Stocks fell sharply late last week as Silicone Valley Bank, the 22nd largest bank in the country failed. Sunday Signature Bank also failed. These were the second and third largest bank failures in U.S. history, only smaller than Washington Mutual (WAMU) which failed after a run and massive exit of deposits in September 2008 at the depth of the Great Recession.
Over the weekend, the FDIC and Federal Reserve jointly set up a Bank Term Funding Program (BTFP) to try and stem a serial run of exiting demand deposits, particularly from banks in the Silicon Valley that cater to the venture funding and small tech company worlds. Nonetheless, stocks of banks in those straits are under renewed pressure in pre-market trading this morning.
The BTFP program provides banks access to loans through the FDIC and the Fed to backstop them and stem a run. That should work for most of the larger banks. Money has to end up somewhere. We can’t put it all under a mattress. One place it can be placed is in U.S. Treasuries. Yields are sharply lower this morning as many take bank deposits and run to presumed safety.
The government made it clear that the new program wasn’t a bailout. The banks don’t get any handouts. It was designed to protect depositors. Most of the deposits at SVB were uninsured. These were not deposits of wealthy individuals. SVB was a 40-year-old institution with close ties to the local tech and venture capital communities. It didn’t fail because it was overleveraged or made bad loans. What was at fault was a mismatch between the duration of its assets (loans and Treasury investments) and the duration of its liabilities (demand deposits). A casualty of skyrocketing interest rates and lower bond prices, as Treasury yields soared and bond prices fell, it needed to raise capital to fill the void created by unrealized bond losses. In addition, banks focusing on the crypto industry, which included Signature that failed over the weekend, spooked depositors and started a run that couldn’t be stopped.
Hopefully, the creation of the BTFP will stem the run on most banks although some banks in California with concentrated deposit bases may still be at risk. But the BTFP doesn’t address the bigger problem for banks and other financial entities that have been living off their abilities to earn a large interest spread on demand deposits that, until today, have paid nothing. As of today, the problem isn’t survival; it’s how do these banks make money. The problem isn’t confined to the banks. It includes any financial institution that makes a profit on the spread between what it can earn on its assets and what it must pay depositors or lenders.
Money is fungible. It will seek the place of maximum risk-adjusted return. For a long time, banks didn’t even care if depositors left. The income banks derived were from their own deposits at the Federal Reserve.
The new Fed tact to raise interest rates rapidly has changed that. A crescendo was reached last week. This wasn’t a repeat of the September weekend that saw Lehman fail, Merrill Lynch disappear into Bank of America, and government bailouts of AIG and Fannie Mae. Oh yes, and the simultaneous ratings reduction for WAMU precipitated a run of 9 days that ended that bank as well. If it wasn’t a repeat in terms of severity, it was a second cousin. Its impact will be felt by everyone over the coming weeks and months. Things that were free won’t be free anymore. Banks will have to pay depositors in some way to keep the money from moving elsewhere. When your deposits were earning nothing but were safe and guaranteed, you didn’t care if the alternative yields in money market funds were only a few basis points. But when there were safe alternatives that paid much more, including CDs, money sought the higher return. That is only going to accelerate from here. If banks want to retain deposits they will have to offer a fair return. Remember when you got a free toaster for opening a bank account? Let’s see what happen now.
Another freebie has been free commissions on securities trades. Discount brokers that historically got paid to execute trades at a low price shifted and made their money by accumulating assets and banking the spread between the cost of money and what they could earn. They became lenders. Essentially, they became banks using free trades as an incentive to gather assets. I suspect it is only a matter of days or weeks before we all start paying for trades again. The model that worked well when money was free doesn’t work as well when there is a cost to gathering assets.
All this doesn’t mean banks, brokers and other similar institutions are doomed, but it does mean their earnings models need to be fixed, probably quicker than comfort allows. Over the next days any individual or company is going to ask itself how do I ensure that my money is safe (first requirement) and that I get the best return at minimal risk? Banks learned last week that sitting back and doing nothing can lead to grave costs quickly.
The Fed’s role in all this is to provide liquidity to mitigate future disasters. The BTFP is an important step. Whether it is the last step or not remains to be seen. Note that the large banks will be very reticent to be the Fed’s partner given the government’s litigious reactions post the Great Recession. The government sued all the major banks for malfeasance, and even for activities of distressed banks the Fed forced these banks to acquire prior to their acquisition. Barring a grant of immunity, which the government is unlikely to do, the banks aren’t going to be anxious buyers of anyone else’s liabilities. SVB was able to sell its UK business to HSBC for $1. It tried to sell SVB over the weekend but apparently didn’t like any offers, if there were any.
As noted, expect lots of changes over the next few days. Some will be obvious, others not so. Next week, the FOMC meets. At one-point last week, after Chairman Powell’s hawkish testimony to Congress, the odds of a 50-basis point increase in the Fed Funds rate rose to over 75%. Even Friday, as SVB was being shut down, the odds were still 40%. This morning Fed Funds futures put such odds at zero. The odds of a quarter point cut, never even discussed this weekend, are now close to 35%. Tomorrow’s CPI report will still be a key ingredient in the mix, but bank stability is paramount. What happens over the next 10 days will trump any inflation data. It isn’t even impossible, should conditions worsen, that the Fed is required to take action before next Wednesday. For now, the Fed will stand back and watch markets closely today. Its primary concern won’t be stock prices. It will be flow of funds. Every major bank will be monitored literally in real time to see whether ere money is flowing in or out.
Unlike 2008, this isn’t a liquidity crisis. Banks are very well capitalized. There isn’t too much leverage although away from banks, problems are beginning to appear at the low quality fringes (e.g., default rates on car loans to those with low credit scores are spiking). Clearly, we are beginning to see very graphically, how a world quickly pivoting from one where money is free to one where money is dear can go through a whole lot of turmoil as it adjusts.
And adjust it will. Virtually all banks will survive, but their earnings models will change. Eventually, they will find a new equilibrium that will generate a fair return. It may require a new mix of fees and net interest margin but they will get there. Depositors will get paid more. Transactions will cost more. Loans might get more expensive.
Is there a lesson for the Fed? Sure. Every credit tightening cycle has an attendant crisis. Remember Long Term Capital Management? September 15, 2008? The failure of Continental Illinois or virtually all banks in Texas? The mortgage meltdown?
Is there a lesson for investors? Yes, there are several. First, it helps not to be in the eye of the storm. Until all the carnage is visible, don’t try and sift through the wreckage. We have learned time after time, that the Fed and the government are there to make us whole. They have lots of tools available and they will use them as necessary. Today, no matter what the market does, is not a day to panic. Crises happen at the end. They are a consequence of earlier actions. They also act to destroy speculation. Bitcoin is trading up this morning, but I would stay as far from the crypto world as possible right now. At the same time, it is a moment to reconsider what is going to work best and worst in an environment where money has a real cost. It will not only impact banking. It will impact every company and every industry. Start up capital is now going to be tougher to find and much more expensive. You already see the impact on the housing industry. As is true in every storm, industries near the eye are the most affected, but all will be affected in some way.
Bottom line: take a deep breath, don’t panic, but adjust as necessary. The Fed and the FDIC probably stemmed to bank liquidity crisis and avoided disastrous consequences, but the aftershocks are likely to be consequential to both lenders and borrowers. Stay tuned.
Today, Jamie Dimon is 67.