Review
I'm curious to learn more about the hold-to-duration thing. It seems like this rule will always lead to situations like this (although usually at smaller scales, hopefully). I can understand if banks don't know what their assets are worth, but t-bonds have a known price.
This isn't a complete answer, but Monday's Matt Levine has a discussion of this in historical context.
More to the point, SVB did disclose their unrealized HTM losses in an appendix of their annual report:
Most relevant, check out page 125 of the 2022 Form 10-K of SVB Financial Group Inc. (Silicon Valley Bank’s former holding company). On page 95, you get the balance sheet showing $16.3 billion of stockholders’ equity. On page 125, in the notes, you get $15.2 billion of unrealized losses on the HTM securities portfolio.
One presumes that traders covering banks spent last weekend (or else this week) re-reading 10-Ks, and the whole world will care a lot more about this term in bank reports, basically forever. Even if it stays legal to report solvency based on HTM marks (which it may not), I think it unlikely that the market will let banks get away with it very much, going forward.
The way the market does not let banks get away with it is by starting a bank run on the bank. If the standard is that banks get bailed out any way that might not happen.
That's not really how it works. The way the market doesn't let banks get away with this is owners of the bank losing money (equity), and getting wiped out in a bank run is just a special case of that. Equity holders of banks don't get bailed out by the FDIC so they're not really getting away with anything.
That said, the (separate) Fed bailout for not-officially-failed banks is likely preventing banks that don't experience runs from correcting properly.
Agree that equity incentives are the relevant forces in market self-regulation here.
That said, the (separate) Fed bailout for not-officially-failed banks...
I am reasonably confused about the BTFP commentary that I've read suggesting it's equivalent to a bailout. My reading of the terms is that it's basically the Fed offering to lend you $100 at (1yr) SOFR+10bp collateralized by (let's say) $75 face value of Treasurys, with general recourse.
If they were lending $100 at SOFR+10bp against $100 face value of Ts, that wouldn't even be a subsidy -- SOFR is supposed to be defined as the going rate for term lending secured by Ts.
And I feel reasonably confident that if a bank went to the Fed with an asset book that was $75mln face value of qualifying securities and said "I would like to use $57mln face = $76mln par of these to borrow $76mln in the BTFP", the Fed would say "yes, here's your money", and then also that bank would get seized by the FDIC that Friday afternoon. So the "bailout" in the par-value detail only matters to banks who wanted to borrow more than 100% of the face value of their qualifying assets, and the only way you pump money out of the government is if you do actually go bankrupt (in which case the Fed has accidentally done a 0% interest T-secured loan to your bankruptcy estate, not the usual definition of "bailout").
My understanding is that the government subsidy is the rate: no one else will give you a loan so close to the risk-free rate when the whole purpose of the loan is that you're a bad credit risk.
Another way of looking at it is that if there was no subsidy, this would be unneccessary because banks could get this loan from someone else.
the government subsidy is the rate: no one edse will give you a loan so close to the risk-free rate when the whole purpose of the loan is that you're a bad credit risk.
For unsecured credit, absolutely. But the BTFP specifically is secured by rounds-to-Treasurys, and the rate it gives is the market-indexed rate for T-secured lending. Your credit really shouldn't come into the economic rate for your secured borrowing.
To the extent that a bank gets cheaper financing from BTFP, it seems to me much more like "other banks would charge you 1% over their economic costs, but the Fed will undercut them and charge only 10bp", which seems more like a (barely profitable) public option, rather than a bailout.
(When the government runs the postal service at a profit but undercuts the theoretical price of private mail, is that helpfully described as a "bailout" to mail-senders?)
The government is agreeing to pretend that this is more-secured than it actually is, since they're treating treasuries that everyone knows are worth $85 (or whatever) are actually worth $100. If these treasuries were actually worth $100, the banks could just sell them for that price instead of needing loans. Also I suspect the cost of a loan from someone else would be much more than 1% higher since the banks needing these loans are very bad credit risks (you'd only take this loan if you're insolvent and hoping no one will notice). The government is taking on a fairly large credit risk in exchange for basically nothing here.
and the whole world will care a lot more about this term in bank reports, basically forever.
I'm usually astonished w how seldom investors and supervisors read the fine print in annual reports. I don't think "this time will be different". Unless GPT-like automated report-readers step in (or maybe precisely because humans will leave this boring details to machines), we'll see it happen again.
