What a difference a few days make. Early last week, a more hawkish Fed had the market pricing in almost a coin flip between a 25bps rate hike and a 50bps rate hike. The theme was “higher for longer.” However, we ended the week with a run on the banking sector, which saw the collapse of two large regional banks. While there are echoes of the Great Financial Crisis, this time around it isn’t so much a credit issue (bad loans) but a duration and liquidity issue.
It seemingly all started with the collapse of a niche regional bank catering to the technology industry. Silicon Valley Bank’s (SVB) historic 48-hour collapse will go into the history books as the second largest bank failure in U.S. history. In short, there was a mismatch between assets (loans) and liabilities (deposits). Given the pace of interest rate hikes from just 12 months ago, the fixed income environment went from extremely overpriced to fairly priced in a short period. Mid-year last year, we at First Foundation[GB1] Advisors had already begun rolling short duration U.S. Treasuries as their yields had begun to look more attractive than over the past decade. As rates increased further, more bank clients were finding higher yielding alternatives than their deposit rates. A old-fashioned bank run then began (or better yet a Venture Capital-fueled, Twitter run), as SVB filled a unique niche in the banking sectors—the highly concentrated industries of technology and venture capital start-ups. These companies began pulling out deposits which put more liquidity stress, and SVB was forced to tap into their bond portfolio to provide that liquidity. Unfortunately, as interest rates have moved up the value of those U.S. Treasury and Agency bonds, which were fixed at lower rates, went down.
The Federal Reserve, U.S. Treasury, and the FDIC enacted two major policy announcements yesterday. The first being the FDIC has utilized their “System risk exception” (SRE) to protect uninsured depositors in two bank resolutions, Silicon Valley Bank and Signature Bank. The second being the Federal Reserve and Treasury announcing a newly created facility, the “Bank Term Funding Program” (BTFP), which would provide advances of up to one year to any federally insured bank that is eligible discount window access in return for collateral in the form of U.S. Treasury and Agency securities. The key aspect of this is that the Fed would value the collateral at par. This would specifically allow for banks to fund deposit outflows without having to realize losses on depreciated assets. The BFTP program will be backstopped by the Treasury department with $25B. One caveat that is different from the Great Financial Crisis is U.S. taxpayers will not be the backstop, but rather the overall banking sector via special assessments and fees.
Interest rates have dramatically shifted course as investors have repriced risk. The 10-year U.S. Treasury was as high as 4.08% on March 2. Currently it is at 3.50%. Domestic equity markets flip-flopped overnight as well as the current trading session. Duration-sensitive sectors have seen positive gains as a cohort of investors now believe that this past week will be the shot across the bow for the Fed to pause. History has shown that the Fed has reacted to the dovish side when facing financial shocks and crisis. During Black Monday in 1987 they eased. The 1997 Asian currency crisis they paused. The collapse of Long-Term Capital Management and the default of Russia in 1998 they eased. During the 2012 Eurozone crisis they added more QE into the system. Oil’s collapse in 2016 they paused. We will have better insight after next week’s Fed meeting.
Investors may or may not have seen peak interest rates in this cycle and we expect continued volatility in equity markets until there is more clarity on the Fed’s interest rate views. One thing that we do believe is that in the long run, investors will get through this wall of worry just as we got through the GFC, Brexit, COVID-19, etc. As the saying goes, this too shall pass.