The Collapse of SVB Exposes the Largest Crack in the Economy.
Today’s news of Silicon Valley Bank undergoing receivership marks the second-largest bank failure in US history. This failure was created by two important moments in time:
- Between 2020–2022, SVB purchased around $100B worth of long-dated government bonds that were yielding very low interest rates (said to have averaged around 1.5%). As interest rates rapidly rose over the past year, the value of those bonds rapidly fell.
- In reporting a several billion dollar loss relating to the sale of those bonds, the company spooked its customers into one of the largest bank runs in history.
To think, however, that Silicon Valley Bank is the only bank affected by this would be a mistake. On the other side of every single low interest rate loan issued since the beginning of the pandemic, there was a company like Silicon Valley Bank that is now marking down their balance sheet.
In early-2021 as the latest housing run-up started to intensify, the 10Y treasury (a proxy for 30Y fixed rate mortgages), was as low as 1%. With the 10Y note having reached 4% this week, the value of mortgages issued by banks has fallen at a record pace.
|UST 10Y (01-04-21)||UST 10Y (03-02-23)|
A 10Y note purchased on the first trading day of 2021 is now worth less than 80 cents on the dollar, a massive loss for an asset class that is spoken of in terms of “safety” and “risk-off”.
It’s important to note that many financially conservative institutions, pensions, and banks have historically been large consumers of bond offerings and mortgage backed securities. These conservative institutions can’t make themselves susceptible to the unpredictable swings of the stock market. However this historically unprecedented series of rate hikes has directly impacted these bond-heavy institutions who are most sensitive to losing money.
One major lesson per decade
This brings us to what I would consider to be the “one major lesson” that happens every decade in the financial world. In the 2008 crisis, a major lesson was that you can’t effectively reduce risk by bundling together lots of risky individual assets into one large bundle of assets. Ultimately, when the United States went through the largest correlated downturn since the advent of modern mortgages, we learned that even “diversified” mortgage backed securities would still create correlated losses.
This decade’s learning: bonds aren’t a universally safe asset class.
On yesterday’s call the CEO of SVB mentioned several times in an attempt to assuage the fears of their customers, that their money was parked and being re-invested in “safe government bonds”. This statement begs to clarify what the word “safe” really means. One aspect of safety, is not losing your investment due to default. Another aspect of safety, is not shouldering massive asset value losses due to macroeconomic changes.
In this case, we need to think of bonds as two separate classes: short and long-term.
It’s unlikely that anyone will get fired or force the closure of a business due to the purchase of short-term bonds. They leave one exposed to very little risk other than the risk of default, and perhaps the opportunity cost of higher returns elsewhere.
However, in the case of SVB, poorly-timed long-term bond purchases were enough to create a death spiral from which they couldn’t recover (and if they could, would have suffered billions in losses from). We can’t look at the safety of 1Y bonds and compare them with the safety of 10Y bonds when we have proof of how rapidly the government can change rates and forcefully devalue investments.
What this means going forward
An unintended side effect of the Federal Reserve’s rate hikes is that many banks and institutions are holding an unfathomable amount of low-yield debt that is now worth far less than it was a year ago. We went from a world where 100-Year Austrian bonds would pay only 0.39% yields, to one where we’re now concerned about 8-9% annual inflation, in just two years.
If institutions rightfully start deeming long-dated bonds to be a risky asset that isn't safe to hold on sensitive balance sheets, we could see bond premiums rise for these longer-dated bonds, raising the cost of capital for companies and governments alike.
This could have knock-on effects for many industries. US mortgage rates could remain higher as they’re typically tied to the 10Y treasury price and seen as long-term debt. The cost of infrastructure projects could grow massively. If a municipal bond issued to fund roadway improvements needs to pay 1% more per annum to attract investors, that could raise the overall cost of the project by more than 10%, making all future municipal projects more expensive. Going forward, I think we'll expect to see financial institutions more closely auditing their low-risk government bonds, and reconsidering the duration risk associated with their investments.
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