Btw, I just noticed that $9.3bi of these $15.2 are MBS - yeah, the same type of security associated w the great crisis of 2007-2008. And the HTM total more than U$90 bi, $72bi of which are MBS and CMBS - so dwarfing their investments in bonds, and their $17.6bi in AFS.
From the post above:
...something called Agency MBS (which you can just read as "government debt with extra steps")
I'm no expert in US markets, but I don't think that's true. For instance, if you try to get a repo w them, you'll probably need a larger hair-cut than w gov bonds.
if people had learned to read bank reports, I'd expect to read more comments on this, instead of the last three pieces I read that basically just said SVB had too much gov bonds.
EDIT: after googling "svb mbs htm," I found tons of surces commenting on this. So, my bad. And most of all, thanks for this post & for this comment, rossry. I believe you saved me at least 1h of googling - to have a better grasp of the situation.
I'm usually astonished w how seldom investors and supervisors read the fine print in annual reports.
If that would be true, you should be able to make good money by reading the fine print of annual reports, buying some options, and then publishing the information.
Why aren't we seeing that in your view?
Because I work for a regulator and am not allowed to do that? Also, many investors won't have enough incentives to read beyond what other investors are reading... except if, as you mentioned, u work w shortselling And shortsellers did make money in this case. So in this sense, the system works... but when it happens to a bank, that's not so cool
Why don't they have incentives? Isn't reading beyond what other investors are reading exactly the way to make profits if you don't just put your money into a diversified index fund?
I'm usually astonished w how seldom investors and supervisors read the fine print in annual reports.
I am occasionally astonished by this as well. My claim is not that the whole annual report will be read more closely for the rest of time; my specific claim is that the specific footnote about unrealized HTM losses will be read closely for the rest of time.
I'm no expert in US markets, but I don't think that's true. For instance, if you try to get a repo w them, you'll probably need a larger hair-cut than w gov bonds.
I suspect it is true that they're haircut less generously, but I do not believe that any part of SVB's trouble looked like "well, if only we could haircut our Agency MBS like our Treasurys, we'd be fine..."
The relevant fact about them for the SVB story is that their credit is insured (by the government, except with extra steps), so ultimately they're like a slightly-weirder interest-rate play, which was exactly the firearm which SVB needed to shoot its own foot. The weirdnesses don't add much to the story.
if people had learned to read bank reports, I'd expect to read more comments on this, instead of the last three pieces I read that basically just said SVB had too much gov bonds.
[E: People just say "SVB had too much gov bonds"] is evidence consistent with [H1: people haven't read the reports closely enough to know the actual holdings] and [H2: people have decided that Agency MBS is adequately described in the category "gov bonds"]. The update that I make, on seeing the evidence that Agency MBS dimension not much discussed, doesn't re-weight my ratio belief between H1 and H2, and I continue mostly believing H2 for the reasons I believed it before.
It turns that the truth is more bizarre. From Matt Levine's Money Stuff:
But today at the Wall Street Journal Hannah Miao, Gregory Zuckerman and Ben Eisen have the actual, horrifying explanation, which is that the Fed’s computers go to bed at 4 p.m. and you can’t wake them up until the next morning
The point I stressed before on government bonds was right: SVB could have borrowed against them. But it seems like I was wrong: it could have borrowed against Agency MBS, too.
Btw, I just noticed that $9.3bi of these $15.2 are MBS - yeah, the same type of security associated w the great crisis of 2007-2008. And the HTM total more than U$90 bi, $72bi of which are MBS and CMBS - so dwarfing their investments in bonds, and their $17.6bi in AFS.
This is technically true but much, much less interesting than it sounds.
The "subprime CDO-squared mortgage-backed securities" associated with the 2008 crisis were:
The "agency mortgage-backed securities" on SVB's balance sheet were:
The problem in 2008 is that these theoretically-perfect-credit, infinite-leverage-allowed instruments were in fact bad credits because the independence assumption was violated. The failure couldn't have happened within the regular system if the banks were restricted to directly owning mortgages.
The problem in 2023 has nothing to do with creditworthiness, has everything to do with the effect of interest rates on asset prices, and could have happened exactly the same way if the bank had directly owned insured mortgages.
