Although the latest banking crisis seems to have some similarities with the financial crisis in 2008, there are some notable differences as well.
One big difference is that we have high consumer price inflation right now that wasn’t the case in 2008. This is probably the big story because the Fed is in a position that makes it more difficult to give unlimited bailouts.
The Fed has already reignited QE, or whatever you want to call it. The balance sheet expanded by hundreds of billions of dollars in March despite its policy of not rolling over $95 billion per month in maturing debt.
We’ll see if the Fed’s balance sheet starts declining again, but it just shows that things can change very quickly. Even if it does start declining again, we could get hit with another bank failure and another Fed bailout at any time.
So while the Fed seemed committed to fighting price inflation (that it created), it seems to be more committed to bailing out bank depositors.
The Fed Takes Away the High
While there is much responsibility to go around, it is hard not to blame the Fed as the primary culprit of the shaky banking system. The Fed’s boom/ bust policies, with wild swings in interest rates, has caused this problem.
The real problem is having any central bank or central authority with a monopoly over the supply of money. But stepping into our statist world of central banking, the Fed has still done far more damage than what could have been. If the Fed hadn’t been so crazy lowering interest rates to near zero and massively creating new money out of thin air, then we wouldn’t be where we are now.
There are many consequences to the loose money. It distorts the economy in many ways. It misallocates resources, and it encourages spending over saving. The consequence that is noticeable – rising consumer prices – finally showed up in 2022. Now the Fed is forced to deal with it.
So now we have gone from near-zero interest rates to interest rates at 3% or 4% or higher.
Why SVB Failed
In 2008, banks and other financial institutions started failing largely because of an implosion of the housing bubble. The financial institutions had stupidly made loans to many people that would not be able to meet the monthly payment obligations.
In addition, they made many loans with very low down payments, so house buyers had very little equity going into the deal.
Of course, this was all fueled by the Fed’s easy money policy before that, but the financial institutions are still partially to blame.
When housing prices started falling, many homeowners were underwater in their mortgage. The house they owned was worth less than the mortgage. So they decided to make a smart financial decision and not pay the mortgage. You can argue whether or not this is the moral thing to do, but it did make financial sense.
The banks were stuck with loans where people were defaulting. This was a large part of the bank failures.
In the case of Silicon Valley Bank (SVB), they weren’t giving out crazy loans to homeowners. They were giving out crazy loans to the government.
Yes, that’s right. The big risky asset that sunk SVB was buying government bonds.
Someone looking at SVB’s financial statements could have easily determined that the bank was being rather conservative with depositor money.
In fact, according to this article by Simon Black, SVB had $173 billion in customer deposits but only had $74 billion in (non-government) loans as of December 31 of last year.
In our world of fractional-reserve lending, this is actually quite conservative.
A majority of depositor money at SVB was put in U.S. government bonds. And that is what sunk the bank.
The Risky Asset
We don’t normally think of government bonds as risky. One of the big risks with any asset like this is inflation. You lend out money and then get paid back in depreciating dollars.
But that’s not the problem with what happened here with SVB.
If you need to sell a government bond, then the value will depend on the current interest rate as compared to the interest rate on the bond.
SVB likely bought most of these bonds when rates were near zero. When interest rates rise, the value of the bond goes down if you need to sell it before maturity.
It makes me think that the people running the show at SVB were more stupid than reckless. They didn’t match up their time horizons.
They were buying longer-term government bonds, like 10-year bonds. But the depositors didn’t have to wait for 10 years to get their money back. They could demand their money at any time. So there was a mismatch.
If SVB had just purchased 1-month or 3-month securities instead of 10-year securities, the bank probably would have been fine. Even if there had been a good mix, it might have been fine.
If you buy a 1-month Treasury bill, you get the whole balance back in one month. If rates have gone up during that time, you can buy another one at a higher rate. If SVB had done this, it likely would have been fine even if there was an unexpected increase in the number of depositors demanding their money.
A Lesson for the Individual Investor
This is why it is so important to be diversified. Even for individuals with a longer time horizon, you can’t predict the future and should have some diversification.
If you buy a longer-term bond, it may lose value if you sell it early, especially if interest rates go higher.
You could hold the bond until maturity, and this seems risk free. But then you have the risk of inflation. When you get your principal amount back at maturity, how much purchasing power will be lost?
If you hold it for 10 years and price inflation is at 7% per year, then your initial investment will have about half the purchasing power from 10 years ago.
Bonds are useful as a hedge against deflation and a depression. They can serve a purpose in a portfolio like the permanent portfolio.
But as we have seen with SVB, U.S. government bonds can be a highly risky asset on their own.