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Explanation of SVB Bank Failure!

March 12, 2023

Last week the market technicals were starting to look like the bulls had won out.

However, trouble in the banking system, most notably the failure of Silicone Valley Bank (SVB, the second largest bank failure in US history) has created a bearish reversal. 

I received and email from a close friend in banking with this short explanation:

"The combination of a high level of longer-term asset maturities and a moderate decline in total deposits underscores the risk that these unrealized losses could become actual losses should banks need to sell securities to meet liquidity needs."

-Martin Gruenberg, Acting Chairman of the FDIC, 2/28/2023

What does the Acting Chairman mean exactly? Here goes.

1. In 14 months the Fed has raised Fed Funds 450 bps, from 0.25% to 4.75%. Rate increases cause bond values to fall. If you own a 2 year UST bond at 2.5% and the current market rate for a 2y UST is 5%, who would want to buy your 2.5% bond? The price has to fall until the combination of price and reate are attractive to the investor.

2. Banks hold USTs and Agency MBS for liquididty purposes primarily. If people withdraw depostis, treasurers sell bonds for cash and return the cash to the withdrawing depositors.

3. if you are a depositor at a big bank earning 0.5% on your savings, and you see that a 2 year UST yielsd 5% at zero risk, you think, hmm...maybe I should withdraw my deposit and buy some UST and earn 450 bps more money for myself. Smart move right? Especially if you have $100k or more sitting there.

4.The biggest change in the bank accounting from 2008 is this: Unrealized Losses on securities no longer count against Tier 1 Capital, and thus the all-important 8% Leverage Ratio (Tier 1 Capital/Total Assets), and therefore bank solvency, is not affected by quarterly market/interest rate fluctuations.

in 2008, you had banks with Unrealized Losses greater than Tier 1 Capital, so they showed as Negative Equity on balance sheet. That's why we had the infamous $700B Hank Paulson bailouts - to capitalize negative-equity banks.

Thankfully, Dodd-Frank changed this accounting rule. Banks can opt -out of reporting URL in Tier 1. Sigh of relief all around, Hence the fact that URL is 8x greater than in 2008 doesn't matter, right?

5. Here's the thing. If banks are forced to SELL their bonds for liquidity reasons (such as a big deposit outflow), they have to REALIZE the losses, taking the actual equity hit. This is what happened to SVB Friday. They had to take the hit.

As a reslult, there is a great disturbance in the Force. Everyone is wondering - what banks have had large deposit outflows? What banks will have to sell bonds next, and realize those losses?

Just a wild stab here, but my guess is htat a lot of nervouse bankers are speed dialing the NY Fed about this, begging them to tell Powell to stop raising rates. URL is getting to be too high.

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