The phrase “In like a lion…” (1) was originally about the weather, which we have had, but it also applies to the markets. The market headlines have been dominated by the failure of three US banks and the supervised merger of two Swiss megabanks. Many fear the crisis may not be over, and there may be some basis for their concerns. The FED raised interest rates from near zero to 4.75% in the past 12 months. You just can’t raise rates that quickly without breaking something. What broke was a fast-growing bank that put their reserves in mortgage backed securities and treasuries with maturities (due to pay back) 20-30 years in the future. On the surface it sounds pretty good, and the assets are good, but when interest rates rise rapidly, it creates a problem for the banks.
Here is the amazing thing about bonds. They are boring until they are not. To explain what happened to Silicon Valley Bank, we will use a relatively simple example.
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Imagine you lent someone $1,000,000 to buy a home, and the prevailing rates for a 30-year mortgage were 3%. (For years, I’ve been saying you’d have to be crazy to do so; nevertheless, banks did). You have collateral, and the borrower has good credit, but you won’t be paid back fully for 30 years. Now imagine rates go to 6%. 6% is better than 3%, so you consider selling your mortgage to another investor so you can buy a 6% mortgage. Here is the problem: no one will pay you back the full amount of the mortgage. You must take a haircut. You loaned out $1,000,000, the banks are in a panic, and the best offer you can get for your mortgage is 70 cents on a dollar or $700,000. So, what do you do? Take a $300,000 hit to your capital, or wait it out?
If you are a bank, you need to report on the value of all your assets periodically, but you don’t want to tell your shareholders, the banking regulators, and the depositors you have a $300,000 loss. So, what do you do? If you are a bank, you can move them over to the “not for sale” (they call it “hold until maturity”) section of the balance sheet and hold them at face value. No problem, right? Sure, until someone figures out you have a substantial portion of your assets in the not-for-sale category. Then they tell their friends, and the next thing you know, deposits are disappearing, and you need cash for customer withdrawals so they can pay their mortgages and car payments. If you are an investor, maybe you wait it out, but if you are a bank, you can’t. You must raise cash. You can do this by selling stock in your company, borrowing from other banks or the FED, or selling assets. SVB tried all three. When someone, there were a few, gets wind of the issue, now you have a problem.
What is fascinating about bonds is that when interest rates go up, the price of bonds decreases. The yield drops when there is a flight to safety, like after the SVB failure, and everyone is trying to buy bonds. A rush to buy bonds happened in the weeks following the bank failures. I was buying bonds due by the end of the year paying around 5.4%. I struggled to buy the same bonds at about 4.4% the following week. Yields went down a full percentage point in a week. This rarely happens, and yet it happened this month. With some luck, March will go out like a lamb. We’ll keep you posted.
(1) Google says the phrase comes from Thomas Fuller in 1732 in in his book about Proverbs that is too long to list here…
March is a big month for me as well. It’s my birthday month, and it was a big one. I have been on the planet for six decades and still believe I have something to give and things to learn. I plan on working for as long as the above is true, which I hope is another 30 years. I appreciate the opportunity to work with you and hope you feel the same. Please let us know if you are celebrating a big event or have something to share.
Have a great month, and know we are here for you. 🏳🌈
David