The only facts about Agency MBS that are relevant to the SVB story are:
in a nutshell (I don't have the time to write a treatise on this, every word I write is 20w i could have read instead): I'm pretty confident (status: ~ .6) that if SVB had 90bi in gov bonds HTM instead of MBS and the like, it wouldn't have failed. You can say it would have had losses (especially in 2022), it would likely have been bought, but not failed. I know of no bank that has suffered a run because they had too much gov long term bonds (from the corresponding government, and unless the gov defaulted, ofc) in the last century (if you have an example, please enlighten me); not only there's a very liquid market for them, but, in the last century (perhaps since Badgehot) central banks will let banks convert them into money easily - because tax payers will suffer no losses. On the other hand, MBS (and other similar derivatives) may be linked to credit risks (even Agency MBS) and it's quite unsure how your liquidity line will work, and the market is not so liquid; and that's why they offer higher yields - which is why they dominated SVB's HTM. Thanks for the memory refreshing lecture on the crisis of 2008. But I still remember almost everything
Matt Levine at Bloomberg also has good comments on this - basically it was a boring bank run/collapse. With it being primarily a duration issue (rather than an impaired assets issue) and a large amount of deposits, I also suspect we'll see an acquisition.
Check the date on this too.
https://www.bloomberg.com/opinion/articles/2023-03-10/startup-bank-had-a-startup-bank-run is the Levine article for anyone else interested in it.
Despite being a near-religious Levine reader, I somehow missed Friday's post and wrote this post without it. (In my defense, he said on Thursday that he'd be off Friday, then came back to talk about SVB.)
Anyway, Matt has a good phrasing of the unusual weirdness in SVB's assets, for a bank:
Or, to put it in different crude terms, in traditional banking, you make your money in part by taking credit risk: You get to know your customers, you try to get good at knowing which of them will be able to pay back loans, and then you make loans to those good customers. In the Bank of Startups, in 2021, you couldn’t really make money by taking credit risk: Your customers just didn’t need enough credit to give you the credit risk that you needed to make money on all those deposits. So you had to make your money by taking interest-rate risk: Instead of making loans to risky corporate borrowers, you bought long-term bonds backed by the US government.
I second the recommendation of reading Matt Levine. https://www.bloomberg.com/opinion/authors/ARbTQlRLRjE/matthew-s-levine . Bloomburg subscription required to see back-issues, but you can subscribe to future ones for free.
One point that's not often (enough) made is that liquidity crises and insolvency are more similar than they are different. They're distinguished by duration and certainty. If the value loss is KNOWN to be temporary, because the long-term securities are truly safe, and "temporary" is on the order of a few months to maybe a year (again, with guarantees of payout), then it's liquidity. If it's longer-term than that, or there's a real chance that it'll NEVER pay out in full, it's solvency.
I'm curious about what the value of acquiring the customers would be. That said, it'd probably be less than you might think because of how clear it is that the customers aren't well-balanced at all. I almost wonder if the acquisition would be more valuable if the bank was split so that it would be easier to balance them out.
Interesting. One could imagine this working by:
Seems like it could work on paper?
That being said, the FDIC's sole criterion for selecting a resolution plan is the option that minimizes payout from the FDIC insurance fund. Assuming they can get it done with one buyer by tonight with $0 from the insurance fund, they won't look at any cleverer options.
On this point, you'll likely be interested in the discussion in Wednesday's Matt Levine. Excerpt:
The third thing you get, the franchise and relationships, looked great a year ago when the tech industry was booming. It looked pretty good a week ago, when the tech industry was slumping but still prominent and profitable. But I think that the story of SVB’s failure has turned out to be that SVB was the banker to tech startups, and tech startups turned out to be incredibly dangerous customers for a bank. 2 So any other bank will have to be careful about acquiring SVB’s customers, no matter how loyal they are promising to be now. You might ascribe a negative value to those relationships: “If I become the bank of venture capitalists, they will push me to do stuff that is not in my best interests, and I will be seduced or pressured and say yes, so the expected value of these relationships is negative.”
That's part of why I was suggesting that it might be more valuable to only acquire of fraction of their customers.
I'm a bit confused by the structure of the T-notes in your examples.
A typical X% bond works like this:
It doesn't really change any of the points you highlight in this post: the price of a bond can fluctate, especially if a bank needs to sell a lot of them ; an increase in interest rates will cause the old bonds to decrease in value (you paid $100 for a $1 annual coupon and $100 back, but now the interest rate is 5%, so for $100 you can get $5 every year and $100 in 5 years ; this has to mean that your old bond isn't worth $100 anymore).
