Week in Review: Who had Bank Crisis on their 2023 bingo card?
Erstwhile high-flier Silicon Valley Bancorp was seized by the FDIC on Friday after an emergency cash raise failed to gain enough support. This was the biggest FDIC rescue in US history behind Washington Mutual. On Sunday, the New York State Department of Finance seized control of Signature Bank. It looks like Silicon Valley Bank got caught betting on interest rates going down and simply did not hedge the interest rate risk on its portfolio of MBS and Treasuries. One of the goals of monetary policy right now is to restrict credit, and I guess casualties like this are to be expected.
Peter Theil supposedly told his clients to pull their money out of Silicon Valley, which started an old fashioned bank run. The stock lost 60% of its value on Thursday and didn’t open for trading on Friday. On Friday, the FDIC seized control of the institution and issued a statement saying that deposits under $250,000 are insured, and the bank would liquidate assets to at least partially cover the deposits above $250,000. Late on Sunday, the Fed established a new funding facility to help banks cover deposits in the event of a run. All Silicon Valley and Signature Bank depositors will be paid in full and have access to their funds on Monday morning, whether or not the deposits were insured. Many of Silicon Valley’s depositors are large companies who raised capital and rely on those deposits to meet payroll and pay operating expenses. Shareholders will get wiped out and senior debtholders might be looking at a recovery under 60%.
This crisis had its roots in the massive amount of money printing the Fed did in order to support the economy during COVID. One of the places the cash went was the tech sector. The amount of money flowing into the tech space started when the FAANGs were red-hot. For those unfamiliar to the acronym, this stood for Facebook, Apple, Amazon, Netflix, Google. These were the darlings of the market, similar to the Nifty Fifty of the 1970s: (Coca-Cola, Proctor and Gamble, American Express, Disney and Pfizer). Like the Nifty Fifty, institutional money managers loaded up the boat and the momentum made a lot of people look like geniuses, at least temporarily.
The sheer amount of cheap money dispensed during the pandemic had to go somewhere, and a lot went to the tech sector. Venture capital, mezzanine equity, illiquid stakes and bond issues. It also went into single family housing, and speculative real estate in places like Boise and Phoenix. The problem is that bull markets based on cheap money can reverse in a hurry when the money spigot gets turned off, and at the end of a bull market the most marginal investments get made and those are the first to fail.
One of the downsides of rock-bottom interest rates is that to generate a return enough to beat your bogey you have to reach up the risk curve since the actuarial tables couldn’t care less that interest rates are zero and the Fed is buying Treasuries to stimulate the economy. If you have to invest money like an insurance company or pension fund you have to earn enough on the assets to cover things like rising life expectancies and health care inflation. You need something like 7%. Risk-free assets don’t make enough so they have to reach up the risk curve. This generally requires investors to load up the boat with leverage, and I wonder how much of the money sloshing around in Silicon Valley is borrowed.
Is this going to turn into another 2008? I don’t think so. The financial crisis was due to a residential real estate bubble, and those are the Hurricane Katrinas of banking, especially since residential real estate is such a widely held asset by Americans. The vast majority of US residential mortgages are insured by the US Government and subprime doesn’t exist any more.
It is too early to make a lot of predictions, but I think the biggest takeaway here is that the Fed is done hiking rates. The markets were handicapping a 50 basis point hike at the March meeting last week and they closed Friday with the markets seeing only a 25 basis point hike. A banking crisis will do more to restrict the economy than another 100 basis points in the Fed Funds rate will, so unless confidence is miraculously restored the Fed doesn’t need to do anything more. The 10 year bond yield was at 3.4% at the beginning of February, and I suspect we return to those levels quickly.
What does this mean to the real estate market? A banking crisis is generally not good for real estate prices, so I would expect the real estate indices to remain under pressure. I also think that mortgage rates are going lower. It probably won’t be enough to trigger a refinancing boom, but it could bring some movement back into the purchase market. Many homeowners who are in the “hate the house but love the mortgage” situation might reconsider moving if we start seeing mortgage rates with a 5% handle on them.
Interestingly, the banking sector is in the same position it was in the 1970s. Bank deposit rates are unattractive compared to other options. This caused depositors to pull their money out of the bank in the 1970s, which was a term called disintermediation. The banks had portfolios of mortgages made in the 1960s when rates were super-low (like 3.5%) and they had to fund those assets with deposits paying 5%. Note that deposit rates were capped (that was part of FDR’s New Deal banking regulations) so people just pulled their money out and found higher returns elsewhere. It ended up causing a bank run in slow motion, and was the impetus for banking deregulation. Deregulation allowed banks to increase their deposit rates in order to attract depositors and allowed them to invest in riskier assets to cover the added cost. Needless to say, a lot of banks got in trouble and we saw the the savings and loan crisis later on as commodity prices fell, Texas real estate based on the oil economy collapsed and farmland values declined. Banking deregulation was not because of Reagan-esque free market ideology. It was due to regulatory failure that never envisioned what would happen if interest rates rose by a lot.
If we are going to re-live the 1970s (and last week’s piece talked about how we seem to be in the late 60s / early 70s type environment) then a banking crisis driven by low yielding assets combined with expensive deposits makes sense. And here we are.