Here we go again. Just two days before the 15thth On the anniversary of the Federal Reserve-backed Bear Stearns bailout, the central bank is offering banks easy money to halt an incipient run on the sector.
The immediate question is whether it will succeed. The secondary question for investors is whether this means an end to the rapid rate hikes that have devastated markets over the past year and what lessons can be learned from this.
It looks likely to work, although Monday’s initial market reaction suggests it won’t be easy. After the collapse of three banks, the Fed is now poised to use magic accounting to lend against government bonds and other safe assets at valuations above their worth.
Silicon Valley Bank, the 16thth largest, failed in large part on Friday because it had bought long-dated government bonds before rate hikes began and had fallen in value. If it could borrow at face value instead of at its far lower real value, as the Fed is now allowing other banks to do, it could have funded deposit withdrawals for a long period of time and perhaps avoided a run.
The sight of repayments to depositors in failed banks should reassure those whose cash balances at other banks are above the $250,000 insured limit. The fundamental problem of unrealized losses on bank-held government bonds remains (although none have had a problem as big as the SVB), but now the risk of deposit withdrawals forcing them to realize losses has disappeared. The Fed has borrowed a leaf from the home lending playbook: expand and fake.
However, will the Fed have to pull back from raising interest rates? Past interest rate cycles have often resulted in major financial problems that have forced the Fed to reverse course, Yardeni Research analyst Ed Yardeni points out. The most obvious was the subprime crisis of 2007, which led to rate cuts, as did the 1998 explosion of hedge fund Long-Term Capital Management fed
However, the Fed has a bigger problem today with inflation. In 2007, the Fed was poised to cut interest rates despite an oil-related acceleration in inflation because the collapse of the financial system was evident. In 1998 inflation had fallen below 2%, while at the time of the peso crisis it was fairly stable. This time around, inflation remains well above target, the labor market is still tight and Fed Chair Jerome Powell talked longer about the need for higher interest rates until the bank collapsed last week.
A better parallel might be the Bank of England, which had its own severe crisis in the autumn. Faced with an implosion in UK pension funds and forced selling in the government bond market, it temporarily stepped in to buy bonds – a form of easing. But he stuck to his plans to continue selling bonds and raising interest rates. The problems in Britain were caused by an incompetent government rather than a bank, but they did not end the currency cycle.
Of course, financial problems affect the real economy. In the UK, significantly higher mortgage rates weighed on housing and the economy and may therefore result in monetary tightening being slower than would otherwise have been the case. The sight of SVB’s tech startup clients panicking about how to do their payroll could make some companies wary, while banks are likely to think twice about expanding, despite the Fed backstop . Both could slow things down and reduce the need for the Fed to raise rates so quickly. But both are uncertain and the Fed is likely to remain concerned about apparent inflationary pressures, at least until signs of a slowdown become apparent.
Investors can learn many lessons from the collapse of the SVB and the other banks. The first concerns single stock risk. SVB Financial Group, the bank’s holding company, was in the S&P 500 and was valued at $44 billion 18 months ago — and still $16 billion as of Wednesday. “Don’t put all your eggs in one basket” is a cliché because it’s true.
The second concerns the nature of the risk. The SVB got into trouble not because it made foolish loans to risky borrowers, but because it bought some of the world’s safest assets, US Treasuries. Similarly, Circle’s stablecoin — a dollar-pegged cryptocurrency — ran into trouble for taking a more cautious approach than some peers and investing a large chunk of its assets in bank deposits. Some of these were with the SVB and their value plummeted well below their dollar peg.
Bonds and companies have different risks of default, different chances of loss. The key to investing in them is that the risks are priced in – and safe assets can be just as overvalued as risky ones.
The third lesson is about double-or-nothing bets. Both SVB and Silvergate, a failed crypto-focused bank once worth $6 billion, had the same interest rate risk on either side of their balance sheets. When interest rates rose, the bonds purchased fell in value.
That’s annoying for shareholders alone, but not existential because banks that want to hold bonds to maturity keep valuing them at face value. It only matters whether the bonds need to be sold to repay creditors or depositors – and here the two banks had doubled down. They focused on clients — tech entrepreneurs and crypto bros — who were particularly sensitive to interest rates. As interest rates rose, both needed their cash, so deposits that had poured in during the boom were washed out and the bonds had to be sold.
Investors often make a similar mistake. It’s easy to think that you can ride out a temporary downturn and invest in risky or hard-to-sell assets. But the most likely cause of a deep temporary downturn is the recession, and that’s likely to hit not only your investments but your income as well. Job losses often lead to forced asset sales at just the wrong time. Take the lesson from SVB.
Write to James Mackintosh at firstname.lastname@example.org
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