It is amazing that on the first business day since the jobs report and one day before the latest CPI print we would be talking about anything other than inflation and the labor market. Yet here we are. Interestingly enough we are still talking about the next Fed meeting which we will get to in a minute. First, let’s start from the beginning.
On Friday, federal regulators stole the thunder of February’s jobs report by shutting down Silicon Valley Bank. So I spent a good amount of the weekend trying to figure out what was true, what was false, what caused this run, and is this a widespread problem.
(Note: Most of this information I got from the podcast “The Macro Trading Floor” and their episode Panic in the Banking System.)
What happened? Without getting too much into the weeds SBV essentially was sitting a ton of bonds that had lost a significant amount of value because interest rates had spiked this past year.
Why is this a problem? After 2008, a bank’s solvency is determined by the liquidity coverage ratio. The LCR is essentially a generic stress test that aims to anticipate market-wide shocks and make sure that financial institutions possess suitable capital to ride out any short-term liquidity disruptions. The bonds being held by SVB had lost so much value that their LCR was unbalanced meaning their bond holdings, aka reserves, no longer fully backed their deposits.
How did this go unnoticed? Bonds are held in two forms by a bank “Available For Sale” and “Held To Maturity.” Bonds held in the “Held To Maturity” bucket aren’t readjusted along with market forces. Using mark-to-market accounting, bonds held in the “available for sale” bucket are adjusted. When bond prices fall this would require the bank to either buy more bonds or increase their cash reserve to maintain their LCR. However, because most of their bond holdings were in the”held to maturity” bucket no one was aware that their LCR had become so unbalanced.
Is this a widespread problem? Yes and no. Yes, bond values are a widespread issue because all long-term bonds have lost serious value but no it is not a problem.
Why is it not a problem? This brings us to the second sin committed by SVB. As mentioned above, most banks are sitting on large bond portfolios that have lost a good amount of value as interest rates have skyrocketed this past year. However, because all bonds suffer from something known as interest rate risk most financial institutions buy insurance to protect themselves.
What is interest rate risk? Interest rate risk is the potential for losses that can be triggered by an uptick in interest rates. As mentioned above, if you hold a bond paying 2% and interest rates rise to 3% the 2% bond is now worth less.
How do you buy insurance? Major financial institutions are aware of interest rate risk and therefore buy insurance policies against their bond holdings. Obviously, they don’t walk into State Farm and insure their bond portfolio. Instead, they buy financial products that take bets against their holdings. They can do this using futures, swaps, options, etc…
What happened to SVB’s hedge? It does appear that SVB at some point did have hedge products on their bond portfolio but for whatever reason decided to drop those right before interest rates spiked.
In conclusion. SVB made two major mistakes. They tied up tech start-up deposits in long-term positions that lost money and then didn’t hedge those positions. This is why this is unlikely to be a widespread problem. We know that most banks have bond portfolios that have lost money but we also know that all the large banks have hedged those positions. It is also unlikely that any other bank across the country will have so many clients burning through cash as quickly as tech start-ups are right now which is forcing them to make big withdrawals with very little money coming in.
So how does this impact the housing?
This might seem somewhat disconnected from housing but this concern over the financial system is going to have one direct impact on rates. The 25 vs 50 basis point hike had seem settled. Especially after the hotter than expected jobs report. Friday morning a 50 basis point hike seemed almost 100%. However, by Sunday Goldman Sachs was already predicting no hike in March…
Wow.
— Carl Quintanilla (@carlquintanilla) March 13, 2023
GOLDMAN: “In light of recent stress in the banking system, we no longer expect the #FOMC to deliver a rate hike at its March 22 meeting with considerable uncertainty about the path beyond March.” [Hatzius] pic.twitter.com/7FZCPpxDAm
By Monday morning, Daniel Ivascyn, chief investment officer at Pacific Investment Management Co, told Bloomberg “This is the first time we have seen a meaningful trade off between the fight against inflation and financial conditions. We think policy officials are going to take notice. It’s possible that the Fed pauses in March and we do think there will be more reverberations around the banking sector.”
Until the government and the Fed is confident in the banking system. The rate environment is likely to be more favorable for the foreseeable future.
