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Is a Bank Crisis Looming?

This is going to be a long one, so settle in...


While the economy has been surprisingly resilient over the past year or so since the Fed began their interest rate hikes, many of us have suspected that there were cracks in the system that would likely break given enough time and pressure.  It was just a question of where those cracks were and exactly how things would break.

We now have at least part of that answer...

For anyone paying attention, the big economic news of the past week has been the collapse of Silicon Valley Bank (SVB), one of the top 20 banks in the nation.  Before we jump into how this might impact the economy overall, let's dig into exactly what happened at SVB.



Let’s break down exactly what happened with SVB…  And more importantly, why it happened.


1. Between 2019 and 2021, the amount of money deposited at SVB increased from about $60B to nearly $200B. 


This is because lots of startup tech companies hold their money there, and during these couple years, many silicon valley companies were raising millions, tens of millions and hundreds of millions of dollars in venture capital.  Because SVB is very friendly to tech companies, these companies were keeping all of their money with SVB.


2. SVB is a bank, and as such, it’s in the business of loaning out its deposits to generate a profit. 


But SVB had just received nearly $140B in just a couple years, and wasn’t able to loan out anywhere near that amount.  But banks don’t like to have tons of cash sitting around, as cash isn’t generating a return for the bank, and is actually losing money to inflation. 


So, from about 2020 through about 2021, SVB decided to take just under $100B in cash and invest it into bonds (both government treasury bonds and mortgage backed securities). 


Quick intermission…


If you don’t know how bonds work and why they can sometimes be risky, I highly recommend reading this article that wrote last fall:


All About Bonds:Is a Bond Crisis Looming?


3. Now, this is the important part of the story… 


When a bank buys an asset that has a termination/maturity date (like a bond), the bank is required to classify that asset as either Hold-To-Maturity (HTM) or Available-For-Sale (AFS). 


HTM essentially means that the bank intends to hold the asset until it matures – for example, in the case of purchasing a 10-year treasury bond and classifying it as HTM, the bank is indicating that it intends to hold the asset for 10 years.AFS means that the bank thinks it’s likely that they will sell the asset prior to its maturity date – for example, selling a 10-year bond in less than 10 years.


But here’s the rub…Allocating an asset to the HTM bucket doesn’t mean that the bank can’t sell that asset before maturity.It still can.The only difference between HTM and AFS is in how the accounting for the asset must be done.


Specifically, any asset in the HTM bucket will stay on the bank’s balance sheet at the asset’s original purchase price – the bank doesn’t have to reflect an increase or decrease in value (even if the asset loses a lot of value).This makes sense – the value of a 10-year bond can drop tremendously over the 10 years, but if held to maturity (never sold), the value drop is meaningless, as the bank will still realize the full value that it was purchased at.


Long story short, a bank can watch the value of its HTM portfolio free fall but doesn’t have to make this information public, as the assumption is that the assets won’t be sold prematurely and a loss won’t actually be realized.


On the other hand, assets classified as ASF are required to be “marked to market,” meaning that the bank is required to continually update their balance sheet to reflect the current value of the asset.If a bond in the ASF bucket gains or loses value, the balance sheet will reflect this and shareholders will know.


So, why wouldn’t a bank choose to designate all assets as HTM?The answer is that if even a single bond is sold out of the HTM portfolio, the entire portfolio now needs to be marked to market, and the entire balance sheet needs to be updated.Large HTM holdings can result in big balance sheet changes if even a small percentage of that portfolio is sold.And these big balance sheet changes can spook shareholders and account holders.


Of the $100B in assets that SVB added to their balance sheet between 2019 and 2022, about $85B were classified as HTM.In other words, the bank wouldn’t need to report bond losses or update their balance sheet for these losses – UNLESS they sold any of these assets.


Between summer of 2021 and fall of 2022, SVB’s HTM portfolio value dropped by nearly $17B.And because these assets didn’t need to be marked to market, few people had any idea.


4. Remember, a typical SVB customer is a startup tech company that is losing money every month. 


So, while these companies may have huge amounts of deposits at SVB, they are withdrawing large amounts of cash each month to keep their operations going.   And SVB needs to have enough cash on-hand to be able to cover these withdrawals.