So, I'm curious, why did you choose an alternative bond structure?
I did my math in zero-coupon bonds (pay $100 at maturity, yield is defined by discount to par) because it's simpler and doesn't change the analysis. Same reason that I rounded 5%/ann for five years to 75¢/$1.
As you said, it doesn't really change the point, but I'm here to say it's not an alternative bond structure, just that the bond happens to be trading at a discount already at the initial conditions. It will trade at a steeper discount as interest rates rise. It would be even less intuitive, but you could also do this analysis with bonds that are trading at a premium (trading at a smaller premium, or even hitting par or switching to a discount, as interest rates rise).
Epistemic status: Reference post, then some evidenced speculation about emerging current events (as of 2023-03-12 morning).
A "liquidity" crisis
There's one kind of "bank run" where the story, in stylized terms, starts like this:
At this point, the simplified bank is stuck. If it sells ~$101-par of T-notes to return the $75 deposit, it won't have enough to pay everyone else back, even if the withdrawals stop here! But if it doesn't give the depositor back $75 right now, then bad things will start to happen.
Equity capital: A liquidity solution
So, we fix this problem by going back in time and starting with an extra step that's now required by law:
Now, the final step of the original story goes differently:
Until...
...and here is where the oops happens. Still, we're much better than the original case, as this bank with an initial 10% equity ratio can weather up to 16% withdrawals in a week, and if it sees anything less than that, it actually comes out stronger (in terms of capital ratio) by the next week when T-note prices reset.
[This is where I'd like to have an interactive chart about deposit withdrawals and their effect on capital position. But the speed premium to getting the post out is too high, alas.]
Furthermore, when the seventeenth depositor asks for a withdrawal, there's a very-reasonable case to be made to say "everything is fine; our equity ratio is still 10%; you can have your money back next week if you want, but right now is just a very bad time, could you possibly reconsider". And if they do hold off, they'll be fine!
If they ask for it anyway, then you give it to them, use $16 of equity capital, and you quickly find a new equityholder to put in another $8.5 of equity capital to get back to 10% equity ratio.
But, if your moral suasion and willingness to pay the seventeenth withdrawal stops the eighteenth and subsequent, then you, like George Bailey, can stop the run on your bank.
And if you do make it to next week (when we assume T-note prices reset), everything is fine (with the deposits at least—your equityholders lost some money, but that's the risk they signed up for).
We'll call this kind of situation a "liquidity crisis".
A "solvency" crisis
There's a different kind of "bank run", which is worse than the first kind. The stylized story starts like:
Okay, so now you have a real problem.
Non-option 0: Hope for rates to go down
Not a real option, then.
Non-option 1: Maintain rates
How much trouble? Well, in order to be back in the position of the George Bailey bank with respect to deposits (except 20% larger), you'll need an extra $15 in fresh equity capital for each depositor, or another $1,500 total.
Even if you offered to sell them the bank for the price of one Snickers bar, on the condition that they put in the $1,500 to make it whole, that's still a worse deal for them than them buying into GB Bank. So you have a big problem, starting from the very first withdrawal.
Non-option 2: Re-float rates
So basically, by the time you've (1) collected deposits, (2) invested them all in 5-year T-notes, and (3) interest rates go from 2% to 5%? You're already in trouble. You're already underwater. Your 10% equity capital is not close to sufficient, and in theory you shouldn't be able to find anyone willing to take your bank from you, even at the price of one Snickers bar.
This is different from the liquidity crisis above! In the liquidity crisis, everything is fine if your depositors make one withdrawal a week in an orderly fashion.
In what we'll call a "solvency crisis", even if one withdrawal happens per week, you will still collapse long before they're finished. Unless you can somehow convince your depositors to stay for the whole five years and accept the 1%/ann interest rate the whole time, in which case you will be okay. You can hope, but that's not really a thing that should happen, especially if people know what's going on.
Your only option is...
Option 3: Liquidation
In real life, this is not what the FDIC will actually do. Instead:
Option 4: Acquisition
This ends up costing the Very Large Bank $900 and a bit of headache to own a bit more bank that's presumptively worth $650. But they enjoy the slight favor of their regulators for the next few years, across their whole business, which is worth far more to them than anything else in this story.
Taxpayers never end up with the bill for "bailing out" the bank, which is good politics. (The negotiated takeover is sometimes called a "bail in", which only makes sense if you don't think about it.)
