Some Notes on SVB & Other Bank Runs

So now we’ve had 3 banks fail in the USA. A couple of them were very big. So why did they fail?

Overview

The short answer is “A few folks panicked and made a bank run on them.”

There wasn’t anything particularly bad, or poorly operated, about those particular banks. Two of them were involved with “crypto”, but not for the majority of their portfolio. Just enough to have “their community” panic about it when poked. The other one, Silicon Valley Bank (SVB), was concentrated in the Venture Capital arena. Several Venture Capital companies had their money in it, and they had their portfolio of companies put the company money in it. This, BTW, had it reporting exceptional above average earnings (which was, I’m sure, part of “the point” behind concentrating the VC wealth in the VC “preferred” bank…).

Now all that was well and good, until The Fed decided to raise interest rates from “nearly nothing” to “quite a lot” in way too fast a way… In Japan & Europe rates WERE zero (or even negative). In the USA we were at some fraction of a percent, somewhere near 1/2 percent. In just a few months, The Fed raised rates by about 5% (or 500 “basis points”). That’s about a 10 x of the original 0.5% rate. Going from 1/2% to 1% doubles your interest payments. At 2% it has doubled again to 4 x the original cost. At 4% you get another double (so now 8 x whatever interest costs you had before). The next 1% (to 5%) is a 25% increase in the interest payment ( 1% is 1/4 of 4% ).

So very very fast, The Fed dramatically raised the amount of cash folks had to pay as interest on any loans. This is intended to quash inflation by “cooling” the economy. Basically you try to crush new sales on credit and new investment in inventory or construction by raising the interest costs. (This, BTW, doesn’t stop inflation. Inflation is a consequence of too much money chasing the same goods. Causing an economic contraction to make less goods doesn’t fix that… but it does squash businesses and assets.)

A lot of old loans are now “variable interest rate” loans. So that portfolio of old loans starts to jack up rates too. This sucks a lot of money out of people’s pockets and that, too, reduces demand for products (so is expected to reduce demand and ease inflation rates…). This ignores that the factories are now in China and reducing our demand doesn’t do anything to US makers… What it really does is prompt folks to float more on their credit cards for things like food and fuel, increasing the money supply. (There’s some quibble about credit card balances and ought they be counted in M1, M2, whatever… but what IS clear is that when you use your card, you are essentially creating some money to buy something that did not exist before. Your bank will front it too you, and then go make sure that “asset” (your loan of that money) is capitalized in some market or other). So how that increase in “money in motion” is supposed to reduce inflation is a mystery to me… /sarc;

OK, that’s the background.

The Technical Hook

Banks have a LOT of assets that have value due to interest payments. Bonds. Car loans. House loans (mortgages). Business Loans. When you go to sell a debt instrument (be it a simple mortgage or a package of them) the value calculation looks at the net present value of that expected future income stream. An expected interest rate is applied (called a “discount rate”) to figure out that present value.

So imagine I promise to pay you 10% on $1000 if you loan it to me for a year. On the face of it, that’s worth $1100 at the end of the year. But what if other investments are only yielding 5%? Those others are worth only $1050. But then we have the “time value of money”. Money I can spend today has a lot less risk than a promise of money in a year… So we “discount” that money by some interest rate. Figure there’s a 5% inflation + risk of loss. That makes that 5% loan “net present value” essentially zero. I’ll give you my money for a year, and when (if?) you pay me back, the payment won’t buy any more than the $1000 today.

OK so far. But now make the interest rate The Fed is paying 1/2%. That makes a 5% note look really good, and a 10% note look great! Folks end up paying a couple of percent over that Prime Rate, so most likely you will be making loans at about 3% to 5%. But, OK, discounted by 1/2% your 5% loan is making you 4.5% “net present value” of that future return (yes, I’m cutting corners on the actual way you figure this. It is to get the idea across, not make you an economist or accountant…)

So you make a LOT of 5% loans and the world is FINE. You are posting “nice” earnings of 4.5% year over year.

But then The Fed raises the prime interest rate. In fact, in just a few short months it jacks it up to 5%! OMG! Now you have this BIG portfolio of 5% loans that are NOT going to make you any money (when the net present value is discounted by 5%). IF you want to sell them, you will need to have MORE than 5% return to induce anyone to buy them. That means selling a $1000 note for, say, $995. They get the $5 “bonus” when the note is paid off plus the $5 interest. Making $10 on $995 is “worth it” to them even with a 5% discount rate.

