB was the bank of choice for Silicon Valley startups. As these highly speculative venture-capital-backed startups launched, they needed a place to deposit the billions of dollars they had raised and planned to use to fund their growth.

For reasons related to physical proximity, competitive rates, and fancy technology SVB became the bank of choice for many of these startups. For a few years this proved to be a great strategy for the bank, as well over a hundred billion in deposits were added in the past three years.

Investors’ appetite for high-risk (often crypto-related) tech startups waned. This meant that these startups started burning through billions of dollars a month to fund their operations, but the spigot of additional funding they had learned to rely on after a decade of “easy money” was no longer open.

This meant that SVB saw their deposits stop growing by billions of dollars a month and started to see billions of dollars in withdrawals.

Here’s where the two ingredients combine and our recipe for disaster emerges. As SVB was being flooded with billions of dollars every month they did what they thought was prudent and invested their depositor’s money in long-dated treasury bonds and mortgage-backed securities. But when billions of dollars started being withdrawn each month SVB was forced to start selling those bonds with significant paper losses. This meant those paper losses (which, because of an accounting rule, the bank doesn’t have to report on their financial statements) became real losses and the bank's equity started to deteriorate.

Word got out that SVB’s equity was being impaired by these forced sales and depositors all rushed to withdraw their cash. This sudden rush of withdrawals (a bank run) forced SVB to sell even more of their long-dated bonds at a loss and by Friday the bank was broke and the FDIC had taken their operations over.

It’s ironic that a bank can go broke investing in what is considered the least risky asset (at least in terms of credit risk), but that is what happened!

How This Problem Could Spread

The first ingredient in this recipe is not unique to SVB. When the Fed created $5 trillion dollars to stimulate the economy during Covid, banks saw their deposit bases skyrocket. Flush with cash and with nowhere to put it, most banks invested heavily into long-dated treasury bonds and mortgage-backed securities at rates that now look laughably low.

In fact, the banking sector is currently sitting on $620 billion in paper losses on these investments as of December 31^st. Bank of America alone has $109 billion in losses. Keep in mind that these paper losses are real, but they are not reported on the banks financial statements because there is a very legitimate expectation that the banks will hold these assets to maturity and these losses with disappear. The problem only emerges if the banks are forced to sell these assets.

Here’s the great news, the vast majority of banks have a far more diversified base of depositors than SVB did. This means that they are dramatically less likely to experience a bank run, which would force them to sell these assets and recognize those eye-popping losses. In fact, the most likely scenario is that most banks continue operations as usual and these paper losses disappear over time having never shown up on their financial statements.

To finalize, some banks do not have a well-diversified base of depositors. Most commonly, there are hundreds of local and regional banks that specialize in a certain type of client or industry.

Therefore, at the moment, the Fed feels the risk of failure is focused on these small and/or highly specialized banks, not on the large and diversified ones. That is not to say that the mismatch in rates between what depositors are getting paid and what legacy borrows are being charged won’t create profitability issues for the entire banking industry, but that problem should manifest over several years. Not overnight.

What is the Federal Reserve Doing About It

If you think back to our “recipe,” disaster really took hold after word got out that SVB’s equity was being impaired by forced sales and depositors all rushed to withdraw their cash. Depositors did that because many of them had millions at SVB, and the FDIC only insures up to $250,000.

To help alleviate depositors concerns that their money would simply disappear, the Federal Reserve, Treasury Department, and the Federal Deposit Insurance Corporation (FDIC) announced on Sunday that all SVB and Signature Bank deposits, insured and uninsured, will be paid in full.

Additionally, they set up the Bank Term Funding Program. This facility will offer loans of up to one year to banks that pledge U.S. Treasury securities, mortgage-backed securities and other collateral at par. This means that banks can obtain liquidity without incurring the losses that come from selling Treasuries and agency mortgage-backed securities, which have declined in value as a result of rising interest rates.

The goal of these actions is to alleviate the fears of depositors in small/specialized banks across the country; and convince them that there is no need to withdraw their funds.

What Mersberger Financial Group Is Doing About It

We are happy to report that our investments in SVB is nearly non-existent and our exposure to other small banks is minimal. That being said, we are keeping a very close eye on this issue. The financial markets are highly complex and interconnected. We are currently reviewing our holdings for their exposures to this issue directly (non-diversified banks) or indirectly (the companies we are invested in or their customers have uninsured deposits at these banks). As the situation develops, or as we identify unwanted exposures, we will be ready to act.