Bank Failures And The Strength Of The Financial System
Back in 1996 when I started my career, I was in credit research for a California-based bank called City National Bank. One of my roles was to analyze the credit of other banks with which we did business. That is where I first came across Silicon Valley Bank.
It’s 27 years later now and a lot has changed. On Thursday of last week the stock was down so I decided to open up their recent annual report and take a look at their balance sheet to see what was going on. Imagine my surprise when, clear as day, it showed that their equity was almost gone if you were to measure their investments at fair value.
A few months ago, I wrote about the problems with target date retirement funds, which included mechanically allocating to assets without analyzing them for whether you are getting good value. One of the examples I gave was that they allocated investors to long-term bonds even when interest rates were 2% or less. This is enormously risky for investors because if interest rates rise to, say, 4%, the value of the bonds would go down a lot. In fact, 20- and 30-year bonds were down around 30% in 2022.
Unfortunately for Silicon Valley Bank, this risk apparently did not deter their investment committee or risk management group from doing the same thing. They bought a large amount of long-term bonds when rates were low. When rates rose last year, the losses almost equaled their equity as of year end 2022. My guess is that they had further losses this year since rates rose more. And once people realized the situation, they tried to pull their deposits all at once and on Friday the FDIC took over the bank.
On Sunday, Signature Bank was also closed. They also made poor investments, but for them it was in the crypto-currency space.
I have heard concerns about banks from a number of people, so I spent the weekend poring over the balance sheets and footnotes of all the major banks, regional banks, and brokerages in the S&P 500.
I felt comfortable with the strength of most of the banks and brokers I reviewed. Nonetheless, there are a handful that I am concerned about. The situation is fluid and a lot depends on the actions of the regulators. However, I have confidence in the regulators to maintain the soundness of the system and have been pleased with their actions so far.
The major concern I have is not the exposure of banks to long-term bonds. None I reviewed took as much risk as Silicon Valley Bank did in that area. However, there some institutions with large books of long-term fixed rate mortgages. If you own a lot of mortgages paying 3% and mortgage rates are now at 7%, you’re holding onto a big loss in fair value. What’s more, if you have to pay your depositors 4-5% but you only earn 3%, you’re losing money on those assets.
A potential positive, ironically, is that the Federal Reserve may stop raising interest rates or even drop them. This might be helpful to long-term assets, such as stocks.
I think it is prudent to review the long-term mortgage and bond exposure of financial institutions. Aside from that, it always makes sense to have a solid long-term financial plan combined with short-term liquidity and reserves.
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