OK, got that?

When interest rates go up: Interest bearing instruments like mortgages and loans and bonds GO DOWN in market value.

Now this isn’t much of a problem if you can just hold that $1000 note to maturity and get paid the full $1000 principle. But it IS a problem if you must sell before maturity and at a discount.

The Events

So The Fed also tells banks how much liquid assets they must carry to cover their cash needs. In the prior 2008 Banking Crisis a key bit was a change to the mandated accounting rule to say assets must be “Marked to Market”. I don’t know if they went back to the older way of face value, or not; but the effect of dropping asset value is the same.

The Fed says “you need more capital that is liquid (cash) or can be sold rapidly”. You need to raise more, or you get a Federal Proctology exam and potential closure.

So in their Investor Call, SVB said they intended to raise an added $2.5 Billion or so of “capital” (this on about a $200 Billion capitalization, so not that extreme). They also refused to say they might not come back to raise more (what bank would?). This spooked the VC Community and all those Venture Capitalists pulled their money AND called their portfolio of companies and told THEM to pull there money too. An over night $42 BILLION bank run happened.

SVB had to liquidate assets to raise the cash AND do it in the highly liquid “right now” markets that demand a deeper discount to hand over cash instantly. In the end, SVB took about a $1.8 Billion haircut on raising that $42 Billion of cash. This put them in even worse posture on “capitalization” and resulted in a Fed takeover.

Now, had those VCs (and their portfolio companies) NOT concentrated their deposits in that one bank, this run would not have happened. Had they not panicked over a relatively normal capital raise, this run would not have happened. AND: Had The Fed raised rates more slowly and judiciously, everyone would have had time to adjust and the capital shortfall most likely would not have happened.

Oh, and dumping completely the “Mark To Market” rule for things like bonds and mortgages can help prevent this too, as you don’t have to say your $42 Billion of bonds is only worth $40 Billion today because The Fed ran rates up too fast to sell them and Mark To Market won’t let you count them at face value as you hold them to maturity and actually GET face value for them….

For the 2 “Crypto Banks”, it was a similar thing in that the too rapid Fed rate hike caused a nominal capital shortage, but in this case it was the association with “Crypto” (tainted by the FTX debacle) that caused the spook / panic and bank runs.

Implications For Retail Banking

There’s a lot of folks running around, hair on fire, shouting that the general banking system is going to melt down in 60 days or less and to get your money out now. NOTHING could be worse than doing that.

Retail banking (folks like Chase, Wells Fargo, etc.) are posting nice earnings and not having bank runs.

Now, realize that a General Panic can cause a bank run on ANY bank; and NO bank can liquidate their portfolio of 30 year mortgages, 5 year car loans, and 20 year bonds at full real value in just a few days.

Yes, the US Financial System is not in great shape, and The Fed is doing stupid things. But there isn’t a lot better out there right now. China pegs to the $US, so their currency inflates at our rate too. Europe is in worse shape. Japan is in worse shape in terms of debt and economic performance. Sometimes you just lose a few percent to inflation.

Frankly, I’d have my money in a Swiss Bank except that they folded on Bank Secrecy to the US and now there are painful reporting requirements for overseas banking. Then they have decided to not be Neutral during a time of European War…

Do I think there will be more bank failures?

Yes. Especially if Mark To Market is still being used. The rapid jump of interest rates by 500 basis points (1/100 of a % per point) or 5% over a very short time was just dumb and will hurt a lot of banks financial numbers. Especially those who are in odd niche markets like Venture Capital Funding and Crypto Banking. But I expect your major Retail & Commercial banks (along with your local Credit Unions) to be Just Fine.

Unless, of course, everyone panics and demands all their money, in cash, right now!…

IF you are worried, AND have over $1/4 Million of actual cash in the bank, just split it up into $250,000 chunks and put one in each bank account. That’s the Federal Insured Amount. Very few folks have that much cash laying around….

Note that The Fed has already stepped in to assure customers of SVB get all their money back. No, I don’t know what will happen to companies that had way over the $1/4 Billion insured amount, but we will know very soon. Stockholders and Bond holders will likely get wiped out, so I’d not be holding a lot of Bank stocks or bonds…

But your grocery money is likely fine…

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