To The Moon

The failure of Silicon Valley Bank ($SVB Financial Group(SIVBQ)$ ) – as well as that of Signature Bank and many others seemingly on the brink of collapse – gets attributed to social media-driven fear in the minds of depositors and investors. In other words, some might argue that there is no cause for concern: the financial sector – while not perfect – is quite robust.

In actuality, a vicious cycle of risky business activities interplaying with government action in recent times exacerbated and laid bare the shaky foundations of the financial services sector. An important key to understanding this is to examine how U.S. government debt issuances are consumed by the financial giants of the world.

Why Treasuries Are Key For Banks’ Market Activity

Ordinarily, banks use cash from customers’ deposits to provide loans to businesses and individuals. The interest payments on these loans ensure that the customers’ deposits used are effectively earning a (modest) payment, along with the banks earning a (often substantial) profit as well. Over the course of the pandemic and its associated lockdowns, borrowers wound down borrowing for business purposes while the massive disbursement made by the government under various schemes meant that past borrowers often paid down their debts. For instance, commercial real estate developers and car dealerships declined to borrow to expand their businesses while high-interest-rate credit card holders paid their debts off with government stimulus packages. If debts are paid off, there is no interest receivable – which means that there is no cash stream to fund the interest payments on deposits or profits for the banks.

This is when the banks began to buy large chunks of what had lately been the least attractive asset to own: government bonds. After all, a yield that is slightly better than zero at no risk is better than no yield. The Federal Reserve had been inactive on the issue of creeping inflation for years by now and had been propping up the U.S. government’s ever-increasing debt issuances by holding it, thereby effectively acting as a “market maker” of sorts. By all means it sounded like a best choice under the circumstances.

Theoretically, US Treasuries are supposed to be held to maturity wherein the holder gets paid. After all, a Treasury Bond is a loan undertaken by the U.S. government, which then pays it off at the end of the specified period. However, the Basel III reforms enacted to regulate banks’ investment activities added another form of utilization: non-cash collateral. The Basel III framework demanded that banks set aside even more “additional capital” against the cash they set aside for trading and risk-taking than they had before. The rules effectively penalized banks if they were to fund themselves with short-term unsecured deposits to invest in longer-term assets. A cash deposit made in a customer account that can be withdrawn at a moment’s notice cannot necessarily be considered “safe cash” set aside to cover cash used in trading. Banks were required to access high-quality liquid assets (“HQLA”) in a significantly greater volume than before to cushion their investment activities. Naturally, U.S. Treasuries proved to be the natural beneficiary of this demand.

It wasn’t necessary that only an investment bank could hold U.S. Treasuries; a smaller regional bank could lend U.S. Treasuries from their vault to another party – a large investment bank, for example – for a fee. Banks are in the business of making loans, after all. When markets are in boom, U.S. Treasuries as non-cash collateral remained in high demand all over the world.

Things Take a Turn

When the Federal Reserve couldn’t ignore rising costs hurting citizens any more, it finally began to raise rates – which was arguably long overdue. The U.S. government’s debt issuances, thus, came with a higher yield than the several trillions in debt already in circulation. This began to affect the balance sheets of banks awash in U.S. Treasuries. At the end of 2022, Bank of America ( $Bank of America(BAC)$ ) held US$ 3 trillion worth of debt securities, which was represented at a value of $862 billion. While accounting rules specify that banks don’t have to record losses due to change in value of these securities unless they were sold, the bank recorded $114 billion as “unrealized losses” for its bond portfolio. Wells Fargo ($Wells Fargo(WFC)$ ) recorded $41 billion; JP Morgan ( $JPMorgan Chase(JPM)$ ) recorded $36 billion and so forth.

It bears remembering that this is an entirely voluntary disclosure. At the time when regulators were seizing Silicon Valley Bank, unrealized losses of $15 billion were estimated on a bond portfolio of just $91 billion. The bank had tangible capital amounting to a total of just $16 billion. Silicon Valley also specialized in “venture debt” wherein the company made unsecured loans on new tech companies and start-ups who also maintained deposits in that bank. When the rate hikes made their debt more expensive, they pulled their deposits. When deposits were pulled, the bank had to liquidate its assets. It started with an attempt to sell a portion of its U.S. Treasury portfolio. After several attempts, the bank managed to sell its bond portfolio with a book value of $23.97 billion at a $1.8 billion loss to Goldman Sachs.

