“The Fed is going to keep raising interest rates until they tame inflation or something breaks” has long been a mantra among financial commentators. Recent inflation reports leave it an open question as to whether or not the Federal Reserve has tamed inflation, but the sudden failures of Silicon Valley
Bank (SIVB) and Signature Bank late last week have left no doubt that something did, in fact, break.
SIVB was the 16th largest bank in the country and its failure was the largest since Washington Mutual in 2008 at the height of the Financial Crisis. SIVB started to unravel on March 9th, the 14-year anniversary of the S&P 500’s low point during the crisis, which also began with bank failures. Naturally, problems in the banking system, a decline in equity markets and the potential for cascading effects throughout the economy gave many investors a feeling of “here we go again.”
While we understand that sentiment, and this is still a developing story, we think SIVB and Signature Bank were unique situations unlikely to be repeated in other banks, especially in light of recent actions taken by the Federal Reserve, Treasury Department and the FDIC. Banks, for all of their seeming complexity, operate a fairly simple business model. They take deposits from customers, pay an interest rate on those deposits, then lend those funds and charge interest on the loans. Deposits not needed for loans are typically invested in investment grade bonds, usually Treasury debt securities. In normal circumstances the interest rate the bank pays customers on deposits is less than the interest the bank earns on its loans and bond investments with the bank keeping the difference, known as the net-interest margin. The system works mostly because depositors don’t all demand their money back from the bank at the same time, in what is commonly known as a “bank run”. These were depicted in the movies “It’s a Wonderful Life” and “Mary Poppins”. Once depositors fear they may not be able to get their money back, panic can quickly spread as everyone rushes to withdraw their funds all at once. However only a fraction of deposits are actually held at the bank; the rest have been loaned to customers or invested in bonds. In order to fund withdrawal requests the bank may be forced to sell loans or bonds at prices lower than their purchase price. To prevent runs, the FDIC was created following the Great Depression to insure deposits up to, $250,000 per account. Of course, that limitation became at least temporarily moot this past Sunday. So why did Silicon Valley Bank fail?
Silicon Valley Bank (symbol SIVB) was uniquely vulnerable to a bank run due to its deposit and asset base. As implied, SIVB is based in Silicon Valley and, for the most part, took deposits from and loaned money to venture capital backed companies operating in the technology sector. An analysis from J.P. Morgan suggests 29% of SIVB’s deposits were from early stage technology companies (a notorious boom-bust industry) and another 20% from technology companies. Retail deposits, the type of accounts that normally remain below $250,000, were less than 10% of their deposit base. For comparison, J.P. Morgan has about 50% retail deposits, Bank of America over 50% and Wells Fargo over 60%. Only about 3% of SIVB’s deposits were fully insured via the $250,000 FDIC limit at the end of 2022. Therefore, their depositors were an unstable mixture of highly sophisticated venture capital investors with uninsured accounts and the ability and sophistication to move money rapidly, a perfect prescription for a bank run.
As far as SIVB’s asset base, it was mostly high-quality assets in the form of long-dated Treasury and U.S. agency bonds. SIVB’s unique problem stemmed from three sources: large inflows of deposits in 2020 and 2021, low cost easy money from the federal government and, last, venture capital investments in technology companies. The bank’s balance sheet increased 250% from the end of 2019 through 2022 compared to 50% or less for most of their peers. SIVB invested a significant portion of those large inflows into Treasury securities at a time of historically low interest rates; the 10-year Treasury was yielding below 2% for most of 2020 and 2021.
As the calendar flipped to 2022, the Federal Reserve, in an effort to bring down inflation, began to raise short term interest rates from 0% to almost 5% at the fastest pace since the early 1980s. During this time venture capital funding for SIVB’s customer base began to dry up as financial conditions tightened and the pandemic related technology bubble of 2020 and 2021 popped, leading to an increase in withdrawals. As interest rates rose bond prices fell and the value of the bank’s Treasury bonds purchased in 2020 and 2021 began to decline. As an example, an exchange traded fund that tracks 7-10 year Treasury bonds lost 15% of its value in 2022, exactly the type of bonds SIVB was holding. The damage was not immediately apparent because SIVB was able to classify those bonds as “held-to-maturity” securities and didn’t have to adjust their value to reflect current market prices lower than their purchase price.
