Recently “Happy Talkers” were trotting out a new phrase. “Disinflationary Process.” Brought to you by the same people that came up with “Transitory Inflation.” Then Silicon Valley Bank, the 18th largest bank in the US, with over $200 billion in assets, collapses.
It is too early to know exactly what happened. However, initial reports indicate that losses in SVB’s US treasury and government guaranteed mortgage bond portfolio are what caused the collapse! Holly smokes! Imagine that! A bank invests in the world’s safest and most liquid instruments and still manages to blow themselves up! How could that happen? Is the Fed responsible? Is the entire financial system at risk? Was it avoidable?
Based on initial reports, it appears the SVB management made the classic amateur mistake of mismatching short-term assets versus long-term liabilities in a rising rate environment. The root cause of many bank failures. Nothing complicated here as far as I can tell. The bank funded themselves in short-term deposits and invested the proceeds in longer dated US treasury and mortgage securities. Interest rates increased and the value of those securities fell.
This case appears unusual as the assets themselves were unimpaired with respect to repayment, being US government backed bonds. But SVB bank management invested in bonds with longer maturities and extension risk that would lose value in a rising interest rate environment.
Should they have known? Is the bank management responsible for this disaster? If these early findings are correct, then they are. One of the most basic risk management functions of a financial institution is to properly match assets with liabilities.
And, it is a function of bank regulators to supervise banks to insure banks do not make such basic mistakes. It would appear there are holes in the bank regulatory process.
The Fed raising rates to fight inflation is being blamed by some. But this is diversion. It is the bank management’s job to monitor market risks and make changes to its portfolio, like lowering the average maturity and duration of a bond portfolio in a rising interest rate environment.
The bank management will most likely say it was impossible to forecast the increase in interest rates that caused them to collapse. But that is not true. The reality is that the train wreck of 2022 and now 2023 was easy to see coming. How easy? As easy as forecasting the 8:08 Amtrak Starlight Express is coming as one stands on the tracks at 8:05.
Easy to feel the ground start to shake in late 2021 as the inflation train was a comin’, comin’ round the bend (a Johnny Cash reference for you Boomers). Hard to miss that big inflation locomotive accelerating to 9% CPI, housing inflation up 20% while Engineer Powell & Co. still running flat out with Fed Funds at zero and suppressing mortgage rates at 3%. No coordination with fiscal policy which continued large deficit spending (and still is). The huge head light warning, get off the tracks, tighten, tighten! Cut spending! Finally, the deafening sound of the train horn right before impact: Russia invades Ukraine, more inflation! Kapowee. Still, transitory talk?!? How can anyone contend that it was impossible to predict the coming rate increases and crash given all the warnings?
As proof, many did forecast the current inflation cycle and rate rise. Larry Summers did. Jamie Dimon did. Mohamed El-Erian did. Larry Kudlow did. Bill Gross did. Jeffery Gundlach did. A number of hedge funds did, along with many others. And yes, so did Lawton on Markets. Warned people well before the crash.
In February of 2022 I advised Lawton on Markets readers to pare risk, sell risky assets, buy low-risk short-term assets, and go on a long vacation to the South Seas.(1) Does not get any more clear than that.
Then in early March 2022 I wrote a blog with the title, “30% Dop in the Long Bond?”(2) Told investors, “It is a new era. The financial history of the past forty years is over. Change your thinking, financial models and algorithms to incorporate the new reality from deflation to inflation and maybe stagflation.”
What happened? Long treasury bonds dropped over 30% as forecasted.
Would have been a five-minute exercise for the managers of SVB to calculate that they would suffer a multi-billion-dollar loss if they had read my forecast or listened to others.
It is not credible for SVB, the Wall Street Journal or many others to say it was impossible to forecast. It was easy to see coming, and many did forecast it.
So now what? Is the collapse of Silicon Valley Bank going to spread, or can it be contained?
The SVB situation itself should be able to be contained. Apparently around 12% of $173 billion in customer deposits was insured, the remainder of $151 billion will be subject to a haircut without a government bailout. Should not be that big a haircut if in fact the portfolio is primarily treasury and agency securities. Maybe a 20% haircut as a guestimate? $30 billion. Not systemically threatening.
The WSJ reported that as of the end of 2022, US banks had $620 billion of unrealized losses. That is concerning, and the contagion could spread and become a financial pandemic if Washington doesn’t deftly manage the current situation. Also places the Fed is a tight spot. Do they slow, stop or even cut rates before they have tamed inflation in order to save the financial system?
We are rooting for those in charge. Still, I would hedge my bets given their recent track record of managing both the rail system and the financial system.