- The Fed’s prolonged period of low interest rates created many financial diversions that are now festering.
- Case in point: Silicon Valley Bank collapsed within a day after interest rate hikes caused it to sell a bond portfolio at a huge loss.
- The situation is an example of how risk-taking with low interest rates can backfire as economic conditions tighten.
The market on Friday watched as regulators closed the doors on Silicon Valley Bank, capping a rapid decline and marking the biggest bank failure since 2008.
The bank’s collapse was a byproduct of the Federal Reserve raising interest rates by 1,700% in less than a year. Once risk-free Treasurys started producing more attractive returns than SVB offered, people started withdrawing their money and the bank needed a quick way to pay them. Eventually they were forced to sell their loan portfolio at a huge loss.
The chaotic episode showed that the Fed’s aggressive rate hike regime could upend institutions once considered relatively stable. It appears that any sensitivity to interest rates is about to be revealed and that past risk-taking behavior is held responsible.
“When you’re raising interest rates quickly, after 15 years of overstimulating the economy with near-zero interest rates, not to imagine that there isn’t leverage in every pocket of society to get stressed is a naive fantasy,” Lundy Wright, partner at Weiss Multi. -Strategy consultants, my colleague Phil Rosen said on Friday.
There are already two recent high-profile examples that are not specific to the banking system, but are still indicative of the pressure higher interest rates are causing.
The first was the collapse of the cryptocurrency market. Since the Fed began raising interest rates in March 2021, bitcoin — once a highly touted inflation hedge — has sunk more than 65%. This pressure on asset prices contributed to the collapse of FTX, which faces criminal proceedings, and crypto bank Silvergate, which just this week went into liquidation. There was also a double-digit decline in high-growth technology stocks over the same period.
The big questions now are which rate-sensitive areas will be next to feel the pain and whether there is a real risk of financial system contagion. But before that, a little background.
New interest rate cycle brings ‘perfect storm’
The collapse of the SVB is a perfect example of the kinds of dislocations exposed when rhythm cycles shift.
In 2020 and 2021, tech startups were buzzing with high valuations, stock prices were soaring to record highs on an almost weekly basis, and everyone was flush with cash thanks to trillions of dollars in government stimulus.
In this environment, Silicon Valley Bank, which had become the go-to bank for startups, thrived. Its deposits more than tripled from $62 billion at the end of 2019 to $189 billion at the end of 2021. After receiving more than $120 billion in deposits in a relatively short period of time, SVB had to put that money to work and it’s loan The book it was not big enough to absorb the massive influx of cash.
So SVB did a normal thing for a bank – precisely on terms that ended up working against it. He bought US Treasuries and mortgage-backed securities. Fast forward to March 16, 2022, when the Fed initiated its first rate hike. Since then, rates have jumped from 0.25% to 4.50% today.
Suddenly, SVB’s long-term bond portfolio, which was yielding an average of just 1.6%, was much less attractive than a 2-year US Treasury note that offered nearly three times the yield. Bond prices fell, creating billions of dollars in paper losses for SVB.
Continued pressure on tech valuations and a closed IPO market led to a drop in bank deposits. This prompted SVB to sell $21 billion in bonds at a loss of $1.8 billion, all in an effort to shore up its liquidity, but which effectively ran the bank out.
As Deutsche Bank analysts reported on Friday, shortly before regulators intervened:
“It’s not too much to say that this episode is emblematic of the higher interest rate regime we seem to be at the beginning of, as well as inverted curves and a tech venture capital industry that has seen much tougher times. late. The perfect storm of all the things we’ve been worried about this cycle.”
What’s next? Is there a risk of transmission?
When it comes to representing the risk of aggressive low interest rate behavior, SVB is the latest and greatest example and the tip of a larger iceberg of interest rate sensitive areas. So which ones are particularly at risk?
Commercial real estate should be the primary concern for investors because there are more than $60 billion in fixed-rate loans that will soon require refinancing at higher rates. In addition, there is more than $140 billion in floating-rate securities backed by commercial mortgages maturing in the next two years, according to Goldman Sachs.
“Floating-rate borrowers will have to roll back interest rate offsets to extend their mortgage, a costly proposition,” Goldman Sachs chief credit strategist Lofty Karui said in a recent note. “We expect delinquencies to increase among floating rate borrowers, particularly in properties such as offices that face secular headwinds.”
And there have already been some major commercial real estate defaults this year, with PIMCO’s Columbia Property Trust recently defaulting on a $1.7 billion loan tied to commercial properties in Manhattan, San Francisco and Boston.
The stock market is also watching, with shares of office REITs such as Alexandria Real Estate Equities, Boston Properties and Vornado Realty Trust falling more than 5% on Friday. Shares of Boston Properties fell to their lowest level since 2009, while shares of Vornado hit their lowest level since 1996.
If that sounds bleak, fear not: despite the drama, it’s hard to see SVB’s fall leading to lasting damage to the wider financial sector for two main reasons. First, banks are highly capitalized thanks to tight banking rules since the Great Financial Crisis. Second, few banks have such concentrated exposure to risky startups as SVB.
But there is one thing that all banks need to pay close attention to, and that is the risk associated with higher interest rates and their impact on deposit levels, fixed income holdings and profits.
Signs are already emerging that businesses that depend heavily on deposits could soon come under pressure. Deposit outflows have increased at all FDIC-insured institutions in recent months as customers choose higher-yielding government bonds and money market funds.
It was ultimately the deposit-dependent nature of SVB’s balance sheet that left it so vulnerable. Once people started collecting their money, it was over.
And perhaps most ominously, SVB is likely not the only bank with billions of dollars in losses on its bond portfolio, so watch out for further interest rate swings.
“Silicon Valley Bank and First Republic have emerged as prime examples of banks with business models and balance sheets that are ill-prepared for an environment of rising interest rates and the ever-increasing risk of recession,” Levitt told Insider. “Investors, smelling blood, turn their attention to the next bank exposed to interest rate risk and certain credit risk, and then the next.”