The Federal Reserve's prolonged period of low interest rates created many financial dislocations that are now flaring up.
Case in point: Silicon Valley Bank imploded in a single day after surging interest rates caused it to sell a bond portfolio at a huge loss.
The situation is an example of how low-interest-rate risk-taking can backfire as financial conditions tighten.
The market on Friday watched as regulators shut the doors at Silicon Valley Bank, capping off a speedy decline and marking the biggest bank failure since 2008.
The bank's collapse was a byproduct of the Federal Reserve's hiking of interest rates by 1,700% in less than a year. Once risk-free Treasurys started generating more attractive returns than what SVB was offering, people started withdrawing their money, and the bank needed a quick way to pay them. They were ultimately forced to sell their loan portfolio at a huge loss.
The chaotic episode showed that the Fed's aggressive interest rate hiking regime could upend institutions that were once thought to be relatively stable. It appears that any rate sensitivity is about to be laid bare, and past risk-taking behavior held accountable.
"When you raise interest rates quickly, after 15 years of overstimulating the economy with near-zero rates, to not imagine that there's not leverage in every pocket of society that will be stressed is a naive imagining," Lundy Wright, partner at Weiss Multi-Strategy Advisers, told my colleague Phil Rosen on Friday.
There are already two recent high-profile examples not specific to the banking system, but still indicative of the pressure being caused by higher rates.
The first has been the collapse of the cryptocurrency market. Since the Fed started raising interest rates in March 2021, bitcoin — formerly a highly touted inflation hedge — has plunged more than 65%. This asset-price pressure helped contribute to the demise of FTX, which is facing criminal proceedings, and crypto bank Silvergate, which just this week went into liquidation. There's also been the double-digit decline in high-growth tech stocks over the same period.
The big questions now become what rate-sensitive areas will be next to feel the pain, and whether there's any real risk of financial-system contagion. But before that, a bit of background.
New rate cycle brings 'perfect storm'
SVB's collapse is a perfect example of the kinds of dislocations that are exposed when rate cycles shift.
Back in 2020 and 2021, tech startups were buzzing with sky-high valuations, stock prices were soaring to record highs on an almost weekly basis, and everyone was flush with cash thanks to trillions of dollars of stimulus from the government.
In this environment, Silicon Valley Bank, which had became the go-to bank for start-ups, thrived. Its deposits more than tripled from $62 billion at the end of 2019 to $189 billion at the end of 2021. After receiving more than $120 billion in deposits in a relatively short period of time, SVB had to put that money to work, and it's loan book wasn't big enough to absorb the massive influx in cash.
So, SVB did a normal thing for a bank — just under terms that ended up working against it. It purchased US Treasury bonds and mortgage backed securities. Fast forward to March 16, 2022 when the Fed embarked on its first interest rate hike. Since then, interest rates have soared from 0.25% to 4.50% today.
Suddenly, SVB's portfolio of long-term bonds, which yielded an average of just 1.6%, were a lot less attractive than a 2-year US Treasury Note that offered nearly triple that yield. Bond prices plunged, creating billions of dollars in paper losses for SVB.
Ongoing pressure on tech valuations and a closed IPO market led to falling deposits at the bank. That spurred SVB to sell $21 billion of bonds at a loss of $1.8 billion, all in an effort to shore up its liquidity but which essentially led to a run on the bank.
As Deutsche Bank analysts put it on Friday, shortly before regulators stepped in:
"It is not a stretch to say that this episode is emblematic of the higher-for-longer rate regime we appear to be at the start of, as well as inverted curves, and a tech venture capital industry that's been seeing much tougher times of late. The perfect storm of all the things we've been worrying about in this cycle."
What's next? Is there risk of contagion?
When it comes to representing the risk of aggressive low-interest-rate behavior, SVB is the latest and greatest example, and the tip of a bigger iceberg of rate-sensitive areas. So which ones are especially at risk?
Commercial real estate should be a a top worry for investors because there is more than $60 billion in fixed rate loans that will soon require refinancing at higher interest rates. Additionally, there is more than $140 billion in floating rate commercial mortgage backed securities that will mature in the next two years, according to Goldman Sachs.
"Floating rate borrowers will have to reset interest rate hedges to extend their mortgage, a costly proposition," Goldman Sachs chief credit strategist Lofti Karoui said in a recent note. "We expect that delinquencies will pick up among floating rate loan borrowers, particularly on properties such as offices facing secular headwinds."
And there have already been some sizable defaults in commercial real estate this year, with PIMCO's Columbia Property Trust recently defaulting on a $1.7 billion loan tied to commercial real estate in Manhattan, San Francisco, and Boston.
The stock market is taking notice as well, with shares of office REIT companies like Alexandria Real Estate Equities, Boston Properties, and Vornado Realty Trust all falling more than 5% on Friday. Shares of Boston Properties fell to its lowest level since 2009, while shares of Vornado hit its lowest level since 1996.
If this sounds grim, fear not: despite all of the drama, it's hard to see the downfall of SVB leading to lasting damage across the wider financial sector for two main reasons. First, banks are extremely well capitalized thanks to strict post-Great Financial Crisis banking rules. Second, few banks have such a concentrated exposure to risky start-up companies like SVB.
But there is something that all banks need to pay close attention to, and that's the risk associated with higher interest rates and its impact on their deposit levels, fixed-income holdings, and earnings.
Signs have already begun to emerge that firms especially reliant on deposits could soon be under pressure. Deposit outflows have ramped up across all FDICinsured institutions in recent months as customers opt for higher-yielding treasury bonds and money market funds.
It was ultimately the deposit-reliant nature of SVB's balance sheet that left it so vulnerable. Once people started yanking their money out, it was over.
And perhaps most ominously, SVB likely isn't the only bank that's sitting on billions of dollars of paper losses on their bond portfolio, so watch out for further rate-driven ripples.
"Silicon Valley Bank and First Republic have emerged as the first cases of banks with business models and balance sheets that are ill-prepared for a rising interest rate environment and the ever-growing risk of a recession," Levitt told Insider. "Investors, smelling blood, then turn their attention to the next bank exposed to interest rate risk and specific credit risk, and then the next."
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