It is difficult to grasp that just a few weeks ago the fed funds futures market had priced the terminal rate at nearly 6%. The market’s hawkish outlook was predicated on the Federal Reserve (Fed) raising rates amid a still solid economy underpinned by a tight labor market and solid consumer spending but with inflation still above the 2% level that reflects price stability. Now, with continued pressure on both domestic and global banks, markets are expecting the Fed will be forced to cut rates toward the end of this year as loan growth slows and businesses, particularly small businesses, and consumers find it more difficult to secure loans. As a result, the broader economy is expected to be negatively affected.
The rapid collapse of Silicon Valley Bank (SVB), followed by continued pressure on regional banks, along with headlines surrounding the struggle to shore up confidence in First Republic Bank (FRC), has the market on alert for other potentially vulnerable banks. Difficulties in the banking sector the past couple of weeks has put pressure on the bank-heavy small cap Russell 2000 Index.
Additionally, the swift crash of Signature Bank, the third largest bank failure in U.S. history, along with Silvergate Bank, has investors and depositors questioning if the banking system is as “sound and resilient with strong capital and liquidity” as suggested recently by both Fed Chair Jerome Powell and Secretary of the Treasury Janet Yellen.
To be sure, the Fed’s emergency bank lending facility, the Bank Term Funding Program, which was quickly put in place to help strengthen the banks, served to restore confidence as banks grapple with depositors who are seeking higher rates elsewhere and who are also concerned about the viability of the banks themselves.
No sooner had news regarding the run on SVB hit the media, generalized fear and panic spread quickly. Depositors mounted a modern-day run on the bank using their smart phones, and over the course of 36 hours, the bank was forced to sell $21 billion of long duration bonds at a loss of $1.8 billion.
The blame was quickly focused on venture capitalists who sent out immediate warnings to their start-up companies to withdraw their funds at once. SVB’s large client base was broadly made up of fledgling technology companies backed by venture capital. It did not take long for depositors to exit. A widely followed newsletter that covers the venture capital world, “The Diff,” has been considered the spark that led to the mass exodus of deposits. In late February it reported that SVB’s debt-to-asset ratio was 185 to 1, implying that the bank was virtually insolvent. The underlying culture of the tech world has also come under scrutiny as to how rapidly it draws conclusions how quickly it acts upon them.
The deficit of a functioning risk management team has been the most enduring criticism of SVB. Criticism has also been leveled at the supervisory team at the San Francisco Fed, which is supposed to monitor the operations of the banks within its regulatory jurisdiction. Silvergate Bank, with $12 billion in deposits, is closely associated with crypto activities and suffered a swift run on its holdings around the same time as the SVB failure. Despite early warnings of fragility in the wider crypto world, and with risks climbing, there was, according to media reports, little contact with supervisors from the San Francisco Fed.
At the Federal Open Market Committee (FOMC) meeting press conference on March 22, Powell addressed criticism that there was little supervision of operations at SVB. He stressed that there were red flags raised months ago by examiners from the San Francisco Fed, but he could not say that the warnings were escalated. “We’re doing the review of supervision and regulation,” Powell said, and, “My only interest is that we identify what went wrong here.”
Senator Elizabeth Warren, the leading Democrat on the Senate Banking Committee, blamed Powell for the banking crisis in no uncertain terms saying that he was an integral part of the process that weakened regulatory oversight of regional banks, “Fed Chair Powell’s actions contributed to these bank failures.”
Moving up the blame chain leads directly to the monetary and fiscal policies that flooded the banking system with government transfers to consumers and small businesses, coupled with interest rates that stayed near zero for too long, which allowed risk to intensify across the investing spectrum.
With the Fed’s insistence that the inflationary effect was “transitory” primarily due to COVID-19-related supply chain challenges, the central bank was slow to begin raising interest rates. With financial conditions remaining loose, risk taking was elevated in venture capital, private equity, and real estate, especially commercial real estate. But as the Fed finally launched its aggressive rate hiking campaign, the dynamic changed.
The collapse of SVB, followed by the other banks that were victims of the immediate panic that ensued, is emblematic of the changing landscape. When all is said and done, the blame falls on all the above for failing to recognize what happens when policies that encouraged risk taking were suddenly reversed.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by Bloomberg, FactSet, and LPL Financial, tracking # 1-05365330.
- US Treasuries may be considered “safe haven” investments but do carry some degree of risk including interest rate, credit, and market risk. Bonds are subject to market and interest rate risk if sold prior to maturity..
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