One of the Best Managed Banks in the Country Just Went Under in Two Days
The Fed Can Bail Them Out – As Always
Scary? Yes. A big problem for banks and stocks? No, in part because the Fed can easily bail out Silicon Valley Bank, the bank that just went under.
How? The Fed can offer to buy Silicon Valley Bank’s Treasury bonds for par value. No discount. That way the depositors can get all their cash back whether they are insured or not insured by the FDIC.
For the Fed it’s a trivial amount of bonds – less than $200 billion. For comparison, at the beginning of 2022, the Fed was buying $100 billion a month. And, that’s on top of the $6 trillion they already hold -- $200 billion is a drop in the bucket.
Silicon Valley Bank Was a Very Successful and Well-Managed Bank Hit by an Unusual Set of Circumstances
It’s worth understanding what happened with Silicon Valley Bank because it was an unusual set of circumstances. Silicon Valley Bank was founded in 1983 and has done a fantastic job of securing long term relationships with venture capital firms and the companies they invest in. The Bank lends to younger tech companies that are a little risky, but also have the potential to grow and become huge clients.
This bank has been very successful through all the ups and downs of the tech world and had amassed total deposits of almost $50 billion by 2018. In the last few years their strategy has worked wonders. In the tech boom of 2020 and 2021, its clients were flush with cash and Silicon Valley’s deposits rose to nearly $200 billion.
Having so much cash so quick meant they didn’t have a place to lend it all. Making loans takes time. So, they did what many banks do is put that money into one of the most liquid and safest investments in the world: US Treasury bonds. Sure, they only paid 1.5% to 2% but they were safe. And they paid more than the short term rates of 0.25%.
But, most of all, they were safe. The US has never defaulted on its bonds. Plus, they have actually made very good returns since the Financial Crisis. If they fell in value, it was only for a short period of time and they didn’t fall very much.
In 2022 that all changed and Treasury bonds fell as much as 20% in one year. Wow!
The problem for Silicon Valley Bank is that in 2022 their young high tech companies went from making big deposits to making withdrawals. They were no longer able to raise the kind of investment money that they did in 2020 and 2021, and they didn’t need to. They had cash in the bank. For Silicon Valley Bank, covering those withdrawals would have been a simple matter of just selling their ultra safe Treasury bonds to get the cash.
But, as 2022 went on, the value of the bonds they were selling were producing bigger and bigger losses as interest rates increased in 2022.
When they reported their most recent loss, they announced they would need to sell more stock to bolster their capital. Unfortunately, that started a two-day spiral of high-tech firms panicking and withdrawing their money. And quickly led to the bank having to be shut down because selling all their Treasury bonds to meet demand would create huge losses.
This isn’t like Jimmy Stewart’s bank run in the great movie, “It’s a Wonderful Life.” Jimmy Stewart’s bank had put its money in illiquid loans to home buyers and businesses. That’s good business, but since they are illiquid, it can lead to not having enough money for withdrawals, if there is a run on the bank.
Silicon Valley did no such thing. They put their deposits in highly liquid and ultra safe Treasury bonds. Easy to sell at a moment’s notice.
The Bank’s Only Problem: The Fed Raised Interest Rates a Lot and Quickly
The only problem is that the Fed had decided to raise their overnight lending rate from 0.25% to almost 5% in one year.
It’s not banking mismanagement that caused the problem. It was the Fed’s management of interest rates that caused the problems. Again, Silicon Valley bank is, in my opinion, one of the best managed banks in the country. They did nothing wrong.
Which is one reason it is easy for the Fed to bail them out. They aren’t protecting any wrongdoing.
However, that also means that other banks which are well managed could have a similar problem to Silicon Valley Bank with their Treasury holdings and the Fed may have to widen their bailout.
The Lasting Problem Is That Investors' Confidence in Treasury Bonds as Ultra-Safe Places to Invest Cash Will Be Shaken
However, what will be subtly damaged is investors’ confidence in US bonds never going down much or for very long. Sure, 2% is fine if there is no risk of loss. But fewer investors will assume in the future that there is no risk of loss. Hence, they may want higher interest rates to buy bonds.
Again, not a big problem, as the Fed can simply go back to printing more money to keep interest rates from rising too much due to lack of buyer interest in bonds at lower rates.
AS WE HAVE SAID BEFORE THAT THERE IS ALMOST NO FINANCIAL PROBLEM THAT CAN’T BE SOLVED WITH MORE PRINTED MONEY.
What’s the ONLY problem that can’t be solved with printed money? INFLATION!!!
But we are still a long ways from double digit inflation that would put big upward pressure on interest rates.
Longer Term, the Silicon Valley Bank Crisis Will Likely Be a Positive for Stocks
So, what does this mean for stocks? Short term, more volatility. Long term, it is a big plus for stocks. As bonds become less attractive -- you’re only getting 4% and there is a risk of loss plus inflation is now at 6.5% -- stocks will become more attractive.
In addition, real estate is becoming less attractive. Higher interest rates reduce the amount buyers are willing to pay. In addition, there is an increasing lack of demand for office space and retail space near major office complexes. And, for housing, affordability is a growing problem.
Real estate will not become a crisis since the Fed can simply print money to buy mortgage bonds to push mortgage rates down. But real estate will become less attractive to investors as a potential source of substantial investment growth.
This adds further to stock’s appeal.
Plus, the US stock market is especially appealing now since international markets are doing poorly. London stock s are selling at a 40% discount to US stocks. Europe will have more trouble with economic growth because it doesn’t borrow as heavily (or irresponsibly) as the US government so it’s economy doesn’t grow as fast. And, they are feeling mostly negative effects from the Ukraine war, especially in energy costs. Whereas the US economy is probably having a net positive economic impact from the war.
Short term, buckle up. I could be a bumpy ride. But, a bumpy ride may also get the Fed back into bailout mode, which always cheers the market. And don’t expect the Fed to sound quite as positive on further rate increases. Its primary duty is to help the economy avoid banking and financial crisis. That is the entire reason the Fed was started.
It knows that. Raising rates is entirely responsible for causing one of the biggest banking failures in recent history and certainly the biggest failure of a well managed bank. They will likely tread more carefully on raising rates in the future. A positive move for stocks.