Unfortunately, 2022 wasn’t a great year for startups to be raising money, so SVB wasn’t seeing many new deposits.They had lots of money leaving the bank every month as withdrawals, but not much coming in to cover those withdrawals.  From beginning of 2022 to beginning of 2023, the bank saw deposits fall from about $198B to about $165B.


There was really only one option: sell off part of their bond holdings to raise cash.


Last week, they sold off a large portion of their ASF holdings, locking in a $1.8B loss on those sold assets.But with the realization of this loss, the bank became under-capitalized and was required by regulators to raise money in order to maintain its capital position.


5.  Unfortunately, SVB was unable to raise the money it needed.


And last Wednesday, the bank announced the restructuring of its balance sheet. 

This led to several VCs advising their companies to pull money out of SVB, and on Thursday, $42B in withdrawals were taken by SVB customers, a quarter of the bank’s total deposits.

This was the first major run on a bank in over 15 years.  And by Friday, SVB was shut down by California regulators.


The rest of the story was actually much least for depositors.  The FDIC/Treasury announced over the weekend that they would be selling off SVB and would be creating a "backstop" that would ensure that SVB depositors -- as well as depositors at other banks facing issues -- would be protected.

As of Monday morning, depositors at SVB once again had access to all their funds, which stemmed the risk of missed payrolls and other missed expenses this week.

Unfortunately, this wasn't the end to the bad news.  While SVB was the second largest bank failure in history, Saturday saw Signature Bank being taken over by regulators, making it the third largest bank failure in history.  And on Monday, trading was halted on 20 bank stocks, while many of them lost significant value.


Now, let's talk about what this means moving forward.  While I don't have a crystal ball -- nor do I even have 20/20 hindsight -- here's my take:

*  First, I don't believe that SVB would have collapsed had there not been a run on the bank.  Had VCs not instructed their companies to withdraw funds, and had the media not sensationalized the situation, it's fairly obvious that SVB would have had plenty of funds for the foreseeable future, giving it an opportunity to raise additional investment and stay solvent.

While we can never know this for certain, it's looking likely that depositors will get their money back from SVB (as opposed to having to rely on the Fed), meaning that SVB was still in a reasonable strong balance sheet position.  This was a liquidity issue for the bank, not an equity issue.

Until last week, it was looking likely that the Fed was going to raise the Federal Funds rate by 50 bsp (a half point) at next week's Fed meeting.  This is now looking tremendously unlikely, and the consensus is that we are more likely to see either a quarter-point increase (about 65% likely) or no increase at all (about 35% likely).

With the media latching onto the idea that the increase in interest rates was the cause of the SVB failure (though again, I would argue that it was the run on the bank instead), it seems like that the Fed is going to want to avoid ruffling feathers with any large rate hikes at this point.  

*  Despite the Fed not being able to raise rates as much as they'd like, it's quite possible that the fear generated by the current bank crisis will accomplish the same goal -- slowing down the economy.  With the media now talking about economic softening and financial risks, it's quite likely that we'll see a shift in consumer spending and sentiment.

Long story short, this whole situation may have been a "blessing in disguise" for the Fed -- they may get the slowdown they are looking for (in order to cool inflation), without having to do the rate hikes they were likely dreading having to do.

*  Along with that previous two points, it's now much more likely that the rates we will see down the road (by the end of the year) will be lower than previously expected.  Assuming there is enough fear in the market to drive us to recession, this isn't farfetched. 

We are already seeing bond yields drop, which is an indication that investors are scared and are moving their money to more secure assets.  If main street follows, that could be the slowdown that the Fed has been hoping for, which could lead to a reversal in rate hikes.

*  In terms of how this might affect real estate and us as investors, it's possible that this will actually be a good thing.  Should the current fear in market lead to a swift downturn, the Fed is likely to respond with rate cuts sooner than expected.

Lower rates from the Fed would lead to lower mortgage rates, as well as a drop in rate cap prices, which has been a big driver of fear in commercial markets the past several months.  Not to mention, lower interest rates could give cap rates some room to move down over the next couple years, ensuring future price stability for commercial assets.

As I mentioned above, nobody has a crystal ball.  But, I suspect that the events of the past week will likely hasten whatever was about to come.  The first domino, so to speak, which leads to a recession and then ultimately a recovery sooner than expected.

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