The failure of Silicon Valley Bank and the sell-off in US banks that followed have highlighted the continuing dangers of strategies used by lenders to boost profits when interest rates are low.
For the past three years, banks have been accustomed to investing customer deposits in fixed income securities when they cannot lend. SVB, which was taken over by US regulators on Friday, is a very heavy user of the strategy: more than half of its assets are invested in securities.
But since rates rose last year, bonds bought by banks with cheap deposits have collapsed, causing paper losses of up to $600 billion. As a result, investors get a better picture of the risks that some banks are taking with excessive deposits.
In extreme cases, such as with SVB, these paper losses can lead to a death spiral where anxious depositors force banks to liquidate their portfolios, turning these paper losses into reality that may be too large for some small or even midsized banks. . That looks like an investor in bank stocks these days.
“I’ll quote my high school economics teacher who said there is no such thing as a free lunch,” said Greg Hertrich, Head of US Depository Strategy at Nomura. “I think we’re more inclined to think about the additional income that can be gained by having longer-dated assets, matching these new rising deposits.”
Starting in April 2020 and peaking two years later, nearly $4.2tn in deposits poured into US banks, according to data from the FDIC. But only 10 percent end up financing new loans. Some banks only hold these new deposits in cash. But most of the money, some $2tn, went into securities, mostly bonds. Before the pandemic, banks alone had more than $4tn in securities investments. Two years later the portfolio grew by 50 percent.
What can make low yield bonds more attractive than new credit, at least low yield government, or government guaranteed bonds, is the perception of low credit risk. And for a while, the new bonds made the bank profitable. But in retrospect it now appears that the banks may have bought above the market. And that now causes problems. Last year, the lender’s bond portfolio collapsed, resulting in losses of $600 billion, although banks did not sell bonds, much of the loss has not been realized.
“The banks are sleeping. No one expected inflation to continue this way,” said Christopher Whalen, a longtime bank analyst who heads Whalen Global Advisors. “Banks with large Treasury books have the most problems.”
Among the big banks, JPMorgan is more cautious than the others. When interest rates were low, chief executive Jamie Dimon told investors that it was “hard to justify the price of US debt” and that he “wouldn’t touch it.” [Treasuries] with a 10 foot pole”. While JPMorgan took in more than $700bn in new deposits after the pandemic, its holdings of securities during that period only increased by $200bn.
But while Bank of America’s deposits rose by $500bn after the start of the pandemic, its bond holdings rose rapidly, rising to almost $480bn. As a result, BofA’s losses last year on its securities portfolio rose to just over $110bn, or more than double the roughly $50bn losses recorded at Wells Fargo and JPMorgan.
Analysts, however, show that most banks can avoid taking losses by holding securities to maturity. This is especially true for the country’s largest banks, which can attract wholesale funding to cover outflows in deposits, and where securities losses remain small compared to their overall size. Still, at a time when banks have to offer higher interest rates to depositors, the fact that they have to hold low-yielding bonds to avoid losses can hurt their profits.
“We think the big banks will do well this year,” said Gerard Cassidy, bank analyst at RBC Securities. “It must have been a whirlwind.”
But what was just a windfall for the nation’s biggest banks could turn into a whirlwind for some smaller lenders with big bets on their collateral portfolios. Much of what happened at Silicon Valley Bank, which accumulated losses of $15bn in its bond portfolio, was only slightly less than the bank’s value.
PacWest, based in Beverly Hills, California, for example, has accumulated losses of $1 billion in its bond portfolio, enough to wipe out more than a quarter of its $4 billion in equity. Shares of PacWest have plunged 50 percent in the past week.
“Most banks don’t go bankrupt,” Whalen said. “But every bank is sitting at a loss.”