Depositors were allowed to withdraw $25 immediately (from the FDIC-controlled bank) and $65 later (from Very Large Bank post-takeover). Plus interest from the time the money was in limbo, which I've been ignoring for simplicity. They're fine.
Silicon Valley Bank
The consensus narrative (at this time - 2023-03-12 morning) about Silicon Valley Bank, the sixteenth largest bank in the US, is that it faced a solvency crisis based on investing in long-term government debt and something called Agency MBS (which you can just read as "government debt with extra steps"). The FDIC has taken over, and will presumably follow Option 3 or Option 4.
Some of the coverage has focused on liquidity elements of the crisis, but my understanding is that the shock to liquidity merely forced the realization that SVB was insolvent sooner than it would have otherwise; it didn't change the inevitable facts of insolvency.
Liquidity: Okay until it's not okay
Like many solvency crises, it was possible to ignore it for a time after the rates moved, while there was sufficient liquidity, because (1) there weren't material amounts of withdrawals, (2) interest rates paid on deposits were slow to catch up to debt-market rates, and (3) no one was looking very hard ahead of the hockey puck for something like this at a bank with less than $250 billion of deposits (when some different regulatory rules kick in).
Regarding (1), we can start with the fact that SVB's deposit base was less than 10% retail deposits made by individuals:
Retail depositors, like most humans, are often looking to minimize contact with their bank as much as possible, and it's not crazy to think that they might stick around even if your interest rate is a few percent worse, or there's some concerning news but it uses a bunch of financial jargon and is hard to understand. Besides, if $250,000 of your deposits are going to be available on Monday in the case of an FDIC takeover, and you have less than that on deposit, why bother?
On the other hand, if you're a professional CFO making decisions for a corporate business, you deal with your bank all the time. You read the news. And if you and all the other CFOs all ready the same bad news, you might collectively withdraw $42 billion from your accounts in one day.
Even worse, SVB was the bank of choice for much of the Silicon Valley startup scene (I've seen estimates of 30% of companies and higher in biotech). This was good business when net deposits were positive every year for many many years, until mid-2022 when that stopped being true. Unfortunately (but not unforeseeably), a sudden industry-wide stop in inflows into startups can be caused by interest rates rising, which made SVB's book of startup deposits and long-term debt doubly vulnerable to interest-rate rises—the liquidity crunch comes exactly when your solvency takes a turn for the worse.
Still, all of this action on point (1) poses a liquidity issue, not a solvency issue. SVB could have had no depositor flight at all—as in Option 2—and still taken a controlled flight into terrain.
The reasons for (3) could be a whole 'nother post, but my understanding is that a material contributor was that the accounting rules (which every bank uses!) allowed SVB (like every other bank with assets <$250bln) to take most of the assets that it had bought at 90¢, and which were now trading 75¢, and treat them as being still worth 90¢ when calculating the amount of assets available to repay deposit withdrawals. This is called "hold-to-maturity", and the rules about when you can and can't apply it are more complicated than this post can contain.
(In)solvency: Why, and where else?
Okay, but if solvency is the big issue, then why did SVB end up with an asset book so exposed to interest rates? Should we expect similar performances from other banks? Paul Krugman has a theory, which seems pretty solid to me:
Matt Levine has a similar take:
In this model of the problem, the least concerning shape of bank in the present environment is one that gets its lending profits from short-term loans to businesses that are risky, but manageably so. If you were good at this kind of thing, I'm sure there were plenty of small businesses that were looking for 2-year bank loans, and if you can find the good ones and charge them 8% above prime and have 6% losses to defaults, then you can turn a profit without taking interest rate risk.
The most concerning shape of bank right now, on the other hand, is one with no on-the-ground lending operations, whose only ability to lend cash and collect interest came from things you could find on a Bloomberg terminal (or in places that themselves took a bath on rising interest rates). Those banks, when they needed slightly higher interest rates, had little choice but to reach for yield by taking things that were (a) lower-credit, (b) longer-duration, or (c) exposed to other risks that recently got toasted. (a) is a well-known problem, and presumably was off the table due to regulatory constraints. But if SVB managed to pile up enough (b) and (c) to get into trouble, are there other banks with little community lending in the same situation?
I don't do this professionally, but I'm interested to find out. We'll see more on Monday.
(Edited to add some recommendations from the comments, but I'm not going to update this article for things that happened after midday Sunday, March 12.)