As we know, Silicon Valley Bank (SVB) was taken over by the Feds after a bank run. Despite assurances from SVB that they were sound, they obviously failed to understand their precarious situation. Based on SVB’s balance sheet, it was technically insolvent. The regulators shut it down and pondered what to do next.
A bank run? How could this happen in modern financial America? Doesn’t the government (the Fed and the Federal Deposit Insurance Corporation [FDIC] in this case) regulate and monitor banks and make them safe? Wasn’t post–Great Recession legislation supposed to prevent this? Apparently not.
According to the New York Times, since 2021 the Fed has issued six warnings to SVB about liquidity issues. The warnings related to the bank’s ability to pay off depositors in the event of a crisis. These warnings were mostly ignored.
At the end of 2022, SVB’s assets were $209 billion, and customer deposits (a liability) were $175.4 billion. So, what happened? Why were they not able to pay all depositors? It was because the value of a significant portion of those assets had declined in value . . . a lot.
SVB’s deposits grew about 225 percent from 2020 to 2022 which was fallout from the Fed’s crazy pandemic monetary infusion, an unprecedented $4.5 trillion of new money. That money spigot was the genesis of today’s inflation. Wads of money found its way to Silicon Valley venture capitalists who funded startups like crazy. Many of those investment companies and their startups banked with SVB.
What do banks do with depositor cash that isn’t lent out? They invest it, mostly in bonds: US Treasurys, mortgage-backed bonds, or corporate bonds. SVB was loaded with long-term bonds paying very low interest rates when they bought them. Shortly thereafter the Fed announced it was raising interest rates to fight inflation. Starting in March 2022 the Fed’s interest rate went from about 0.5 percent to about 4 percent. That is a huge jump for the bond market.
Higher interest rates devalue bonds with very low rates. Let’s say you paid $1,000 for a ten-year bond yielding 0.5 percent, for an annual return of $5. Let’s say the next day the Fed raised rates to 4 percent. You go to sell your bond but find that no one wants to pay $1,000 for a $5 yield when they can get a $40 return for the same amount. Buyers will discount the value of your bond to an amount that equals a yield of $40. In this example, the current value of that low-interest bond would be about $716. This is overly simplified, but you get the point.
It took a year for the Fed’s interest rate to get from 0.5 percent to 4 percent, yet SVB, despite the Fed’s warnings, stuck with their low-interest bonds which resulted in those bonds being substantially devalued. That is what alarmed the Fed. Now their liquid assets (bonds) were less than their deposits which meant they were technically insolvent.
Anyone who knows anything about economics and monetary theory knew inflation was coming long before it happened. The consumer price index, a measure of inflation, went from 1.23 percent in quarter one 2020 to 8.29 percent in quarter two 2022. The Fed has only two tools to combat inflation: raising interest rates, and shrinking the supply of money. For some reason SVB’s management was either ignorant of the iron laws of economics or foolishly ignored the problem despite the Fed’s warnings. You pick.
So, what’s the Fed to do? Since 97 percent of SVB’s deposits exceeded the $250,000 FDIC guarantee, those uncovered depositors stood to lose much of their funds. In an unprecedented move, the FDIC, Fed, and Treasury announced they would guarantee the return of all depositor money, not just the $250,000 limit. By law they can’t do that unless the failure of the two regional banks (SVB and Signature Bank) represent a “systemic risk” to the financial system.
This was a very controversial call. Treasury secretary Janet Yellen said it wasn’t a bank bailout because the bank’s shareholders wouldn’t be saved. Technically true, but it does bail management out of the consequences of bad banking decisions. Also, it is a bailout of Silicon Valley companies who parked huge amounts of money at SVB without considering the potential risk of bank failure. For example, Roku had $487 million in deposits. BILL (New York Stock Exchange) had $300 million there. They too will be bailed out from their bad money management decisions.
Bailouts lead to problems. The issue is what in economics is called “moral hazard.” If you allow someone to get away with something they’ll probably do it again. If there is one thing free-market capitalism does well it’s reward success and kill failure. If a company goes under because of bad decisions, the lesson to investors is to stop funding it. Economist Joseph Schumpeter called this “creative destruction.” You shouldn’t waste capital propping up failures; invest in successful companies, which will benefit everyone.
Bailouts encourage risky behavior. Banks, financial companies, and large corporations now know they will get bailed out by the government in crises. This became famously known as the “Bernanke put,” a term referring to the former Fed chairman Ben Bernanke’s willingness to bail out “structurally significant” institutions during the Great Recession. It means the Fed will pump vast amounts of new money into the economy, reduce interest rates to near zero, and bail out failing companies in the hope that it will prop up a faltering economy.
Because of this financial turmoil, two things have emerged that should give us pause. One is that we are seeing moral hazard in play in real time. The Bernanke put apparently has encouraged risky behavior by banks. The other thing is that it reveals the fragility of our financial infrastructure. Liquidity, the ability of capital to go where it is needed, is tight, a symptom of the instability of our capital markets. Since capital sustains our economy, it is, as they say on Wall Street, risk off.
THIS ARTICLE ORIGINALLY POSTED HERE.