May 26, 2023
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SVB’s collapse and the feds response will continue to have ripple effects

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Legendary investor Warren Buffett is famous for saying “Only when the tide goes out do you discover who’s been swimming naked.” Today, the “tide going out” is the rapid rise in interest rates that the Federal Reserve has implemented to combat inflation. When combined with leverage, the result is… nudity.

The collapse of Silicon Valley Bank (SIVB, the company’s ticker sign on the NASDAQ) was triggered by a loss of depositor confidence, forcing the bank to sell its “safe” portfolio of longer-term Treasury bonds, which had lost value because of rising rates.  

SIVB carved out a distinct and riskier niche than other banks, setting itself up for large potential capital shortfalls in case of rising interest rates. The irony of SIVB is that most banks have historically failed due to credit risk issues. SIVB’s primary issue was a duration mismatch between high-quality assets and deposit liabilities.

The FDIC acted within 4 days to designate SIVB (along with New York’s Signature Bank) as systemic risks to the financial system, which gave them the authority to backstop uninsured deposits at both institutions. At the same time, the Federal Reserve introduced the Bank Term Funding Program (BTFP), which allows banks and other depository institutions to pledge US treasuries and other qualifying assets at par value in exchange for a loan with maturities of up to one year. The BTFP essentially eliminates the need for banks to sell high-quality securities at a loss to meet deposit withdrawal shortfalls, deposit outflows and forced asset sales.

Silicon Valley Bank’s collapse may have been the first crisis to blindside Wall Street since the Federal Reserve started aggressively hiking interest rates last year; odds are it won’t be the last. While the California-based lender’s failure might not be a threat to the broader financial system thanks to rapid government action, it’s very likely a sign of more pain to come.

“The possible systemic element of the SVB situation is the dramatic reshaping of the yield curve over the past year, which affects virtually every financial institution, every levered corporation and household, every bond portfolio,” Anne Walsh, the chief investment officer of Guggenheim Partners, wrote in a note on March 13.

Where exactly the pain from the fastest Fed tightening cycle in a generation will appear next is a big question. Already there are signs of mounting stress in key corners of global finance. Commercial real estate is at risk, with tens of billions of office debt maturing this year and banks shying away from refinancings with building values falling. 

Loan stress can feed on itself quickly in commercial property as rates rise because loan refinancing becomes more costly and harder to find as banks look to reduce their exposure, which leads to more sales at lower prices and more risk of losses for lenders. Declining property values are already here. A widely followed index of commercial real estate prices published by the National Council of Real Estate Fiduciaries plunged 3.5% last quarter, the biggest decline since 2009 and only the second quarterly drop since then. The decline was led by office and apartment properties.

The leveraged loan market, where private equity firms have layered companies with mountains of debt, is another potential pain point. According to Bloomberg data, the amount of distressed corporate bonds and loans globally has jumped 5.6% to $586 billion over the past week.

Markets are now waiting for the Federal Reserve’s next interest rate move. Will the stress already caused by rapid rate increases be enough to slow down persistently high inflation? Or will the Fed have to continue tightening fiscal policy, causing more nudity? Whatever the answer, we have found it always pays to heed Warren Buffett and make sure that financial swimsuits are securely in place.