Silicon Valley Bank: A Lesson In Liquidity
This is a fascinating tale of what we have discussed for over a year. When you know where to look for warning signs, they become clear. Where those end up manifesting is tough, but knowing something is wrong is helpful.
How long have we talked about the yield curve and the warnings it was presenting? Many will discount it as nothing yet we get situations like this.
To quickly recap, the yield curve, both LIBOR and Treasury, has been telling us for a year that inflation and growth expectations are tempered. This means that, over time, they were going to collapse. Of course, in this world of short attention spans, this does not mean by the next report.
The bond market was telling us something else. Things are very sick, something many want to ignore. When you have the 3 mo paying 100 basis points higher than a 10 year, we end up with no demand for long date bonds. This is a problem.
SVB got caught in a position where liquidity dried up. Do not think for a second this is the last bank to see this fate. We are going to have many smaller banks (non national mega banks) encounter the similar problem.
Understand how banks operate reveals the entire situation.
So let's take a look and see what we are dealing with.
Trading Account Versus Book Value
Bond have a par value along with a coupon rate. A 10-Y Treasury will have a par value of, say, $10,000 with a coupon rate of 1.5%. This means the bond pays $150 per year for 10 years. This was the case a couple years ago.
Now, due to increase in rates, we have the 10-Y at 3.75%. That means, for $10K, the bond will pay $375 per year.
If a new bond is yielding that, why is someone going to pay $10K for $150 per year? The answer is they will not. That means the value of the first bond drops, by like 60%. That means we are dealing with a bond that has a value of $4,000.
This is what the market is telling us. It is also what led some to claim that the bank was hiding losses. It was not.
When a bond is on the balance sheet as book value, it is not mark-to-market. Why is that? Because the bond is going to garner $10K at maturity. The par value is paid up along with the last interest payment at that time. Hence, any instituion holding bonds to maturity know exactly what they will get.
So far, so good. It is not a difficult concept once you know how things work.
Liquidity Crisis
What happened with SVB is people started to want to get their money. This is where the term bank run comes from. Since banks are not sitting on the deposits in cash (which is impossible since people want to be paid interest), there is not enough cash. Here is where liquidity funding enters.
Interest rates going up the past year means that many of the long dated bonds were now worth a great deal less than they were before. Hence, when SVB went to sell them, they were getting 30%, 40% or 50% of the par value. It is likely the bank made no plans for rising rates and had a lot of long end securities (they had mortgage backed securities too).
Things really escalated when you exit the trading hours of traditional markets. Here is where the weekend liquidity crisis can crop up. Without the ability to secure short term funding (to get them to whem markets open), they are screwed. Here is where SVB ran into a wall.
Having hundreds of billions in assets is of no use if you cannot put you hands on a couple billion in liquid form. This is where SVB was a couple days ago.
Short Term Lending
We talked a great deal about the Eurodollar system. This provides an estimated 90% of the funding for global trade. Few understand this market since it is not something they deal with on a regular basis. That said, they do enjoy the benefits of it.
Liquidity is crucial for financial institutions. It crops up all over the place. For example, how do you have $7,000 in your account the day after selling the stock? Stock transactions take a number of days to settle. By rights, you should not have access to that money for 3 days. Yet, here you can trade again the next morning.
The reason is the brokerage firm entered the short term funding market and borrowed the cash if needed. This is how it can keep all its customers going even though transactions are not settled.
So now Janet Yellen is promosing no bailouts. Instead, they are going down the path of bail ins, just like Europe did a 15 years ago. This will make everyone happy since we all know how the masses hate bailouts.
Of course, now that many tech companies, including small businesses, do not have access to their accounts, how are they going to make payroll. The contagian from this is going to be widespread.
The decisions made 15 years ago took place during an election year. We know how these things work. This year is not.
That means they will favor the rhetoric, while promising to protect the depositors.
I am sure many of the companies in Silicon Valley had payrolls more than $250K per pay period.
So much for that money.
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