Photo source: New York Times, 2020
On March 12 and 13th two substantial bank failures rocked the US financial system and put other financial stocks into a tailspin. Over the weekend, the Federal Reserve, Treasury Department, and Federal Deposit Insurance Corporation worked to put together a bandage before markets opened in Asia.
On Sunday, we were informed that all depositors in Silicon Valley and Signature Banks would be made whole, regardless of the size of their deposits. This move came after ceaseless belly-aching from tech-affiliated CEOs and fund managers on Twitter, who confidently asserted that a refusal to backstop large deposits would lead to many more small bank failures.
The FDIC will backstop large deposits, without using taxpayer dollars, by using the war chest of funds it has collected from insurance premiums in years past. This war chest is called the Federal Deposit Insurance Fund, and the plan is essentially to burn through it faster than they otherwise would. Imagine that you have an auto insurance policy with State Farm with an umbrella (the absolute maximum that they will pay out on a loss event) of $250,000. But then, you plow your car straight into the load bearing wall of a 10 million dollar office building.
Much of the structure collapses and the whole thing is rendered a total loss. You, the insured, are now responsible for $9,750,000 of damage. However, let's say you're really good friends with the CEO and CFO of State Farm, in the same way that Silicon Valley Bank's board was stacked with friends of the Democratic Party. State Farm agrees to cover all losses instead of just the $250,000 you are entitled to, but don't worry, they won't need to charge their customers to make this happen.
State Farm is simply going to take money out of their reserve fund, which its other customers have paid in over several years to pay the claims their policies entitle them to, and use it for your claim! Like State Farm in this example, there's a limit to the FDIC's ability to do this. They've also opened themselves up to significant losses having pulled this lever. The limit is the amount of assets in the Deposit Insurance Fund, which as of December 2022 was $128.8 billion. $122 billion of those assets are US Treasury Bonds, which they reported a $3 billion unrealized loss on, similar to Silicon Valley Bank.
Treasury, the Fed, and FDIC have bet all their chips on the expectation that backstopping SVB and Signature will convince depositors of other banks that their money is safe, eliminating the risk of more runs. However, they've also tacitly agreed to more excess deposit insurance payouts in the event that they're wrong. Even with SVB's 94 percent of depositors uninsured, two banks are not going to suck the insurance fund dry. But another cascade of failures would, and it would not be the first time. The FDIC fund went into the red after losses in 2008 and 2009, and its sister organization, the Federal Savings and Loan Insurance Corporation, saw its fund go negative during the S&L Crisis. The 2009 losses were plugged with a forced loan from member banks. The 1980s losses were plugged with $124 billion taxpayer dollars over several years. Both incidents resulted in taxes on the economy, regardless of the source of funds.
The Fed also announced a "temporary" facility called the Bank Term Funding Program (BTFP) to help banks meet cash obligations in the months ahead, and it's a sweeter deal than bankers could've hoped for.
Imagine that you're having trouble paying your bills and manage to arrange a deal with an oddly generous banker. You bought your car new and it has since depreciated by 30 percent. Despite the depreciation, the banker will allow you to post the title to the car as collateral for a loan, and they loan you as much as you paid for it. 100 cents on the dollar.
The Fed knows that many banks are sitting on bonds that pay ultra low rates and have depreciated 20 to 30 percent since March 2022. This BTF program allows banks to post those underwater bonds, worth 70 to 80 cents on the dollar, and receive 100 cents on the dollar for them in loans. The loans will be for terms of up to a year and banks will be charged an interest rate barely higher than the market rate. Oh and by the way, the Treasury covers any of the Fed's losses.
The announcement of these soft bailouts appeared to calm markets on March 13th, but bank stocks and bank bonds crossed back into the red as of the market close on March 15th.
S&P Financials Sector ETF (XLF) is down 8.6 percent on a 5 day basis
Credit Suisse is down 18.4 percent (CS)
Pacwest (PACW) is down 48 percent.
First Republic Bank (FRC) down 67.1 percent
Perhaps the most telling indicators, developed government bond yields, are still cautioning danger ahead. Bond yields move opposite bond prices, so a rapid drop signals a rapid surge in bond prices, indicating a sudden surge in buying pressure. It's often called the "flight to safety" trade. The US 2 year yield has fallen an entire percentage point over the course of a week.
Market prices are useful in that they often provide signals as to what's ahead, and these market prices are saying Signature and SVB are not the last financial institutions to face trouble.