What could possibly go wrong when the chief risk officers for the United States banking system, the Federal Reserve Bank, encourage speculation and risk taking by making it virtually impossible for any enterprise to earn a safe, respectable rate of return on assets?
The questions about the failures of Silicon Valley Bank (California) and Signature Bank (New York) should be redirected to the easy money, low yield policies of the Federal Reserve System. Those policies fooled the rich and famous who dine at the French Laundry in Yountville, CA with surprising equality to the nightly viewers of Jim Cramer on Mad Money.
Rich and Poor—Savers Everywhere Owned Bonds
In 2022 before the Fed announced it would raise rates to fight inflation, investors sought yield without understanding how duration created huge risk. This was clearly true for Silicon Valley Bank whose depositors were described by California Governor, Gavin Newsom, as representing the “entire innovation ecosystem that has served as the tent pole for our economy”.
SVB’s depositors included really smart venture capitalists like Sequoia Capital and Draper Capital, and really successful early-stage IPO wunderkinds like Peloton and Zip Recruiter. Their average SVB deposits were millions of dollars, not thousands like ordinary citizens, and more than 90% of its deposits exceeded the $250,000 FDIC insurance limit. This was no ordinary bank.
This tent pole group of depositors could afford dinner at the exclusive French Laundry where the monthly wine bill alone usually topped what the average American had in his retirement bond account. Many of these tent pole depositors also had family office staff, treasury staffs, chief financial officers and financial advisors who were responsible for understanding investment risk and especially how depositing money above the $250,000 FDIC insurance limit in a small bank that was buying long maturity Treasury Bonds might be really risky if the Fed started to raise rates to fight inflation.
Is There Anyone In American Who Doesn’t Know There Is A $250,00 Limit on Federal Deposit Insurance?
However, based on my research no one at SVB never raised this issue as a risk. According to SVB’s 2021 Proxy Statement SVB’s Risk Management Committee met the fewest number of times of all Committees in 2021, and because two members of that Committee declined to stand for reelection to the Board the Risk Management Committee was depleted in 2022.
Rich and Poor Were Equally Unlucky
2022 was the worst year in history for long term bond investors. According to “The Financial Times” stock and bond investors worldwide lost $30 Trillion of market value in 2022. The US bond market lost between 13% and 15% of its value, and the 30 year US Treasury Bond lost almost 40% of its value. Anyone who had long duration bonds, irrespective of quality, suffered substantial losses in an asset class most people consider pretty safe. Investors with great investment pedigrees and retirees with none shared a quite uncommon brotherhood of being equal losers in 2022 in the US Bond Market.
Strange Bank Accounting
Due to an accounting quirk, banks are permitted to carry Treasury securities at maturity value, not market value, so SVB’s balance sheet looked fine after publishing its 2021 financial statements in early 2022 even though the market value of its assets had declined substantially by the middle of 2022. However, by buying longer maturities SVB was able to report higher GAAP interest earnings in 2021. SVB management reached for yield to support stock price and forgot about their precarious, uninsured depositor funding totaling more than $100 Billion Dollars.
An experienced banker would tell you, however, that the single biggest bank risk is asset/liability management. You must match the stickiness of your short-term funding (deposits) to the liquidity of your short term assets (3 month CDs). Investing in long dated assets funded by uninsured demand deposits is a moon-shot speculation. It increases reported earnings but puts the bank’s existence and depositors at risk if interest rates rise which was a known risk in early 2022.
SVB did not hedge its asset/liability mismatch, nor did it take market losses when it could have saved itself.
Normal Citizens Made The Same Mistake
This was the same dilemma bond holders throughout the United States had in 2022 when the bond market crashed. Friends at the Fed saved SVB and Signature but left the rest of the citizen bond losers to eat Trillions of dollars of their own losses. Had they been of “tent pole” pedigree they could have bought the same long duration bond trade by depositing in SVB and they would now have a 100% bailout.
When you are carrying long term Treasury assets at par, but their market value is 85% of par and your deposits can all disappear in 48 hours, the liquidation value in the trading markets predictably will be less than the cash demanded by fleeing depositors. A run on a bank ensues and you invade your equity capital and your ratios fall below an acceptable level and bank regulators seize your assets to preserve value for depositors. Even the foggy directors of SVB knew the Fed was going to raise interest rates when they supported management keeping long dated, but higher earning, assets to goose reported earnings. They also did not hedge against the known risk of rising interest rates so their collateral value was 100% exposed to the rapid increase in interest rates.
The Real Story From Former FDIC Head Sheila Bair
However, the real story you are not hearing is revealed in a transcription of a WSJ “Free Expressions” interview by Gerry Baker with Sheila Baird, a former head of the FDIC and my candidate for head of the Federal Reserve Bank click here to read www.APuzzlingBailout.com. Here is her assessment of how The Federal Reserve improperly concluded that SVB was “systematically important” in order to justify a bailout for the rich and famous:
“Gerry Baker: SVB was a small bank, is a small bank, by any measure in comparison with the major US financial institutions. It’s not designated a systemically important financial institution. More than 90% of deposits were deposits over the FDIC guaranteed limits. So those depositors presumably knew any risks they were taking, putting more than that FDIC limited amount in there. Why should those depositors have got a bailout?
Sheila Bair: Good question. Based on what I know, I don’t think they should have. I was there pretty astonished, just because as you observed this was a $200 billion institution in a $23 trillion banking system.
The uninsured depositors were very well-healed. It was the who’s who of venture capitalists and the portfolio companies that they funded. An argument was made that there were some small startups that needed their uninsured deposits for payroll. I don’t know who those were? I think it was probably a pretty small number.
It’d be nice if somebody disclosed that list, but even if that was the case, at the end of the FDIC’s usual practice, they would’ve declared probably at least a 50% dividend to the uninsured next week, or excuse me, the week following the failure. So that would’ve given the uninsured some access to cash. So their usual processes, I think, should have been used, they were perfectly adequate to deal with this bank failure, and I’m astonished that they made a systemic risk assessment.”
That Ms. Baird did not see SVB as either “systemically important” or its depositors as the tent pole of the California economy will surely disqualify her from succeeding Jerome Powell. However, the tent pole metaphor chosen by Governor Newsom properly identifies his tent where he was a depositor and the tent where his supporters put their cash. For the rest of the uninsured bond market losers in 2022 totaling in the Trillions their household tent poles were shattered with no $150-200 Billion handout from the Fed.
How About A Lottery For All Bond Losers?
Fairness suggests we should have a national lottery with the money earmarked to save SVB put in a national lottery where everyone who lost money in the bond market gets one free ticket but SVB depositors take their losses just like everyone else. Now that is a plan that makes sense and treats us all equally. Also, prepare to read the rest of the story when Michael Lewis publishes a book.
The above commentary is for informational purposes only. Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.