Last week (March 10th, 2023) was wild and rocky on Wall Street. Bank-run drama in Silicon Valley and New York and a persistently hawkish Fed contributed to the headlines. There was no shortage of fireworks, and major U.S. equity indexes markets fell sharply.
1. A Note of Caution
Given the enormity of the Silicon Valley Bank and Signature Bank of New York collapses, sharing related insights and context is essential. However, this situation is constantly evolving, so keep in mind that this blog may cover only some of the latest developments (written on March 14th, 2023).
You can stay up-to-date with minute-to-minute developments with news sources like CNBC, The Wall Street Journal, and The New York Times.
2. What Happened?
The current bank collapse saga goes back to Tuesday, March 7th, and Wednesday, March 8th, when Federal Reserve Chairman Jerome Powell testified to Congress and struck a hawkish tone indicating that the Federal Reserve thought they might need to raise rates faster than expected.
On Wednesday, the 2-year treasury note yield hit its highest level since before the Great Financial Crisis. The futures market indicated a 70% chance we would see the Fed raise the Fed Funds Rate 50-basis-point in March, 25-basis-points in May, and 25-basis-points in June with an expectation that by year-end, the Fed would push the Fed Funds Rate 1.25% above its current target rate of 4.5%-4.75%.
Following Powell's hawkish testimony, Silvergate Bank failed on Wednesday. That same day, Silicon Valley Bank, the nation's 16th largest bank with $200 billion in assets, announced that it had been liquidating its "available for sale" portfolio of securities and planned to raise additional capital by issuing equity that Friday.
Because of the announcement, the bank saw a massive outflow of deposits on Thursday and Friday. So on Friday, regulators stepped in and shut it down. That's where things left off on Friday, leaving many wondering what would happen with their deposits and how they would meet their obligations.
On Sunday, March 12th, New York regulators shut down Signature Bank of N.Y. Signature Bank had roughly $110 billion in assets.
3. Why Did It Happen?
Silvergate catered to the cryptocurrency industry and was small in bank size, with about 12 billion dollars in assets. Unfortunately, the cryptocurrency rout combined with the FTX collapse proved to be a fatal combination for Silvergate.
Silicon Valley Bank was different.
Here are three things that impacted Silicon Valley Bank:
Deposits: 86% of its deposits were uninsured, which made them susceptible to a bank run. The typical bank will have about 50% uninsured deposits. At any sign of bank trouble, uninsured depositors will pull their money from a bank after it announces its plans to sell assets and raise equity. Approximately $40 billion of deposit outflows occurred on Thursday and Friday.
Customer Base: The bank's customer base was primarily venture capital firms and venture capital-funded companies. Rising interest rates reduced the V.C. funding, which is where a lot of SVB's deposits came from, and the management of these V.C.-funded companies made poor decisions and did not adjust their cash burn rates which also contributed to reducing deposits.
Asset Base: The bank's deposits quadrupled over five years. At that rate, it was difficult to make loans keep up with the inflow of new deposits, so the bank purchased high-quality bonds with longer maturities to try to earn a spread on what they were earning on the invested money versus the interest they were paying to depositors. Credit risk wasn't the issue because they purchased high-quality securities. However, they had interest rate risk because they bought longer-maturity bonds. Bond duration measures how much bond prices are likely to change if and when interest rates move. Generally, for every 1% increase or decrease in interest rates, a bond's price will change approximately 1% in the opposite direction for every year of duration. For example, if a bond has a 10-year duration and interest rates rise by 1%, the bond's price will fall by 10%. Interest rates have risen significantly since the end of 2021. The Effective Fed Funds Rate in December of 2021 was 0.08%; now, as of February 2023, it is 4.57% (450 basis points higher). This rapid increase in interest rates caused the value of their bond assets to decline significantly, weakening their balance sheet.
Like Silicon Valley Bank, roughly 90% of Signature Bank's deposits were uninsured. Signature Bank focused on digital assets, like Silvergate, and was one of the few banks accepting crypto deposits.
4. How Did The Government Respond?
Over the weekend, the government tried to find a buyer for these banks but could not find anyone who wanted to catch the falling knife. So the Treasury, Federal Reserve, and FDIC released a joint statement with a robust response on Sunday evening. They announced that all Silicon Valley Bank and Signature Bank depositors would be made whole, but the management and shareholders of these banks would be allowed to fail. They also announced a backstop line of credit that banks could draw on to support their loans and secure them with assets even if they had declined in value.
5. How Have Markets Responded?
Bond yields have declined. The 10-year treasury yield has dropped from over 4% earlier this month to about 3.5%. The 1.25% of future expected fed fund increases were taken out, and indications are narrowly holding on that the Fed will raise 25 bps in March, and that is it. Share prices of regional banks have declined sharply, and equity prices in the U.S. and overseas have declined. The S&P 500 fell to levels not seen since January.
6. What Does This Mean For The Economy?
Over 300k jobs were added in February. Retail sales and employment were strong. The U.S. economy was going to slow down but not dramatically. Over in the U.K., the Economy had been doing better than many had expected, and in China, growth had increased with the removal of COVID-19 lockdowns.
There will likely be a tightening of credit markets, making loans more difficult to get. We will also probably see a decline in business and consumer confidence causing many to take a "wait and see" approach to spending or investing. If everyone waits and sees, it can undoubtedly cause a drag on the Economy. However, the economic strength we have seen up to now could provide resilience. U.S. banks and the banking system appear to be in decent shape.
7. What Does It Mean For The Path Of Monetary Policy And The Fed Funds Rate?
This week, an inflation report was released. The consensus was that the February inflation rate would fall slightly to 6.0% YOY down from 6.4% in January. We haven't seen a wage-price spiral. It's more like a wage-price slinky. This is the 23rd consecutive month that average hourly wage increases did not reach the level of CPI inflation. Inflation is coming down slowly, and between wages not keeping pace with inflation and the weakness in demand for goods, the Fed may not raise rates. However, owners' equivalent rent is sticky and will provide some support to inflation. The Fed knows this, and they may raise rates because of it.
Banks have many bonds on their balance sheets with unrealized losses because rates have increased. Since bond prices are inversely related to interest rates, the best way to support those asset prices would be to lower rates. It is a delicate balance between raising rates to curb inflation and causing damage to bank balance sheets.
8. What Does It Mean For Investing?
It is so important not to get caught up in the crisis headlines. We will likely see some additional volatility and perhaps some additional "naked swimmers," as Warren Buffet says. However, that should not deter our focus. People have a habit of getting out of the market when they are scared and getting in when they feel comfortable, which is usually a good recipe for selling low and buying high. We don't know the complete fallout yet, but if we look forward several quarters or a couple of years, with hindsight, we will feel good about the decision to stick to our financial and investment plans.
9. How Do FDIC And SIPC Protection Work?
It is important to note that most banks are not Silicon Valley or Signature Bank. Their business models don't derive from lending to cryptocurrency firms, tech start-ups, or venture capital firms. For banking products, FDIC provides protections up to certain limits. While the FDIC covers banking products, the SIPC protects investors of securities held at clearing firms.
10. Times Like These
While these headlines may seem concerning, we have been here before and have weathered financial storms that were far worse and systemic. Long-term investors reaped the rewards of holding through turbulent times.
Let's remind ourselves of that and remain disciplined in our long-term journey. For some investors, dollar-cost averaging may make sense in the coming days and weeks. For others, staying disciplined and sticking to the plan may be the answer.
If you're looking for ways to structure your budget during today's market volatility, check out our blog A Fiduciary's Ten Tip Guide to Budgeting During Market Uncertainty.