14 Mar Bank Failures and Macro Implications

With all the news around the failure of 3 American banks in one week, we wanted to take a little time to explain the situation and some truths.

The media will always sensationalise news into headlines that sell products. But when you look under the hood things are often not as bad as they seem.

The three banks liquidated so far (Silvergate, Silicon Valley Bank and Signature Bank) all had ties to crypto either through concentrated exposure to the same demographics and industry that fueled the crypto boom or through direct relationships including stablecoin and exchange deposits.

These three banks are unique in their client base and product focus. Silvergate was a specialist crypto lender that was widely known to be in trouble for a few months and has no real impact anywhere.

SVB and Signature are different but similar.

Their customers were predominantly tech firms funded by Venture Capital. When the period of zero interest rates came to an end so did the source of Venture Capital funding. Clients started drawing down on deposits to meet costs and the bank was forced to sell assets to raise cash to cover the withdrawals.

Selling those assets realised losses for the bank, which they covered by issuing equity. But the nail in the coffin came when Peter Thiel’s Venture Capital firm advised all its companies to withdraw cash from SVB. That created a run on the bank and the rest is history.

The impacts of this have been felt across many different markets.

Regional US banks all fell between 20% and 60% in two days. Markets fear the same will happen to them. But it won’t.

After the GFC regulation was increased on all US banks. But in 2018, Trump relaxed this regulation and instead of affecting any bank will more than $50billion in assets it was increased to $250billion. That left the door open for smaller banks to take higher risks.

Banks like SVB did just this. During the height of the Venture Capital Funding boom SVB sported an ROE higher than all other banks. It could only do that by taking higher risks than all the others.

I raise this point to illustrate how different SVB was to the majority of regional banks. Signature Bank was similar.

2yr and 10yr Bond yields have fallen almost 1% in 3 days. The only explanation for this is panic buying of safe securities.

Markets are never rational. They are driven by emotional traders who make instant decisions driven mainly by fear. Even the professionals are not immune to this. Those professionals all fear losing their bonus this quarter and so still make panic decisions.

First Republic Bank (FRC) was down 60% yesterday. Traders fear clients will lose faith and bail out from regional banks to the large banks. So why was Bank of America (BAC) down 6% and Citibank (C) down 8% yesterday? Surely they will win business here?

Depositor Bailout

Over the weekend the FDIC and the Reserve Bank announced that all depositors in SVB and Signature would get their entire deposits returned. The FDIC is going to do this to keep the Reserve Bank and ultimately, the tax payer, out of it.

At present, the FDIC guarantees all cash deposits up to $250k. They are going to change that to unlimited as a special exemption.

How are they going to do this? The bank owns assets and those assets can be sold. Using the latest numbers I can find, it looks like SVB has enough assets to cover the entire deposit base. So the FDIC might not need to raid their piggy bank for anything. At the time of writing the FDIC has been unable to find a buyer for these assets. But I’m sure a deal will be done somewhere – SVBs UK arm was bought by HSBC for 1 pound.

Summary – the bank has failed. All depositors will get their money back but shareholders and bond holders in the bank will lose their investments. No one ever said investing was risk-free.

Bank Term Funding Program

Ok. So SVB and Signature are gone but clients haven’t lost anything. What’s the big problem then?

The big problem is other banks. Are they in the same scenario?

Unknown at this point. You can guarantee the FDIC is running around asking lots of questions to all banks to find out. My bet is no other bank will fail. Mainly because the Federal Reserve has just put in place the Bank Term Funding Program.

This facility will allow banks to borrow up to 1yr term at OIS Swap plus 10 points in exchange for posting government-backed bonds at par with the Federal Reserve.

The problem with SVB was it went and sold these bonds in the market to raise cash for depositors. What the Fed has done is say, rather than selling in the market and taking a loss, give them to me (they were issued by the Federal Reserve in the first place) and I’ll give you full face value back in cash for 1 year. You can use that cash to meet depositor withdrawals.

It means banks are fully liquid and will not suffer losses on asset sales.

That will keep them open and running and profitable.

There really is nothing to see here. These 2 banks will be open for business tomorrow, no one (bar investors) will lose. There will not be another failure, at least not for some time.

Some of these banks look like a buy right here on an overreaction sell by emotional traders. Take a look at HBAN and CMA.

What you can guarantee is the regulations and stress testing will come back for these smaller banks just like prior to 2018.

I can see Biden saying Trump caused this mess by removing regulation and he will fix it by bringing that same regulation back.

Macro Implications

The Federal Reserve has raised interest rates at the fastest pace in over four decades in the past year, and it’s no surprise that process eventually broke something. Markets now price a rapid re-think of monetary policy

After Chair Powell’s testimony to the House last week markets priced Fed Funds at 5.691% for the November meeting’s terminal rate. That meeting price is now 4.460% with the terminal rate coming in June at 4.811%. Hike pricing for the meeting due in 9 days is only for 15.7 bps (62% chance of a 25 bps hike assuming no chance of 50 bps). Rate cuts are priced from September forward and a total of 50 bps priced by year-end as the market assumes the fallout from the banks will stimy US economic activity.

I doubt this will be the case and rather suspect this news disappears fast and interest rate expectations are reset over the coming weeks.

I disagreed when the market thought Powell would deliver a 50Bps raise next week and I disagree now that he will go to zero. That is just preposterous. He will deliver 25bps just like he was always bound to do.

The zero-crowd claim his actions can break banks. But his job is to break inflation first. He will put that ahead of possible investment losses for banks that took too much risk, especially as his Bank Term Funding Program will stop these losses closing banks.

It will be really interesting what happens tonight if CPI comes in hot and traders have to backflip their views.

Warning

Stock values can go down as well as up. It is possible to lose 100% of your investment in a stock. Any advice given by Capital 19 is general advice only and does not take your personal circumstances into account and might not be suitable for you.