March 13, 2023 | Premium Service | Why did Silicon Valley Bank, the 18th largest bank in the US fail last week? Because the bank’s management naively invested half the bank’s assets in “risk free” securities. The bank had 43% of total assets in mortgage-backed securities vs an average of 12% for the 132 largest banks in the US. Extension risk killed Silicon Valley Bank.
Source: FFIEC
What is now the most sought-after list on Wall Street by short-sellers? The list of banks with above-peer holdings of MBS. We first wrote about the risk of duration to US banks back in 2017 (“Banks and the Fed’s Duration Trap”):
“As and when the balance between buyers and sellers in the MBS market slips into net supply, volatility will explode on the upside and the considerable duration extension risk hidden inside current coupon Fannie, Freddie and Ginnie Mae MBS could prove problematic for the banking industry.”
When you see the FDIC forced to stand up a bridge bank and issue IOUs to large depositors of Silicon Valley Bank, this is not an ideal situation. Fed Chairman Jerome Powell and Treasury Secretary Janet Yellen need to address the growing crisis of confidence in smaller US banks.
With the sudden failure of Silicon Valley Bank and its parent, SVB Financial Group (SIVB), investors have started to come to grips with the liquidity risk created by the Fed since 2008 and particularly since 2020. To review, let’s go through the steps taken by the FOMC to create our shared predicament.
First the FOMC began quantitative easing or “QE” in November 2008, expanding the balance sheet to compensate for the huge retreat of investors from the financial markets. QE is Fedspeak for massive open market purchases of securities. We can call this early use of securities purchases “good QE” and by 2010 the Fed had essentially achieved its goal. QE should have ended.
Second, the Bernanke FOMC began the first of a series of efforts as social engineering, expanding asset purchases to compensate for the fact that interest rates were already at the zero bound. The pro-inflation tendency on the FOMC led by Yellen pushed for even more asset purchases and other market manipulations. Yellen argued that inflation was too low. Few of the members of the FOMC other than Jerome Powell publicly raised any concerns about the negative impacts of QE on the economy and the financial system.
Second, the FOMC began the first of a series of efforts at social engineering, launching QEs 2 and 3. In 2012, the FOMC stated: “To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.”
For several more years, the Bernanke and then Yellen FOMCs engaged in various market manipulations that have left the US bond market and the term structure of interest rates in shambles. In particular, one of the more idiotic policy proposals of the FOMC was “operation twist,” where the Fed used redemptions on short-term securities to load up the portfolio with long-dated Treasury debt.
Bond purchases continued under the Bernanke and the Yellen FOMC, through to 2017 when the FOMC announced a move toward “balance sheet normalization.” By 2019, however, after the market meltdown in December 2018, the FOMC retreated from earlier commitments to normalize the balance sheet and indicated that a ~ $4 trillion balance sheet was the "new normal."
By refusing to reduce the size of the portfolio, the Fed essentially agreed with earlier warnings from Chairman Bernanke and others that once you start QE, you cannot later withdraw the liquidity. The inflation of the Fed's balance sheet is permanent. When the FOMC reinvests principal repayments from the portfolio, this represents a permanent debt subsidy to the US Treasury. The Treasury, after all, is the primary beneficiary of QE.
By the first quarter of 2020, the onset of COVID provided the FOMC with a pretext for ramping up asset purchase to even larger levels, pushing the total Fed balance sheet from just below $4 trillion to $10 trillion. COVID allowed the US Treasury to borrow trillions more to fund various fiscal giveaway schemes from Congress that added to inflation.
The massive scope of the Fed’s purchases of debt and lowering of interest rates in 2020-2021 helped to refinance two-thirds of all mortgages and an equal portion of corporate debt at very low yields. But the Fed’s actions also concentrated this huge amount of debt within a band of just three percentage points, roughly between 2 and 5 percent. As we noted earlier, 75% of all mortgage backed securities fall between 2% and 4.5% MBS coupons.
When the Fed began to tighten policy and end asset purchases in 2021, much of the COVID era debt was quickly left underwater. As we noted in an earlier post (“QT & Powell's Liquidity Trap”), as the Fed pushed up short-term interest rates, the effective duration of the Fed’s $3 trillion in agency and government MBS ballooned to over $10 trillion today, with a commensurate reduction in price. The MBS owned by SIVB and other banks went from a three-year average life to in excess of 15 years today. The change in duration of MBS is responsible for the huge unrealized losses on the books of US banks.
By the time that SIVB collapsed in March of 2023, the FOMC had moved short-term interest rates nearly six percent. Any first year associate at a bank knows that if you issue a security at 3% and then the Fed raises interest rates by 500bp, the value of that security is going to fall by about 20 points from its original value. SIVB had half its balance sheet in “low-risk” government and mortgage backed securities (MBS), but the market risk overwhelmed the bank and caused a deposit run. Now you know why the short-sellers focused on SIVB.
As Q1 2023 comes to a close, the US banking industry is on a knife’s edge. The bond rally in Q4 2022 helped to reduced the unrealized losses of all banks, but the movement in the bond market may push these losses higher in Q1. Rising market volatility will only further reduce the value of trillions of dollars in low coupon securities issued in 2020-2021. The table below shows the mark-to-market for the US banking industry at Q4 2022.
Source: FDIC
The table below shows the same analysis for JPMorgan (JPM) as of Q4 2022.
Source: EDGAR
The fact that not a single member of the Big Media managed to ask Fed Chairman Jerome Powell about the state of the US banking system during two days of testimony is breathtaking. Fortunately, we don’t have this problem. Members of the financial media need to start asking some questions.
The IRA Bank Book Q1 2023
As the US banking sector heads to the end of Q1 2023, the chief concern of CEOs is managing the growing number of risks being created by the conflicting policies of the FOMC. Banks large and small are spending more time dealing with the curve balls coming from the Fed and other regulators than they are running their businesses. How is this helpful to achieving full employment and price stability?
Below subscribers to the Premium Service of The Institutional Risk Analyst may download the latest edition of The IRA Bank Book for Q1 2023, where we describe some of the current and emerging risks to US banks and financial markets. Stand-alone copies of The IRA Bank Book report are available in our online store.