Look deeper into the latest US banking crisis, and the cause may come as a surprise to anyone still thinking in terms of the crash of 2008. It wasn’t dodgy loans to impecunious homebuyers that sank Silicon Valley Bank (SVB). It was a stash of what are thought to be the safest securities on Earth: US Treasuries.
Those loans to the government were, of course, entirely safe in a very important sense. Uncle Sam is going to be good for the cash. (Set aside an unforeseen disaster with the debt ceiling — more on which in a moment.) But the final repayment date of SVB’s bonds was typically years away. The problem is what happens to their price in the meantime. Purchased during a time of ultra-low interest rates, those long-maturity Treasuries were always liable to lose their immediate resale value if rates took off. Which they’ve done in a big way over the past year.
The Federal Reserve raised rates at the fastest pace in decades to tame inflation, pushing its key policy rate from about zero to a range of 4.75% to 5%. Treasury prices spiralled downward, since bond prices move in the opposite direction of rates. That is only an immediate problem for someone who wants to sell a bond before it matures. Unfortunately for SVB, it fell into that category. Its clients, many of whom had much more than US$250,000 ($332,305) — the cap on federal deposit insurance — at the bank, got nervous and started yanking out their money. SVB could only sell Treasury holdings, as well as mortgage bonds backed by government agencies, at steep losses. The bank collapsed within days.
“We always refer to Treasuries as the world’s safest asset,” says Paul McCulley, the former chief economist for Pacific Investment Management Co. “That’s from the standpoint of credit quality. That’s not from the standpoint of asset price stability. There’s a huge difference.”
Kim Forrest, chief investment officer of Pittsburgh-based Bokeh Capital Partners, says she cannot get over how SVB bankers failed to spot the duration risk they were taking. “It’s kind of head-spinning,” she says. “They have to really know the parameters of what is going to happen to these bonds, given the forecasts for interest rates. What the heck happened? The supposedly bright people out in Silicon Valley couldn’t put that together and do a little calculus?”
Most banks do not have as many uninsured deposits from jumpy tech start-ups as SVB did, but US lenders hold more than US$4 trillion in government-backed securities. And Treasuries last year posted their worst losses since at least the early 1970s, with the longest-dated ones tumbling almost 30%. That is one reason fear of bank contagion won’t go away, even after the Department of the Treasury, the Fed and the Federal Deposit Insurance Corp (FDIC) swooped in to offer emergency protection for all depositors at SVB and New York’s Signature Bank, which collapsed around the same time. Policymakers have not said for sure whether other lenders will enjoy the same cover. Deposits have continued to flow out of banks — especially smaller, regional ones.
See also: China regulator is looking for buyers of SVB’s local venture
The Fed loaned billions to banks after SVB’s collapse to ensure their liquidity, including new emergency programs that offered generous terms for borrowing against Treasuries and other bonds that had lost value. Essentially, the central bank — which already holds trillions of dollars’ worth of the low-yielding debt issued in the pandemic — was taking even more interest-rate risk out of the banking system.
But the Fed is also pushing ahead with monetary tightening. It raised rates another quarter of a percentage point on March 22. Bond prices have rallied anyway, because markets think Chair Jerome Powell and his colleagues will change course. If they do not, that could spell more losses for Treasuries — and more trouble for banks that hold them.
Rising rates are not the only problem in the US$24 trillion Treasury market. Another is a long-standing concern about the market’s liquidity — essentially, the ease with which trades can be carried out. Many institutions and businesses count on the Treasury market to function smoothly. The past month’s fear and uncertainty has created near-unprecedented volatility, with the largest swings in some yields seen in 40 years. Liquidity was “significantly compromised”, JPMorgan Chase & Co strategists told clients in mid-March, as trading in Treasuries surged to a record US$1.5 trillion on one day.
See also: Blackstone's Schwarzman says US banking crisis is 'solvable'
There are various explanations of the liquidity problem. Treasury debt has ballooned by more than US$7 trillion since the end of 2019, and there is a widespread belief that the size of the market has outstripped the capacity of bank dealers to keep it orderly. Many say regulations imposed on banks after the 2008 financial crisis have also crimped dealers’ ability to keep enough bonds on hand to make sure buying and selling proceeds without hiccups. The Fed, Treasury and other regulators have been working for years on proposed fixes, but change has been slow in coming.
Then there is the looming debt ceiling standoff — the possibility that politicians will not reach a compromise on raising the nation’s self-imposed borrowing limit. Failure to do so before the Treasury runs out of ways to keep funding government spending could potentially trigger an unprecedented default on US public debt and throw a wrench into the global financial system that relies on Treasuries. The 2011 debt ceiling episode spurred S&P Global Ratings to downgrade US government bonds from the top AAA rating, days after a deal to lift the limit and avert default was reached.
The recurring fights in Washington over debt limits may be one reason investors around the world have been showing more interest in potential alternatives to US Treasuries as a safe place to store wealth. Another is America’s aggressive use of financial sanctions, including the freezing of Russian central bank assets after the invasion of Ukraine, which has left some countries that hold lots of Treasuries wondering: Could that happen to us, too, someday? Global alternatives that sometimes get touted include old favourites such as gold, new monetary units based on commodity baskets, or the currencies of other large economies, like China’s yuan — even though it’s hard to make a persuasive case that any of them are better than Treasuries.
For many American investors seeking a riskfree asset, cash seems like the best option. Below the US$250,000 cap on FDIC insurance, a bank account is reliable. But many individual and institutional savers alike have over the past months been seeking other options, like higher-yielding US money funds — which just attracted their biggest weekly influx since early in the pandemic. Those funds invest heavily in Treasuries, though at very short maturities that largely protect them from interest-rate risk. As rates go up, the funds can keep rolling over their holdings and pay investors the new higher rates.
How much more volatility is in store for Treasuries — and how much more damage the financial system suffers as a result — mostly hinges on the Fed. History suggests the US central bank has a poor track record when it comes to pulling off a major policy shift without something blowing up. SVB is already Exhibit A for this cycle.
McCulley recalls the wrecking of the US savings and loan industry in the 1980s — smallish mortgage lenders who went bust partly as a result of the same kind of duration risk that is piled up on bank balance sheets today. He points out that the Fed has been raising rates at the fastest pace since back then, when former chair Paul Volcker oversaw the inflation fight. And he says his key question for the Fed is this: “For the last year you’ve been channelling Paul Volcker. How much Volcker is too much Volcker?” — Bloomberg Businessweek