One reason a loss had to be booked when considering U.S. debt is that the market had shrunk to a handful of participants. Chief among them are foreign central banks who buy U.S. debt issuances as policy tools. Given that these issuances guarantee delivery of the U.S. dollar, it could be considered as a proxy of the U.S. dollar to balance the books of trade. However, the highs of the U.S. dollar have created the need for foreign central banks to defend their currencies. The U.S. central bank’s Foreign and International Monetary Authorities (FIMA) repurchase agreement facility, established in March 2020 to enable foreign central banks to post their US Treasury holdings as collateral in exchange for U.S. dollars, recorded the fastest liquidation of U.S. Treasury holdings in nine years after US$90 billion in cash was pulled.

Only about 30% of the U.S. government’s debt is held by foreign entities. The rest of it is owned domestically. One such holder is the Federal Reserve itself with over US$7 trillion. Recently, it has estimated an unrealized loss of over one trillion dollars.

While U.S. banks have collectively declared over $620 billion in unrealized losses, some recent studies estimate actual unrealized losses for the banks to be at over one US$ 1.7 trillion. In other words, the unrealized losses declared are still some way away from the actual picture in the present.

It’s not just U.S. Treasuries that are burgeoning with unrealized losses. Mortgage-backed instruments – where are guaranteed by the U.S. government – also are leading in unrealized losses.

Mortgage loans have seen rising interest rates which, in turn, have had a couple of interesting effects: homeowners with “locked-in” low rates from 2020 or 2021 are unlikely to prepay or refinance while home-buying activity is expected to be grim this year. Since the bank holding the mortgage-backed bond is also “locked-in”, there isn’t enough capital for banks to provide for newly-issued mortgages. This will create significant downward pressure on the mortgage market.

On the commercial mortgage space, frenzied commercial building activity in the U.S. over the past several years might have led to a gross overshooting of demand. The CBRE estimates that roughly 1 in 5 office buildings are currently vacant, with net availability in cubic feet terms being grossly outsized relative to net absorption. 

Nearly US$30 billion of the approximately US$160 billion in commercial real estate loans maturing in 2023 are now past due. A key segment that has provided commercial real estate (CRE) loans is the small regional small bank. Unfortunately, this means that the stressors on these banks are far from diminished.

In Conclusion

Silicon Valley Bank’s collapse evoked an interesting response from the government: instead of limiting the protection of deposit accounts at US$250,000, the U.S. government guaranteed that the entirety of deposits was safeguarded while the bank’s stock and bond holders were left high and dry. This is entirely different from the level of protection accorded to big banks, which are deemed “Systematically Important Banks” (SIBs), and indicative of a two-tier system in place where there should be none. Nonetheless, the divergence in the rescue operation for depositors at SVB evokes hope that similar protection would be extended to other small banks despite the fact that the U.S. Treasury Secretary has remained non-committal in stating so outright. An omission of statement is a cause for stress in the lower end of the spectrum of banks that comprise the financial services sector. This also imparts a survivability bias towards the SIBs and those closest to them than the rest.

While sky-high U.S. dollar valuations continue to trigger Treasury selloffs from foreign central banks and a downward pressure on U.S. debt valuations, they also create lower depositary balances as rising costs eat into savings. This, in turn, will continue to trigger further rate hikes and continue to lower valuations of past U.S. debt issuances. This is yet another vicious cycle at play in this sector. For the two vicious cycles to end, there has to be further reformation of banking activities as well as a string of indicators signifying a sustained climb-down of both the U.S. dollar as well as living costs. At this current juncture, it is impossible to predict this happening any time this year with certainty. A close eye is merited on events and indicators as they transpire and update respectively.

For investors, tactical bets on some of the key players in the sector exposure might work out to be an interesting strategy to explore, given that this sector will continue to bear witness to volatility. For instance, sophisticated investors can consider ETP plays on both the upside and downside for:

• JP Morgan with $2X JPMORGAN ETP(JPM2.UK)$ on the upside and $SJPM on the downside;

• Citi with $CIT2 on the upside and $CITS on the downside;

• Goldman Sachs with $GS2 on the upside and $SGS on the downside.

A larger sector-wide play can be considered on the Financial Select Sector SPDR Fund (XLF) – which is a market cap-weighted benchmark for the entire U.S. financial sector. The $XLF3 ETP is available for the upside while the $XL3S ETP is available for the downside of this play.

For articles on broader events and topics in Asia such as culture, business and so forth, visit asianomics.substack.com