Wednesday, March 15, 2023
Those of us who lived through the Bear Stearns, Lehman Brothers and Washington Mutual (to sadly only name a few) financial collapses are shuddering at the thought history may be about to repeat itself. Thankfully, as we wrote about in Monday’s blog, there are important reasons why we think this time may in fact be different. Unlike the subprime mortgage-backed securities and esoteric collateralized debt obligations that turned out to be toxic assets and were ultimately (near) worthless, the securities at issue today are AAA-rated U.S. Treasury and Agency mortgage-backed securities. However, despite the fact that these securities will mature at par (there is virtually zero default risk), the aggressive Federal Reserve (Fed) rate hiking campaign has put downward pressure on older bond prices and these securities are trading at deep discounts to par. Shown below is a representative basket of Treasury securities (but not the ones on any one bank’s balance sheet) that currently trade, on average, at $90, which generates $10 of unrealized losses.
The sudden bank run, and subsequent need for capital, forced Silicon Valley Bank (SVB) to liquidate assets at these deep discounts, which turned these unrealized losses into realized losses and turned a liquidity crisis into a solvency crisis. However, while it was too late for SVB, the Fed introduced a new facility (the Bank Term Funding Program) that will act as an additional source of liquidity for high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress. A key element of the program is that if an eligible financial institution needs to raise capital quickly (in the event of a bank run, for example) it won’t need to sell its discounted debt. It can use existing bonds that are trading at discounts to par as collateral and receive new securities that are trading at par. This will allow banks to fund potential deposit outflows without realizing losses on depreciated securities, which would likely prevent another SVB type scenario from happening again.
So what’s next for the Fed? The Fed is certainly in a difficult position with the need to balance financial stability risks but also still fight elevated inflationary pressures. This week’s consumer price index shows the Fed still has more work to do. As such, we think the Fed is on pace to hike the fed funds rate another 0.25% next week, but with more signs showing the economy is weakening, the Fed may be close to the end of its rate hiking campaign. And while the SVB failure may bring back bad memories of the Global Financial Crisis, we do not think history is about to repeat itself.
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