As customers began withdrawing money, SIVB was forced to re-classify those bonds as “available-for–sale” and realized market losses on those bonds. A little more than a week ago they sold $21 billion of securities at a loss of $1.8 billion and announced plans to raise $2 billion of additional equity capital to help offset those losses. However, that effort failed as customers/depositors, fearful the bank was in serious financial trouble, withdrew an astonishing $42 billion on Thursday alone, rendering the bank insolvent almost overnight. The FDIC took over SIVB on Friday and on Sunday the FDIC guaranteed all deposits including those above the $250,000 limit. In addition, the Federal Reserve announced a new funding facility (described below) intended to prevent other banks from having to sell large amounts of debt securities trading below their par value.
In our opinion and the opinion of many others, what happened at SIVB is unlikely to spread to other banks in any meaningful degree due to the unique nature of SIVB’s depositor base, the timing of purchasing large amounts of long-term bonds that are highly sensitive to interest rate movements and because of measures taken by the Fed and Treasury Department. Most regional banks have a diversified depositor base, a higher concentration of retail clients with accounts under the $250,000 FDIC insurance limit and did not experience the incredible growth in deposits that SIVB saw in 2020 and 2021. Raising the FDIC insurance limit should quell fears of uninsured depositors and prevent additional bank runs. As mentioned above, to reduce the likelihood of additional bank failures the Federal Reserve created the Bank Term Funding Program (BTFP) that offers loans to banks of up to one year, allowing them to pledge their Treasury, agency and mortgage-backed securities as collateral and value them at par, as opposed to current market value. Had this facility existed last week, instead of having to sell Treasuries at a loss of $1.8 billion, SIVB could have pledged their $21, billion in Treasuries to the Fed as collateral for a $21 billion loan for one year and would probably still be in business today.
You may have noticed that the decline in stock price was not limited to regional banks but also included Charles Schwab, which happens to provide custody services for our client accounts. Schwab stock fell almost 40% from the market close on Wednesday to midday on Monday before recovering some of the loss and is down about 28% as of this writing. In addition to asset management, wealth management, custody and brokerage services, Schwab also offers banking services through Schwab Bank. Some investors have concern about the unrealized losses on the debt securities held on Schwab’s balance sheet.
While Schwab does have a banking business, client investments custodied at Schwab are held at the broker-dealer and are not commingled with assets at Schwab’s bank, eliminating their exposure to potential issues at the bank. The deposit base of Schwab Bank is very stable with 80% of all deposits below the $250,000 FDIC insurance limit. Total bank deposits at Schwab were $367 billion at the end of 2022. Schwab has $40 billion of cash on its balance sheet and $300 billion in Treasuries and agency mortgage-backed securities. While Schwab does have an unrealized loss of about $28 billion on those $300 billion in securities the bank has not experienced a run on deposits, has access to an $80 billion lending facility at the Federal Home Loan Bank (FHLB) and can now pledge its $300 billion Treasury and mortgage-backed securities portfolio at par to cover even the worst-case scenario. We feel confident in Schwab’s balance sheet and the lending facilities it has available.
The events of the last week have certainly raised investor anxiety and volatility in financial markets, as evidenced by recent price declines of regional bank stocks. Risk and the possibility of large short-term price fluctuations have always been, and always will be, part of investing in equities. It’s why we urge clients as often as possible to maintain a long-term perspective on investing and financial planning and remain properly diversified through varying market conditions. While some might fear that recent events may be 2008 all over again, the broad consensus – one we agree with – is that this situation is nothing like 2008. We should be mindful that since the low on March 9, 2009, at the depths of the Financial Crisis, the S&P 500 has returned 15.8% per year. Opportunities to buy quality investments at lower prices are often found during times of crisis, or perceived crisis, and we will continue to work to that end on your behalf. Should you have any questions or would like to discuss anything further, please reach out to us or come by the office at any time.
As always, thank you for your trust, your confidence and your business. Have a wonderful weekend.
=The Sutton Wealth Advisors Investment Committee
W. Edward Sutton
Zachary Sutton, CFP®, EA
Derek R. Gage, CFA
The information contained herein (1) is intended solely for informational purposes; (2) is not warranted to be accurate, complete, or timely; and (3) does not constitute investment advice of any kind. Neither Sutton Wealth Advisors, Inc. nor Purshe Kaplan Sterling Investments is responsible for any damages or losses arising from any use of this information. Past performance is not a guarantee of future results.
Securities offered through Purshe Kaplan Sterling Investments (PKS). Member FINRA/SIPC. Some employees of Sutton Wealth Advisors, Inc. (SWA) are registered representatives of PKS. SWA is otherwise not affiliated with PKS. PKS’s SIPC coverage only applies to those assets held at PKS and that other custodians may be SIPC members and that clients should contact those custodians directly or refer to their coverage specifically.
